Restructuring

Whether a contract is executory is an often-litigated issue in bankruptcy because of the treatment afforded to such contracts.  Although the Bankruptcy Code does not define the term “executory contract,” most courts follow a variation of the definition provided by Professor Vern Countryman in a 1973 law review article.¹ The well-established Countryman definition provides that an executory contract is a contract under which “the obligation of both the bankrupt and the other party to the contract are so far underperformed that the failure of either to complete performance would constitute a material breach and excuse the performance of the other.”  While straightforward in theory, in practice, this definition is not always easy to apply, especially when the parties dispute the nature of their obligations under a contract.    

Matter of Provider Meds, L.L.C., 907 F.3d 845, 848 (5th Cir. 2018) is an example of such a dispute. In Provider Meds, a patent holder, Tech Pharmacy Services, Inc. (“Tech Pharm”) filed a petition in Texas state court contending that certain former chapter 7 debtors had failed to comply with their obligations under an exclusive patent license agreement.  A secured creditor of the former debtors, RPD Holdings, L.L.C. (“RPD”), intervened in the state court action and removed the proceeding to the bankruptcy court, claiming that it purchased the patent license in a bankruptcy sale.  The bankruptcy court held in favor of Tech Pharm and found that RPD did not have rights under the license agreement because, either it did not purchase the patent license or, even if it did, the patent license was executory and rejected by operation of law prior to any alleged transfer.  The district court affirmed the decision and the Fifth Circuit agreed.

State Court Patent Litigation

Provider Meds’ (“Debtors”) business involved dispensing controlled pharmaceuticals to on-site nurses through machines running proprietary software known as OnSite.  In 2010, Tech Pharm, which held certain patents related to the remote pharmaceutical dispensing process, sued several parties, including Provider Meds, for patent infringement.  The parties settled the litigation and entered into a settlement and license agreement (the “License Agreement”) whereby Tech Pharm granted the Debtors a nonexclusive perpetual license to use the Onsite technology in exchange for a one-time licensing fee of $4,000 for each new pharmaceutical dispensing machine placed in circulation, and quarterly reports reflecting all new machines placed in service.  Both parties also provided a mutual release of all claims related to the litigation, or the patents, or any alleged infringement of invalidity of the same.  Following the settlement agreement, the court dismissed all claims with prejudice.

Provider Meds’ Bankruptcy

Beginning in 2012, Provider Meds and its affiliates commenced chapter 11 bankruptcy cases, and such cases were subsequently converted to chapter 7.  In connection with the liquidation, RPD purchased certain collateral from three of the bankruptcy estates and entered into an asset purchase agreement for each sale.  The sales were approved by the bankruptcy court and none of the asset purchase agreements explicitly referenced the License Agreement.  The License Agreement was not identified on the Debtors’ schedules and statements of financial affairs, and RPD was unaware of the License Agreement at the time it entered into the asset purchase agreements and when the motions to approve such agreements were filed.  RPD admittedly became aware of the License Agreement before the bankruptcy court entered the last of the three sale orders.  In addition to the purchase agreements, RPD also entered into a settlement agreement with the trustees from the other debtor estates and a third party secured creditor, pursuant to which RPD was purportedly transferred certain “subject property,” including several broad categories of OnSite technology.  The assumption and assignment of any executory contract subject to the asset purchase agreements and subsequent settlement agreement occurred more than 60 days after the chapter 7 cases were commenced.

The timing of the asset transfers was key. The Debtors were in chapter 7, and, in chapter 7, any executory contract not assumed within 60 days after the commencement of the case is automatically deemed rejected pursuant to section 365(d)(1) of the Bankruptcy Code.  To avoid the imposition of the statutory deadline and the resulting rejection of a valuable agreement, RPD argued that the License Agreement was not an executory contract. 

Applying the Countryman definition, the Fifth Circuit first considered whether Tech Pharm and each of the relevant Debtors had outstanding obligations under the License Agreement, and whether any party’s failure to perform would constitute a material breach excusing the other side’s performance.  Tech Pharm had an ongoing obligation under the License Agreement to refrain from suing counterparties for patent infringement for new machines placed into service.  The Debtors had an ongoing obligation to pay reporting fees and a license fee each time it placed a new machine into service and to satisfy reporting requirements. 

At first blush, the License Agreement is clearly executory.  However, RPD contended that, because Tech Pharm provided a release of its claims and the litigation was dismissed with prejudice, its obligation under the License Agreement to refrain from suing the Debtors for patent infringement involving future machines was illusory.  RPD also argued that the License Agreement was “perpetual” so long as the patent was valid, thus, breach by the Debtors could not excuse Tech Pharm’s performance.  Likening “perpetual” to “irrevocable,” RPD asserted that Tech Pharm would be not be relieved of its performance obligations even if the Debtors breached by failure to meet its reporting requirements. 

The Fifth Circuit, like the district court and the bankruptcy court before it, disagreed with RPD.  First, the court noted that the release of infringement claims related to past and not future acts.  As a result, Tech Pharm was not precluded from suing the Debtors solely because the case was dismissed with prejudice.  Indeed, the court found that Tech Pharm would be able to bring infringement claims if the underlying act had not occurred at the time of the dismissal.  Importantly, only by contractual agreement memorialized in the Licensing Agreement was Tech Pharm’s legal right to bring an infringement suit limited.  Second, the Court found that there was no support for the proposition that if the Debtors materially breached the License Agreement, Tech Pharm would be excused from performing.  Finding no authority to support RPD’s proposition that a license which is “perpetual” under its terms (but not “perpetual and irrevocable”), is in fact irrevocable in the face of material breach — the Fifth Circuit concluded that both parties had real ongoing material obligations under the License Agreement, thus making it executory and subject to the 60-day deadline imposed by section 365(d)(1) of the Bankruptcy Code.

Unfortunately for RPD the court found no basis to read an implicit exception into section 365(d)(1) and when an executory contract is rejected, it is no longer subject to the bankruptcy estate.  The Provider Meds decision illustrates the continued tango parties engage in to determine whether a contract is executory and underscores that the outcome of such analysis greatly influences the rights of the parties involved.