Rejection of an Executory Contract Does Not Relieve a Debtor of Assumed Liabilities

on December 22, 2010 ·

Posted in Executory Contracts & Unexpired Leases

One of the most touted (and one of the more misunderstood) benefits of chapter 11 is the ability to reject executory contracts and unexpired leases.  Contrary to popular belief, rejection of an executory contract or an unexpired lease pursuant to section 365 of the Bankruptcy Code does not rescind or undo such contract or lease.  Instead, rejection simply constitutes a breach of such contract or lease that relieves the debtor from future performance under the contract.  Taylor-Wharton Int’l LLC v. Blasingame (In re Taylor-Wharton Int’l LLC), Adv. Pr. No. 10-52792 (Bankr. Del. Nov. 23, 2010) at 6-7.  Taylor-Wharton shows the significance of this distinction.

In Taylor-Wharton, the debtor had entered prepetition into a purchase agreement whereby it purchased certain assets of the seller and assumed certain liabilities of the seller relating to accidents caused by products manufactured by the seller.  After the closing date of the purchase agreement, certain plaintiffs commenced a lawsuit against the debtor relating to products manufactured by the seller.  The debtor rejected the purchase agreement in the chapter 11 case.  It then filed a complaint in the bankruptcy court asserting that the rejection of the purchase agreement excused its obligations to assume the liabilities of the seller and thus the debtor was not liable to the purchasers of the seller’s products. 

The bankruptcy court disagreed.  The court noted that “rejection does not undo past performance under the contract. . . [T]o the extent that both or either of the parties have performed under the executory contract, the debtor’s rejection has no effect on such performance.”  The court found that pursuant to Alabama and Delaware state laws, the debtor’s assumption of the seller’s liabilities was complete upon closing of the purchase agreement and the debtor became directly liable for such obligations on the closing date.  Because it constituted past performance, assumption of the liabilities was no longer executory in nature and, thus, the assumption could not be undone. 

The court contrasted this with Philadelphia Newspapers, which involved the debtor’s request to reject an agreement that provided for the debtor’s assumption of certain liabilities in a form of reimbursement.  In Philadelphia Newspapers, the debtor assumed certain liabilities relating to workers’ compensation claims from the seller.  However, because the seller remained the insured on the workers’ compensation policies, the seller continued to pay the assumed claims, and the debtor routinely reimbursed the seller for such payments.  In re Philadelphia Newspapers, LLC, 424 B.R. 178, 180 (Bankr. E.D. Pa 2010).  In approving the rejection of the agreement, the Philadelphia Newspapers court determined that the debtor’s assumption of the workers’ compensation claims was executory because the obligation to reimburse the seller was continuing in nature, and reimbursements to the seller were still ongoing at the time of the rejection. 

Notably, in Philadelphia Newspapers, the rejection of the agreement did not absolve the debtor from the reimbursement obligations.  Instead, rejection of the agreement resulted in a claim for damages, which is typically a general unsecured claim.  The end result in Taylor-Wharton will likely be similar.  Although the court did not rule on the merits of the plaintiffs’ claims against the debtor, if allowed on the merits, the claims would also be general unsecured claims because the liabilities were assumed prepetition.  It is therefore not clear why the debtor in Taylor-Wharton was so adamant about using the Philadelphia Newspapers case to show that the assumed liabilities were ongoing obligations that were subject to rejection.       

As Taylor-Wharton and Philadelphia Newspapers make clear, rejection of an executory contract will not free a debtor from all financial obligations under the contract.  Accordingly, identifying and scheduling all financial obligations under executory and even non-executory contracts is paramount, especially in a reorganizing chapter 11 case.  If proper notice is given to all potential obligees under debtors’ contracts, the debtors can discharge those obligations in the chapter 11 case.

Follow this link to read the update to this blog post, posted on January 19, 2011.

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