This post is part of a series of posts entitled First Considerations for the Financially Distressed Business. For a comprehensive list of articles contained in this series, click here.
Filing a chapter 11 bankruptcy allows a company to reject certain contracts that require continuing payment or other performance obligations that may be negatively affecting operations. This ability can be extremely beneficial for a debtor as it is not uncommon for distressed companies to find themselves overwhelmed by obligations stemming from certain contracts, known in bankruptcy as “executory contracts.” While the Bankruptcy Code does not define the term “executory contract,” it is most commonly thought of as a contract under which all parties have continuing obligations and includes unexpired leases.
Executory contracts are treated differently in bankruptcy than other pre-bankruptcy obligations of a debtor. The debtor in a chapter 11 case has three options for dealing with executory contracts:
- Rejection of the executory contract;
- Assumption of the executory contract; or
- Assumption and assignment of the executory contract to a third party.
Each of these has different consequences to the debtor-creditor relationship and, for that reason, will be discussed separately.
a. Rejection
The first option—and arguably the most important to a distressed company—is the ability of a chapter 11 debtor to reject an executory contract with the bankruptcy court’s approval. As a general rule, the bankruptcy court will approve rejection of an executory contract if the debtor can demonstrate that, in its business judgment, rejection will benefit the bankruptcy estate and the creditors. Often, this power allows a debtor to renegotiate contracts that are no longer commercially reasonable. Because of this allowed treatment of executory contracts, a reorganization may be especially beneficial to a business that has financially burdensome long-term contracts and needs to be free from continued performance obligations that are no longer beneficial.
b. Assumption
A debtor’s second option is to assume an executory contract with the bankruptcy court’s approval. The effect of assumption is to fully reinstate the executory contract and make it mutually enforceable as between the parties. This option allows a distressed business to maintain contracts they favor subject to the Bankruptcy Code’s requirement that all outstanding defaults on said contract be cured.
c. Assumption and Assignment
The final option available to the debtor is to assume an executory contract and assign it to a third party. In order to assign an executory contract, a debtor must first assume it by complying with certain requirements including curing any outstanding defaults. In addition, any assignee must provide “adequate assurance of future performance” whether or not the debtor has defaulted under the executory contract.
