In this post, I will discuss executory contracts and ipso facto clauses. These are both important basic concepts for bankruptcy proceedings, especially Chapter 11 proceedings (commonly known as a “reorganization” as opposed to a “liquidation” under Chapter 7).
1. Executory Contracts
Though the name may sound daunting, an executory contract is simply a contract that contains outstanding obligations for both parties to the contract. The U.S. Supreme Court explained executory contracts as follows:
Section 365 of the Bankruptcy Code enables a debtor to “reject any executory contract”—meaning a contract that neither party has finished performing. 11 U.S.C. § 365(a). The section further provides that a debtor’s rejection of a contract under that authority “constitutes a breach of such contract.” § 365(g). Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S.Ct. 1652 (2019) (emphasis added).
An example of an executory contract is a supply agreement. The supplier is typically obligated to send goods to the customer, and in return, the customer is obligated to pay the supplier. Thus, during the term of the agreement, both parties have obligations under the agreement. The importance of an executory contract cannot be understated. Executory contracts are susceptible to assumption and assignment to a third party, or rejection by the debtor. Or an executory contract can simply be assumed by the debtor so that the debtor can continue to enjoy the benefits of such agreements during and after the reorganization process. There are many rules and nuances for executory contracts, and which executory contracts can be assumed and assigned.
There can be a misperception about contracts when a debtor files for bankruptcy. If every contract could be rejected or terminated by the counterparty, no debtor could reorganize, or it would make it extremely difficult for a debtor to reorganize.
To help distinguish between executory and non-executory contracts, guidance from the Ninth Circuit Bankruptcy Appellate Panel (“BAP”) is helpful. As the BAP stated:
A contract is either in the asset/liability category or in the executory contract category. For example, a contract that obliges a counterparty to pay the debtor $10,000 per month for 10 years but as to which the debtor has no remaining duties is an asset and is not executory. To be sure, there may be perplexing questions of characterization when it comes to characterizing a contract as asset, liability, or executory. In re JZ L.L.C., 371 B.R. 412 (9ths Cir. BAP 2007).
At a high level, these concepts make sense. If a debtor could simply terminate or reject a loan (a non-executory agreement), one can imagine the chaos that would ensue. Though these concepts can be difficult at times, most of the time, these issues are relatively straightforward.
2. Ipso Facto Clauses in Executory Contracts
Once you determine whether your agreement is executory, the next issue that often arises is when your client wants to terminate the agreement because the debtor filed bankruptcy. It is quite common, if not the norm, for an agreement to have a termination clause that states that a party can terminate the agreement if either party files for bankruptcy protection. Just pull any agreements you have, and odds are you will find such an example. However, can an executory contract be terminated upon or after the bankruptcy filing solely because it contains such a termination provision? In general, the answer is no.
11 U.S.C. § 365(e)(1) states:
Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the [bankruptcy] case solely because of a provision in such contract or lease that is conditioned on – (A) the insolvency or financial condition of the debtor at any time before the closing of the case; (B) the commencement of a case under this title; or (C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
Though there are many cases that help further define and refine the foregoing, for purposes of this discussion, we are focusing on “B”, above (“the commencement of a case under this title”). Even some lawyers fail to understand that the U.S. bankruptcy code usually trumps the express language of an agreement and that contractual provisions trying to change this fact rarely work.
This does not mean that the non-debtor counterparty is forever bound by an executory contract. For example, if the debtor fails to perform under an executory contract after the filing of a bankruptcy, the non-debtor counterparty will likely have the right to terminate the agreement (which can be subject to other requirements – like court approval).
3. Concluding Remarks
Bankruptcy is oftentimes not at all intuitive. Executory contracts and ipso facto clauses are basic concepts in the bankruptcy world. Understanding how such concepts might impact you and your business is becoming increasingly important as we increasingly seem to be headed into troubling economic waters.