What Happens to an Executory Contract in Bankruptcy?

An executory contract is a legal agreement where both parties still have significant performance obligations to fulfill. The term gains its importance within the framework of federal bankruptcy proceedings. When a company or individual files for bankruptcy, these ongoing contracts are subject to special rules under Section 365 of the U.S. Bankruptcy Code. This section grants the party in bankruptcy, known as the debtor, specific rights to decide the future of these agreements, which can substantially affect the debtor’s reorganization.

Core Characteristics of an Executory Contract

The defining feature of an executory contract is the presence of outstanding material obligations for both parties. Courts apply the “Countryman test” to identify such an agreement, defining it as a contract where both parties have duties so unperformed that a failure by either to complete them would constitute a material breach. A material obligation is one that is fundamental to the agreement’s core purpose.

For example, in a commercial real estate lease, the tenant must pay rent and the landlord must provide the property. An equipment lease involves the lessee’s duty to make payments and the lessor’s duty to provide the equipment. With a software license, the licensee must pay any royalties, and the licensor must permit use of the software and potentially provide support.

Employment agreements can also be executory, as the employee must provide services and the employer must provide compensation. The mutuality of these unperformed duties is what subjects these agreements to special treatment under the Bankruptcy Code.

The Debtor’s Options in Bankruptcy

A debtor or bankruptcy trustee must decide the fate of each executory contract based on the “business judgment test.” Under this standard, a court will approve the debtor’s choice if it is a rational business decision that benefits the bankruptcy estate.

The first option is to “assume” the contract, meaning the debtor elects to continue with the agreement and reaffirm its terms. This choice is made for contracts that are profitable or necessary for the debtor’s reorganization.

The second option is to “reject” the contract, which terminates the agreement and relieves the debtor of future performance obligations. This path is taken for burdensome or unprofitable contracts. Rejection is treated as a breach of contract, creating consequences for the other party.

A third option is to “assume and assign” the contract to a third party, often during an asset sale. The debtor must first assume the contract and then transfer its rights and duties to the new party. This can maximize the value of the bankruptcy estate.

Consequences of Assumption

To assume a contract, the debtor must first “cure” any existing defaults. This means promptly paying all past-due amounts, such as unpaid rent or service fees. Non-monetary defaults, like a failure to maintain property, must also be cured to make the other party whole.

The debtor must also provide “adequate assurance of future performance.” This involves demonstrating the financial capacity to meet future obligations under the contract. Proof might include financial projections, a guarantee, or a deposit, which gives the non-debtor party confidence that the debtor will not default again.

Consequences of Rejection

Rejecting an executory contract is legally defined as a breach of the contract. This breach is considered to have occurred immediately before the bankruptcy petition was filed. This timing is important because it determines the nature of the other party’s resulting claim for damages.

The non-debtor party can then file a proof of claim for damages. For instance, a landlord whose lease is rejected can file a claim for unpaid rent and damages from the termination. However, the claim for future rent is often capped by the Bankruptcy Code.

The damage claim is treated as a general unsecured claim. This places the party in a pool with all other general unsecured creditors. As a result, they will likely receive payment that is only a fraction of their total allowed claim, paid on a pro-rata basis with other creditors.