• Seventh Circuit Clarifies "Financial Accommodations" Exception To Executory Contract Assumption
  • August 10, 2004 | Author: Richard A. Graham
  • Law Firm: Weil, Gotshal & Manges LLP - New York Office
  • The United States Court of Appeals for the Seventh Circuit recently examined the "financial accommodations" exception to a debtor's power to assume executory contracts. In In re United Airlines, Inc., the debtor sought to assume a credit card processing agreement. The Seventh Circuit held that so long as the contract as a whole is not one to extend credit or make "financial accommodations to the debtor," the Bankruptcy Code's "financial accommodations" exception does not apply.

    The Power to Assume Executory Contracts Under Bankruptcy Code Section 365

    The Bankruptcy Code broadly empowers a trustee or debtor in possession, subject to bankruptcy court approval, to assume beneficial executory contracts and reject burdensome ones. Generally, when each party has remaining unperformed material obligations under a contract it is executory. Assumption binds the debtor (and the non-debtor party) to the burdens and benefits of the contract. Rejection constitutes a breach of the affected contract, but damages flowing from the breach of a rejected contract become general unsecured (nonpriority) claims subject to the bankruptcy claims resolution process.

    Section 365(c)(2) of the Bankruptcy Code places beyond the debtor's general power to assume executory contracts to extend "debt financing and financial accommodations to or for the benefit of the debtor." The policy behind the exception is the notion that parties to transactions based on the financial strength of a debtor should not be required to extend new loans to a debtor in bankruptcy. However, the Bankruptcy Code does not define "financial accommodations," so courts have struggled to establish the bounds of the section 365(c)(2) exception.

    The United Airlines Case

    In order to facilitate credit card purchases of its airline tickets, United Airlines ("United") entered into a five year agreement with merchant bank National City Bank of Kentucky and National Processing Company, LLC ("National") to handle the transactions of its customers who pay by credit card. The agreement provided that, in exchange for honoring certain credit cards, United would receive cash proceeds of the face amount of the sales transactions -- less a processing fee and less chargebacks -- after a "settlement" process, which consisted of National placing the transaction records with the appropriate credit card network for collection from the card-issuing bank.

    Chargebacks are reversals of the credit card transaction. In United's case (as with any airline), they often occur as a result of flight cancellations or itinerary changes by holders of refundable tickets. When the credit card customer refuses to pay the charge for a ticket on a cancelled flight, for example, the rules of the credit card networks made National liable to the card-issuing bank for the resulting refunds or chargebacks, whether or not it could collect them from United.

    Although National deducted processing fees from the proceeds of a given transaction before crediting United's account with the cash proceeds, chargebacks often occurred weeks or months after settlement. Thus, National was exposed to a risk of nonpayment from United with respect to chargebacks. National's agreement with United also required that United establish a reserve account to cover payment to National in the event United's bond rating fell below a specified level, which occurred prior to the bankruptcy filing. United funded the reserve account prior to its chapter 11 filing in accordance with the agreement, and was not in default at the time it filed its chapter 11 petition.

    When United sought to assume its card processing agreement with National, National asked the bankruptcy court to determine that the credit card processing agreement was a "financial accommodations" contract and thus, barred from assumption under section 365(c)(2) of the Bankruptcy Code. Alternatively, National requested that it disapprove assumption on the grounds that continued performance under the agreement would subject National to "unreasonable risk" absent the establishment of a large cash reserve of several hundred million dollars. The bankruptcy court denied National's requests and the district court affirmed the bankruptcy court's decision. National appealed to the Seventh Circuit.

    The Seventh Circuit's Decision

    While the Seventh Circuit reached the same result as the lower courts that "a trustee in bankruptcy, or a debtor in possession may assume a credit-card-processing agreement," it applied a slightly different standard in reaching its conclusion that United's agreement with National was not subject to the "financial accommodations" exception.

    The court first examined National's assertion "that the credit card system operates like a revolving line of credit" to United. National argued that the cash United received through the credit card system was, in effect, an indirect loan that United would repay by providing either airline service or a refund. Because an agreement for a direct line of credit from National to United would not be assumable, National urged that the agreement that did exist with United be treated similarly. National argued that under the agreement, United was still receiving credit, and National was exposed to the risk of United's nonpayment under circumstances in which chargebacks exceeded new sales, and United was unable to repay the difference to National.

    The court rejected the "indirect loan" argument by pointing out that National did not provide the funds for any such "loan." National advanced funds to United only after the issuing bank placed funds into the credit card system on behalf of United's customer. Thus, the court concluded that National was merely a conduit of funds, and that the only promise to make a "loan" that qualified for exception from assumption was that of the issuing bank to the cardholder. The court noted "[t]hat many small loans to passengers add up to a large cash flow for the carrier does not turn the intermediary's role into a 'financial accommodation.'"

    The Seventh Circuit then turned its attention to the chargeback process which National argued created exposure through its guarantee of United's contingent obligations should chargebacks exceed new sales. According to National, since the rules of the credit card system made it responsible to the issuing banks for chargebacks regardless of payment from United, it would become a guarantor of the contingent debt that could arise if United scaled back its operations to the extent that chargeback liability would exceed proceeds from new ticket sales. Noting that the Bankruptcy Code does not define the term "financial accommodation," the court observed that the parties agreed that guaranties or other forms of suretyship are "financial accommodations." National argued that so long as "any non-trivial part of a complex business arrangement can be called a guaranty, then none of the deal may be assumed in bankruptcy." The court disagreed that "any nontrivial" guaranty would suffice to bring a contract within the scope of the "financial accommodations" exception. Citing the language of the statute that assumption is impermissible if "such contract is a contract to make a loan, or extend other debt financing or financial accommodations," the court held that the appropriate test is whether the contract as a whole is a "financial accommodation," rather than whether a single clause could be so characterized. Otherwise, reasoned the court, nearly any contract in which the parties do not perform their duties simultaneously could be characterized as extending credit or a "financial accommodation," and the exception would swallow up the rule.

    The court agreed with the Eleventh Circuit's decision in Citizens and Southern National Bank v. Thomas B. Hamilton Co. (In re Thomas B. Hamilton Co.) (the only other appellate court to address this issue), that a court must determine the nature of the entire transaction rather than seeking to judge whether individual features may be properly characterized as loans or guaranties. However, the Seventh Circuit disagreed with the Eleventh Circuit's conclusion that a court should look to the primary purpose of a transaction. The lower courts in the United Airlines case and the Eleventh Circuit in the Hamilton case proposed to look at the "primary purpose" of the parties' transaction. The Seventh Circuit found that standard difficult to apply, since "the contents of business entities' heads are elusive," and ultimately irrelevant, since the statute does not mention purpose. The "objective" role of the loan or guaranty in the transaction rather than the "subjective" purpose of the parties ought to govern. In the case before it, the court found that National's guaranty role was small, becoming relevant only if United's balance of payments became negative, which had never actually occurred during the course of the parties' relationship. Further, the court found significant that even if its role were larger, the guaranty provision could be carved-off from the balance of the contract, since it benefited the debtor and National would be better off without a guaranty provision.

    More importantly, however, the Seventh Circuit was skeptical that there was any true guaranty that benefited the debtor in the contract United sought to assume. Because the allocation of risk to National derived from the rules governing the credit card processing system rather than its specific agreement with United, National had no contract with the debtor that would oblige it to cover the debtor's obligations to its customers. National's obligations under the rules of the payment system governing the parties transactions were extrinsic to the contract at issue and thus, should not be factored into the determination of whether the contract itself was one for credit or "financial accommodations."

    Finally, the Seventh Circuit rejected National's final argument that, even if the "financial accommodations" exception to assumption did not apply, the bankruptcy court should not have approved assumption, at least not without requiring United to set aside a "reserve of several hundred million dollars." National argued that such approval would expose it to "unreasonable risk." The court pointed out that while the Bankruptcy Code provides that debtors may assume contracts in default only by curing or providing adequate assurance of prompt cure, and by providing adequate assurance of future performance, it placed no such requirements on debtors assuming contracts not in default. The court noted that a bankruptcy judge should withhold approval of executory contracts in good standing only where assumption is not in the debtor's best interest or upon a finding that the debtor is unlikely to perform, "but not on an open-ended ground such as 'unreasonable risk' to the other contracting party." The Seventh Circuit, disagreeing with language in the Eleventh Circuit's decision in Hamilton, indicating that courts should not approve assumptions that expose the other side to "unreasonable risk," concluded that while section 365(a) of the Bankruptcy Code does require court approval of assumption, such court approval should not be contingent on reducing the other party's risk to zero.

    The Seventh Circuit noted that the contract between United and National anticipated the risk of United's deteriorating financial condition. Moreover, National bargained for higher fees and required a reserve account upon a decline in United's bond rating as consideration for the risk it was now asking the court to reduce. The Seventh Circuit advised National to take measures to decrease risk in the future, such as increasing fees, or indexing them to some measure of risk, requiring a larger reserve, and/or reducing the term of the contract.

    Conclusion

    The Seventh Circuit's decision is important because it applies a new approach that assesses the overall nature of an agreement, and how it affects the debtor. This approach does not focus on tangential aspects of the agreement that may constitute financial accommodations, but are not central to the transaction, and thus, should not preclude the debtor's ability to assume the agreement. A party's role in the transaction, and its relationship to the debtor is key. National's financial accommodation did not run to the debtor; it protected the issuing bank. This tangential aspect of the contract did not transform the debtor's contractual relationship with National into a non-assumable financial accommodation. The Seventh Circuit's approach brings new clarification to the meaning of "financial accommodation" and the kinds of contracts that the legislators had intended to exclude from the purview of assumable contracts. It will be interesting to see how other circuits confront the issue, and we will advise you of further developments.

    In re United Airlines, Inc., 368 F.3d 720 (7th Cir. 2004).

    Citizens & S. Nat'l Bank v. Thomas B. Hamilton Co. (In re Thomas B. Hamilton Co.), 969 F.2d 1014 (11th Cir. 1992).