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New SDNY Decision on Administrative Priority for Executory Contracts

To encourage parties to transact with debtors in bankruptcy, the Bankruptcy Code in corporate bankruptcies provides highest priority to “administrative expenses,” which include “the actual, necessary costs and expenses of preserving the estate.”  11 U.S.C. § 503(b); id. § 507(a)(2).  Section 365 of the Bankruptcy Code permits the assumption or rejection of any executory contract—a contract in which the parties have ongoing duties of performance to each other when a bankruptcy case is filed—and provides that if the debtor rejects the contract, such rejection is treated as a breach occurring “immediately before the date of the filing of the petition.”  11 U.S.C. § 365.  Because section 365 treats liability from such a breach as arising pre-petition, it is not treated as an administrative expense and is usually a general unsecured claim.  The combination of these provisions therefore raises a question: what happens if there is an ongoing executory contract which, during the bankruptcy case, potentially provides benefits to the estate, but then is rejected by the debtor?  Does liability for breach in this circumstance have administrative priority?  This question was addressed in Finance of America LLC v. Mortgage Winddown LLC (In re Ditech Holding Corp.), 21-cv-10038 (LAK), 2022 U.S. Dist. LEXIS 172793 (S.D.N.Y. Sept. 23, 2022).

Finance of America Revenue LLC (“FoA”) is a reverse mortgage lender.  It retained Reverse Mortgage Solutions, Inc. (“RMS”), a mortgage servicer, to subservice certain loans, under the terms of three agreements.  The first agreement was entered in March 2011, and expired on March 19, 2018, but the parties executed a series of successive extension agreements, extending it through March 31, 2019.  The other two agreements gave FoA a monthly renewal option, which it exercised through February 2019, for the second agreement and through September 2019 for the third agreement.  RMS filed a chapter 11 petition on February 11, 2019.  After the petition was filed, FoA and RMS entered into several more extensions of the March 2011 agreement, the last of which expired on September 30, 2019, when RMS’s chapter 11 plan of reorganization took effect.

On November 11, 2019, FoA filed a proof of claim seeking administrative expense priority for damages allegedly resulting from RM’s breaches of the agreements between the date of RMS’s bankruptcy petition and the date the plan became effective.  The plan administrator filed an objection, and the bankruptcy court granted the objection, finding that the post-petition extensions were not new contracts as a matter of New York law, claims based on rejected pre-petition contracts arise pre-petition, and the alleged breaches at issue were within FoA’s “fair contemplation” at the time of the contracts.  FoA appealed.

The district court vacated the bankruptcy court’s ruling.  First, the district court rejected the bankruptcy court’s reliance on state law to determine whether the extensions were new contracts.  The district court held that when the claim arose was governed by federal law, and the appropriate federal-law test was whether the breaches were within the parties’ “fair contemplation” when they entered the underlying subservicing agreements.  Second, the district court held that as to the first agreement, the risk of breaches after April 1, 2019 was not within the fair contemplation of the parties at the time of contract, because the performance obligations under the first agreement would have expired on March 31, 2019 were it not for the post-petition extensions.  The court reasoned that excluding claims for breaches after April 1, 2019 would contravene the purpose of section 503(b), because it would remove the incentive for a debtor’s counterparties to extend a contract benefitting the estate after a bankruptcy petition is filed.  As such, the court held that FoA’s breach of contract claims for breach of the first agreement were eligible for administrative priority to the extent they constitute “actual, necessary costs and expenses of preserving the estate.”

The court applied a different analysis to the second and third agreements, which were not extended by mutual agreement but by the exercise of FoA’s unilateral rights under the agreements.  As to these, the court held that it was foreseeable at the time of contracting that FoA could extend RMS’s obligations through the post-petition period, so FoA’s breach of contract claims under these two agreements were not eligible for administrative priority.  However, the court further held that FoA’s quasi-contract claims may be eligible for such administrative priority, relying on a line of cases holding that administrative priority is available for claims arising from a debtor’s election to receive a claimant’s goods or services under a contract post-petition.  The court clarified that in light of the general principle that statutory priorities in bankruptcy are narrowly construed, for administrative priority to be available the claimant must be induced to provide a benefit it would not otherwise have provided; mere receipt of benefits is insufficient.  The court left it to the bankruptcy court on remand to determine whether any of FoA’s claims have administrative priority under this standard.