It’s Too Late, Baby, Now It’s Too Late: the New Cure Standard for Nonmonetary Defaults Under Section 365(b)

on May 23, 2011 ·

Posted in Executory Contracts & Unexpired Leases

Contributed by Will Hueske

Among the fundamental general precepts of bankruptcy law are that a debtor in possession has the option of assuming or rejecting an executory contract under section 365 of the Bankruptcy Code and that a condition to assumption of an executory contract is that the debtor in possession promptly cure any defaults under the executory contract.  Bankruptcy courts look to the provisions of the underlying contract and non-bankruptcy law to determine the nature of the debtor’s default and the cure that is required for purposes of deciding whether such contract may be assumed and what cure is necessary.  What happens, though, when a so-called “historical default” – a breach of a nonmonetary covenant (other than an ipso facto provision), often requiring performance by a certain time – would require turning back the clock to cure the default?  Even bankruptcy judges don’t have that kind of power.

Examples of such historical breaches include a tenant “going dark” under a commercial lease for a period of time, failure to go operational by a date certain, and failure to close by a specified date under a real estate purchase agreement where time is of the essence.  State courts tend to view breaches of such clauses as material defaults that would excuse the non-defaulting party from performance. 

Pre-BAPCPA, due to ambiguous language in former section 365(b)(2)(D) of the Bankruptcy Code, circuit courts split on whether such nonmonetary obligations had to be cured at all before the executory contract could be assumed.  Prior to the amendments, former section 365(b)(2)(D) exempted from cure defaults relating to “the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations.”  The disagreement among courts stemmed from whether the word “penalty” modified both the word “rate” and the phrase “provision relating to a default arising from any failure of the debtor to perform nonmonetary obligations.”  If “penalty” applied only to “rate,” then nonmonetary obligations were not exempt from cure; conversely, if “penalty” applied to both “rate” and “provision,” then nonmonetary obligations were exempt, and cure was not required.  In the Ninth Circuit, a debtor was required to cure all material nonmonetary defaults, and if cure was impossible, the contract could not be assumed.  On the other hand, the First Circuit and the Bankruptcy Court for the District of New Jersey held that former section 365(b)(2)(D) relieved debtors of all obligations to cure nonmonetary defaults and could assume contracts in spite of such defaults. 

In 2005, Congress eliminated this ambiguity by adding “penalty” as a modifier to both “rate” and “provision,” leaving most nonmonetary defaults subject to the otherwise operative cure requirements of section 365(b).  Congress also amended former section 365(b)(1)(A) by explicitly protecting real property leases – and only real property leases – from the obligation to cure nonmonetary defaults if cure cannot be made “by performing non-monetary acts at and after the time of assumption.”  By amending sections 365(b)(1)(A) and 365(b)(2)(D), Congress provided no room for the contention that nonmonetary defaults in non-lease executory contracts are exempt from the cure obligation other than to the extent a party could argue that the underlying covenant was an unenforceable “penalty provision.”

In Escarent, the United States Court of Appeals for the Fifth Circuit became the first federal court of appeals to apply the new standard under the 2005 BAPCPA amendments to section 365(b)(2)(D) when it held that the debtor in possession could not assume a prepetition contract to sell real property because of the existence of an incurable nonmonetary default.  The Escarent debtor had entered into a prepetition contract to sell certain land, and the contract specified an outside closing date.  The timing of the closing date came at the end of a stipulated 90-day feasibility period during which the buyer was to inspect the property and obtain financing for the purchase, and had the option to terminate the contract for any reason during that period.  A week before the closing date, the debtor filed a voluntary chapter 11 petition, and the closing date passed without further action.  When the debtor-seller then attempted to assume the contract and proceed with the closing, the buyer objected, arguing that cure was impossible and therefore the contract was unassumable.  The Bankruptcy Court for the Western District of Texas allowed the assumption, finding that cure could be accomplished by allowing a new 90-day feasibility period for the buyer to obtain financing, and the district court affirmed.

The Fifth Circuit reversed, holding that, because the timing of the closing date was essential, cure was now impossible.  The initial 90-day feasibility period allowed the buyer to secure financing that would allow it to purchase the property by the original closing date for a certain cost.  When that closing date passed, however, the buyer’s financing arrangements expired as well.  As the court stated,

Economic conditions deteriorated and, as a result, [the buyer] was no longer able to secure alternative financing after [debtor]’s default. [Debtor]’s failure to close was thus not only a material default, but effectively an incurable one, as the parties are unable to return to [the closing date], when [debtor]’s performance was originally due.

Thus, the Fifth Circuit held that, because of the incurability of the debtor’s nonmonetary default, and the strict requirement that both monetary and nonmonetary breaches must be cured prior to assumption following the BAPCPA amendments, the debtor could not assume this contract.

Escarent demonstrates the harsh result that may occur as a result of the BAPCPA amendments of section 365(b) and the elimination of any ambiguity over the treatment of incurable nonmonetary defaults under executory contracts.  Before entering into chapter 11, a potential debtor would be well-advised to remember that any “historical breach” of an executory contract may render such contract unassumable.  In other words, it may find that “it’s too late, baby, now it’s too late.”

Former Section 365(b)(2)(D):
(b)
   (2) Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to—
       (D) the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.
In re Claremont Acquisition Corp., Inc., 113 F.3d 1029, 1033 (9th Cir. 1997).
Eagle Ins. Co. v. BankVest Capital Corp., 360 F.3d 291, 296–301 (1st Cir. 2004).
In re Walden Ridge Dev., LLC, 292 B.R. 58, 66–67 (Bankr. D.N.J. 2003).
Former Section 365(b)(1)(A):
(b)
   (1) If there has been a default in an executory contract or unexpired lease of the debtor, the trustee may not assume such contract or lease unless, at the time of assumption of such contract or lease, the trustee—
      (A) cures, or provides adequate assurance that the trustee will promptly cure, such default;
Section 365(b)(1)(A):
(b)
   (1) If there has been a default in an executory contract or unexpired lease of the debtor, the trustee may not assume such contract or lease unless, at the time of assumption of such contract or lease, the trustee—
       (A) cures, or provides adequate assurance that the trustee will promptly cure, such default other than a default that is a breach of a provision relating to the satisfaction of any provision (other than a penalty rate or penalty provision) relating to a default arising from any failure to perform nonmonetary obligations under an unexpired lease of real property, if it is impossible for the trustee to cure such default by performing nonmonetary acts at and after the time of assumption, except that if such default arises from a failure to operate in accordance with a nonresidential real property lease, then such default shall be cured by performance at and after the time of assumption in accordance with such lease, and pecuniary losses resulting from such default shall be compensated in accordance with the provisions of this paragraph;
Section 365(b)(2)(D):
(b)
   (2) Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to—
       (D) the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.
Section 365(b)(2)(D):
(b)
   (2) Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to—
       (D) the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.

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