In our latest installment of “Breaking the Code”, we take a look at a common section of the Bankruptcy Code that comes up in nearly every chapter 11 case: section 365(a). Section 365 contains one of the most powerful rights conferred upon a chapter 11 Debtor: the right to take a step back, evaluate its contracts and leases, and assume profitable agreements while rejecting unprofitable agreements. An issue that often comes up when a Debtor has a number of contracts or leases with a single counterparty is whether a debtor can cherry pick among those agreements in its assumption/rejection decisions? Is there a uniform federal standard? Unfortunately, no – it is a fact specific analysis that varies state to state and depends on the governing law of the contract.
Contracts Assumed As a Whole
Under section 365(a) of the Bankruptcy Code, a debtor, subject to the bankruptcy court’s approval, “may assume or reject any executory contract or unexpired lease of the debtor.” To assume or reject an unexpired lease or executory contract, the debtor must deal with the agreement as a whole – cum onere – rather than assuming only the beneficial aspects and rejecting the burdensome ones. Consequently, a debtor’s ability to cherry pick desirable contracts or leases among a series of agreements with the same counterparty will depend on whether those leases are construed as independent agreements or as a single integrated agreement. Though simple in theory, in a world where customers and vendors or lessors and lessees transact by way of general terms agreements or master lease agreements, it can sometimes become very difficult to decide where one agreement ends and the next one begins.
Contract Severability Depends on the Governing Law of the Agreements in Question
Courts have recognized that for purposes of assumption or rejection, the “agreement” between parties may consist of multiple documents that are integrated to form one agreement. In the context of assumption and rejection under section 365 of the Bankruptcy Code, “all of the contracts that comprise an integrated agreement must be either assumed or rejected, since they all make up one contract.” Consequently, a debtor can only cherry pick its desirable contracts and leases if those agreements are determined not to form an integrated agreement.
So when does a series of agreements form an integrated contract? Unfortunately, there is no single theory of federal common law to guide us – it’s a state specific analysis. Bankruptcy courts have consistently held that the contract terms and underlying contract law govern whether multiple agreements constitute a single integrated transaction.
The relatively simple holding that applicable state law governs whether a series of agreements form a single integrated contract has significant implications on chapter 11 debtors’ reorganization efforts. The focus on state law allows savvy companies to contract under the laws of states where the law on integrated contracts is well developed and then take actions to ensure that a ruling on contract integration will go their way. For example, to help bankruptcy-proof its agreements, a lessor who had read this article and “cracked the code” could choose a state law where the law on contract integration is clear (e.g., New York, Delaware, or Texas) and then ensure that the terms of its agreements as well as the facts and circumstances surrounding the execution of those agreements all line up to prevent a bankrupt lessee from picking and choosing between its leases. Some potential downsides to the lack of a uniform answer across the country to the question of cherry picking are increased case complexity and the likelihood of different results on the question of integration for different agreements within a single debtor’s estate based on the governing law of the relevant contract. Contract parties should take into account the applicable law in developing their strategies for dealing with their debtor counterparties.
Ben Farrow is an Associate at Weil Gotshal & Manges, LLP in New York.