|August 7, 2013|
Previously published on August 6, 2013
One of the quintessential principles of the Bankruptcy Code is that when a debtor assumes an executory contract, it must assume the contract as a whole - a debtor cannot cherry pick the contract provisions it wants to assume while rejecting others. Two recent bankruptcy court decisions - In re Hawker Beechcraft, Inc. and In re Contract Research Solutions, Inc. - demonstrate a growing trend among debtors to test the parameters of this general rule. But they also provide guidance to parties on how they can structure their agreements to limit or expand a counterparty’s ability to selectively assume contract provisions in bankruptcy.
Section 365 of the Bankruptcy Code and the Rule Against Piecemeal Assumption
As a general rule, a debtor cannot retain the benefits of a contract without accepting its burdens, but must assume or reject a contract in its entirety. However, a single contract may be comprised of multiple agreements and a debtor can assume certain parts of a contract while rejecting others so long as the contract is divisible or severable under applicable state law. While the applicable state law will differ, the determination of whether a contract is divisible often turns on the intent of the parties as expressed by the terms of the contract.
Recent Decisions Testing Limits of the General Rule Against Piecemeal Assumption
The extent to which a contract is divisible for purposes of assumption under the Bankruptcy Code was recently addressed by two bankruptcy courts - with opposite results.
In In re Contract Research Solutions, Inc., 2013 WL 1910286 (Bankr. D. Del. May 1, 2013), the debtor sought to reject the third amendment to a real property lease that it sought to assume, arguing that it was severable from the lease and the prior two amendments because, among other things, it was for a different building. In rejecting the debtor’s argument, the Bankruptcy Court for the District of Delaware found that (1) the third amendment explicitly stated that it amended and ratified the lease, (2) the obligations in the lease and the third amendment involved the same two parties and the same subject matter, and (3) the parties’ obligations were mutually dependent and interrelated. In addition, the court found it significant that the parties had entered into a separate lease for space in another building, which demonstrated that they were capable of making a truly separate agreement. Based on these factors, the bankruptcy court held that the third amendment and the lease were a single, indivisible agreement that could not be severed.
In contrast, in In re Hawker Beechcraft, Inc., 2013 WL 2663193 (Bankr. S.D.N.Y. June 13, 2013), the Bankruptcy Court for the Southern District of New York held that a debtor could assume two master agreements while rejecting purchase orders that were issued thereunder. The bankruptcy court found that the master agreements were option contracts that gave the debtors the ability to order certain components, but, significantly, did not obligate the debtors to purchase anything. Instead, each purchase order created distinct purchase and sale obligations- the provision of parts in exchange for the payment of the purchase price of such parts. The terms of the master agreements permitted the debtors to terminate or suspend some purchase orders and perform others, as well as to terminate the master agreements without affecting pending purchase orders. Thus, the Court found that even though the purchase orders incorporated the general terms of the master agreements, they were divisible not just from the master agreements but also from other purchase orders, and could be rejected piecemeal.
Lessons for Contract Counterparties
While these two cases do not refute the long-standing rule that a contract must be assumed or rejected in its entirety, they do illustrate the flexibility of the rule and the circumstances under which bankruptcy courts are willing to allow debtors to assume or reject contracts in part. While there is no universal standard for determining whether a contract is divisible (as it will depend on the contract terms and applicable state law), these cases highlight certain factors that bankruptcy courts will likely look at: (1) whether the various parts of the contract involve the same parties and the same subject matter; (2) whether the obligations of the parties in one part are interrelated with the obligations found in another part; and (3) whether the agreement contains termination provisions that permit the termination of one part without affecting another.
Thus, creditors seeking to prevent a counterparty from assuming some parts of a contract while rejecting others, as well as parties seeking to maintain the greatest degree of flexibility in which contract terms they will need to perform upon a bankruptcy filing, need to be careful in how they structure their agreements. As these cases demonstrate, contract terms need to clearly express the parties’ intent about whether the contract is indivisible in order to be protected by, or be excepted from, the general rule against piecemeal assumption of executory contracts.