Court Decision Reviews Key Concepts Concerning Executory Contracts
This post reviews some concepts concerning executory contracts. The ground covered will be familiar to insolvency experts and should be insightful for readers who don’t specialize in U.S. bankruptcy law.
The springboard for the overview is an opinion issued last week, In re Cho, Case No. 17-22057, 2018 LEXIS 700 (MMH) (Bankr. D. Md. Mar. 13, 2018). Before the chapter 11 case was filed, Chong Ok Lim and Young Jun (“Plaintiffs”) owned a dry cleaning business that was later owned and operated by Byung Mook Cho (“Cho”). The parties had a dispute that led to lawsuit and a judgment for the Plaintiffs. Plaintiffs later alleged that Cho and He Sook Paik (“Paik“) “conspired to fraudulently convey” the dry cleaning business to Cho.
In 2017, the parties reached an oral agreement to end the dispute. But when the agreement was put in writing (the “Settlement Agreement”), Cho would not sign it. Plaintiffs filed a motion to enforce the agreement. The state court judge ruled for the Plaintiffs, but Cho still would not sign, and Plaintiffs moved to hold him in civil contempt. Before that motion was heard, Cho and the dry cleaning business, The New Belvedere Cleaners, Inc. (together, the “Debtors”), filed for chapter 11 and then a motion to reject the Settlement Agreement.
Bankruptcy Judge Michelle H. Harner first ruled that the Settlement Agreement (which, as noted above, Cho never signed) “represents the agreement reached by the parties and should be recognized as a valid and enforceable contract.”[i] The next issue was whether the Settlement Agreement was an executory contract. The classic definition of an executory contract (and also an unexpired lease) is one where, when a bankruptcy case is filed, both parties still have unperformed obligations such that the failure of one to perform would constitute a breach of the agreement. The unperformed obligations must be material and not trivial.[ii]
The parties agreed that the Debtors still had material, unperformed obligations under the terms of the Settlement Agreement: they had to transfer the dry cleaning business and make a cash payment. But the Plaintiffs argued that their unperformed obligations were not material. They had to dismiss the state court action and claims against Paik in the bankruptcy court, and file a notice of satisfaction of claims against Paik in state court. These obligations, Judge Harner ruled, were also material because they “speak directly to the primary purpose of settling the litigation and providing finality and certainty for the parties.”[iii]
She also concluded that another term both sides agreed to — not to disparage the other — was material. She noted that some courts “have found negative covenants insufficient to render a contract executory for purposes of the [Bankruptcy] Code.”[iv] But in view of the facts of this case, Judge Harner concluded that the non-disparagement clause was material.
When a contract is executory, a debtor in a bankruptcy case can either assume or reject it. Typically, a court will respect a debtor’s business judgment. A contract can be assumed if a debtor cures defaults and gives adequate assurance of future performance.[v]
Courts will permit rejection when a debtor can show a contract is burdensome to a bankruptcy estate. Here, the Debtors said the Settlement Agreement was burdensome because it required the Debtors to transfer the business to the Plaintiffs and make a cash payment. And, Judge Harner noted, the Debtors had not acted in bad faith in seeking to reject the Settlement Agreement. Instead, they were trying to “get out from under a deal [they] now do not like.”[vi] Therefore, she granted the motion to reject.
Rejection of an executory contract constitutes a breach of the agreement just before the petition date and permits the non-breaching party to file an unsecured claim for damages. But, while the Plaintiffs could file a claim for damages, Judge Harner made clear that the law would not allow them to seek specific performance. In other words, the Plaintiffs couldn’t force the Debtors to transfer the dry cleaning business.
The benefit of this case is that it does more than address the concepts of executory contracts and assumption and rejection. It shows the power of rejection when applied to a straightforward commercial dispute over ownership of a business. Several years before the motion was granted, the Plaintiffs thought they had an agreement to settle a lawsuit with the business to transfer to them. But that didn’t happen. Motion practice in state court and a resulting bankruptcy case led to the motion to reject. And when the Court upheld the Debtors’ business judgement, the Plaintiffs were left with an unsecured claim for damages, but were unable to press for what they had negotiated for in the prior settlement discussions: possession of the business.
[i] 2018 LEXIS 700 at *15.
[ii] This definition is referred to as the Countryman definition because it was articulated by Professor Vern Countryman. Another test is referred to as the functional test: it considers if assumption or rejection (concepts discussed below) provide a benefit to a bankruptcy estate.
[iii] 2018 LEXIS 700 at *20-21.
[iv] Id. at *25.
[v] Debtors can also assume and assign executory contracts, and the assignee must provide adequate assurance of future performance.
[vi] 2018 LEXIS 700 at *29.