Dealing With Avoidance of Executory Contracts Under the Bankruptcy Code

In this article, we discuss another aspect of the US Bankruptcy Code (the “Code”) as it relates to business contracts. In a previous article, we discussed the automatic stay, which limits your rights to continue efforts to collect debts owed to your business. Here, we discuss how to protect your business from provisions in the Code allowing bankruptcy debtors to reject executory contracts. This is among the many reasons that it is important to have a corporate attorney review and draft your contracts. Every San Diego business needs a good corporate attorney to protect its best interests.

San Diego Corporate Law: Bankruptcy Statutory Framework

When a person or company files for protection under the Code, the debtor’s bankruptcy estate — directed by the appointed trustee or, sometimes, a debtor-in-possession — has the right to assume or reject executory contracts. See 11 U.S.C. § 365. The bankruptcy court must give approval for assumptions and/or rejections.

This provision applies to most contracts, since most contracts are executory. In general, there are contracts that are “executory” and contracts that are “executed.” The former is a contract where some obligation must be fulfilled in the future. As an example, your business signs a contract to deliver 10,000 units of machine parts next month. This hypothetical contract is “executory” when it was signed and the contract remains “executory” until “next month.” Other examples include:

• Unexpired leases — real estate and equipment
• Licenses — such as those allowing use of trade secrets, copyrights, etc.
• Employment contracts
• Ownership buy-sell agreements
• Contracts for the sales of goods or services — most often
• And more

Note that the Code has many provisions that apply to various categories of executory contracts. Thus, subsection (n) applies to executory licensing contracts related to “intellectual property.”

On the other hand, once delivery and payment are made, the contract becomes “executed.” Most do not realize it, but legally speaking, retail transactions are contractual in nature, and mostly, they are executed contracts. A retail sales business offers various goods at various listed prices. The customer enters the store and carries, for example, a bag of potatoes to the cashier. The customer pays for the potatoes and, now, the contract has become executed. Interestingly enough, as the customer is walking to the cashier, the contract is executory.

“Assumption” of an executory contract means that the debtor is agreeing to continue his or her or its obligations under the contract. “Rejection” of an executory contract allows the debtor to, essentially, nullify the contract. Technically, the debtor is breaching the contract, but the remedies allowed to the non-breaching party are limited by the Code.

Thus, continuing our machine parts example, if the manufacturer files for bankruptcy, the delivery contract can be rejected with the approval of the court. If approved, then the debtor cannot be required to deliver the machine parts and cannot be sued for breach of contract.

San Diego Corporate Law: Dealing With Bankruptcies in Your Contracts

Note that the rights provided by the Code are only given to the debtor. That is, with respect to our hypothetical machine parts contract, only the debtor is allowed to reject or assume the contract going forward. But, a bankruptcy is a significant commercial event. Your business may now feel that the seller or customer or contracting party is, after the bankruptcy filing, now a riskier commercial partner. Maybe your business would now prefer to obtain machine parts from a different manufacturer, one that is more financially sound.

To solve this potential problem, a good commercial contract will contain a provision that makes it an “event of default” under the agreement if one party files for protection under the Bankruptcy Code (or is forced into bankruptcy by its creditors). A typical provision would be this:

“Termination — Insolvency/Receivership: This Contract shall terminate, without notice, (i) upon either party becoming insolvent, subject to receivership or involved in proceedings, voluntarily or involuntarily, for the settlement of said party’s debts or (ii) upon the institution by or against either party of insolvency, receivership or bankruptcy proceedings or any other proceedings for the settlement of said party’s debts or (iii) upon either party making an assignment for the benefit of creditors.”

Note that clauses like these might not be enforceable as regards to a bankruptcy filing. See 11 U.S.C. §541(c) and §365(e)(1). However, it is still important to use such clauses because insolvency issues can arise even if no actual bankruptcy filing is made. Plus, you want to have as many arguments as you can have, the laws change and judges may make equitable adjustments to statutory language. As noted above, a good corporate lawyer can help ensure that your business contracts protect your business.

Contact San Diego Corporate Law Today

For more information and/or for legal advice related to dealing with bankruptcies and insolvency, contact skilled and experienced corporate attorney Michael Leonard, Esq., of San Diego Corporate Law. Mr. Leonard was named “best of the bar” three years running by the San Diego Business Journal. To schedule a consultation, contact Mr. Leonard via email or call at (858) 483-9200.

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