Contributed by Courtney Stone
On June 14, 2016, Judge Thuma of the Bankruptcy Court for the District of New Mexico issued a memorandum opinion holding that a debtor could reject a prepetition settlement agreement that was determined to be executory in nature. In so holding, the Court noted what many a restructuring professional has often thought – when it comes to the determination of the executoriness of contracts in which the nondebtor may not owe material performance and the debtor does, why bother? Isn’t it enough to say that the nondebtor party has a claim?
After a dispute arose between a developer of a subdivision northeast of Albuquerque and a homeowners’ association (“HOA”) over the ownership of certain common areas in the subdivision, the HOA brought an action against the developer seeking to compel it to convey the disputed property. The parties eventually settled the action, and the developer agreed to convey common areas to the HOA. The settlement, however, did not end the dispute – the parties continued to contest whether certain property fell within the common areas to be conveyed pursuant to the agreement. After a court determined that the settlement agreement clearly required the developer to convey the disputed property to the HOA (but before the order was entered), the developer filed for bankruptcy and moved under section 365(a) of the Bankruptcy Code to reject the settlement agreement.
Executory Contracts and the Countryman Test
Section 365(a) of the Bankruptcy Code permits a debtor, subject to the court’s approval, to “assume or reject any executory contract or unexpired lease of the debtor.” The Bankruptcy Code does not define “executory contract,” but most courts, including the District of New Mexico, have adopted the “Countryman” test:
[A] contract is executory if the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete the performance would constitute a material breach excusing the performance of the other.
The HOA argued that, as it had no material obligations under the settlement agreement, the settlement agreement was not executory and, therefore, could not be rejected by the developer. Such an argument is a strange twist on “executoriness,” in which the nondebtor party then argues that the debtor has no choice but to comply with its obligations under the contract. In applying the Countryman test to the settlement agreement, however, the bankruptcy court rejected the HOA’s primary arguments: 1) that due to the debtor’s prepetition breach, the HOA had no remaining obligations to the debtor and 2) that the HOA had no remaining “significant” or “material” obligations under the agreement.
First, the developer’s prepetition breach did not render the settlement agreement non-executory given that section 365(b) expressly authorizes the debtor to assume or reject an executory contract that was breached prepetition so long as the breach is cured. Moreover, the breach clearly did not terminate the agreement, as the HOA still intended to enforce the settlement in state court.
Second, the HOA still had at least one significant outstanding obligation – the release of claims against the developer. Though the release was contingent on the developer’s conveyance of the common areas to the HOA, the bankruptcy court held that such contingency does not render a contract nonexecutory when, as here, the contingent obligations are essential to the contract. The court explained that the mechanism of performance and timing of performance is not at issue in determining executoriness as the same obligations could have been structured in varying ways.
It’s Executory, but So What?
Ultimately the court concluded, with a poetic citation to Shakespeare’s Macbeth no less, “in cases where the debtor owes material performance but the nondebtor may not, the wrangle over executoriness may be a tale ‘full of sound and fury, signifying nothing.’” In such cases, the court explained, rejection of the executory contract would result in the same damages claim as non-performance of a nonexecutory contract. Citing to Judge Bernstein’s opinion in In re Hawker Beechcraft the court added, “time spent searching for executoriness can be spent more fruitfully doing almost anything else.”
So, perhaps parties should take a cue from Judges Thuma and Bernstein, as well as Shakespeare, and move past the often unnecessary argument over whether a contract is “executory” to find a more commonsense application of section 365 – a debtor may use section 365 to keep (assume) or to breach (reject) a contract in its bankruptcy, and the nondebtor party has the rights afforded to the non-breaching party under the Bankruptcy Code. If all courts adopted that approach, would we still need to cling to the Countryman definition and waste time and money arguing over executoriness?
Courtney Stone is an Associate at Weil Gotshal & Manges, LLP in Houston.