Contributed by Jordan BrykMustang Sally, think you better slow your mustang down. You been running all over the town now. Oh! I guess I’ll have to put your flat feet on the ground. All you want to do is ride around Sally, ride, Sally, ride. – Wilson Picket, Mustang Sally
A recent decision of the U.S. Bankruptcy Court for the Southern District of Texas applied the contract assumption defense to bar a preference action by a litigation trustee for debtor MPF Corp. seeking to recover payments made pursuant to an executory contract that had been assumed and assigned. So what’s the “contract assumption defense”? Read on.
The dispute arose out of an engineering contract between Mustang Engineering Ltd. (a UK-based engineering company unrelated to Ford Motor Company, manufacturer of the legendary Mustang) and MPF Corp. Ltd. (an oil and gas exploration and production company). When MPF filed for chapter 11 protection in September 2008, it listed the engineering contract on its schedule of executory contracts. In March 2010, Mustang, MPF, and COSCO Shipyard Co. Ltd. entered into a novation agreement whereby (i) MPF agreed to transfer all of its rights and obligations under the engineering contract to COSCO and (ii) COSCO agreed to pay Mustang a cure amount of £873,280 to settle all claims between the three parties.
In June 2010, MPF confirmed a plan of reorganization, which (i) assumed and assigned to COSCO all executory contracts identified on Schedule 1 of the plan, including the engineering contract and (ii) transferred all causes of action not expressly released into a litigation trust to be pursued by a litigation trustee. In September 2010, the litigation trustee commenced an adversary proceeding to recover approximately $4.36 million in prepetition payments made to Mustang under the engineering contract as avoidable preferences.
The court ultimately held that, since the engineering contract was assumed under section 365 of the Bankruptcy Code, the contract assumption defense bars the litigation trustee as a matter of law from pursuing the preference action against Mustang to avoid prepetition payments under the engineering contract. Further, the court held that, even if the contract assumption defense is inapplicable, the avoidance action should be dismissed because it was settled and released in the plan of reorganization.
The contract assumption defense provides that when a debtor assumes an executory contract in bankruptcy, the debtor may not later pursue an avoidance claim for preferential payments made pursuant to that contract. Citing a Seventh Circuit decision, the court described the concept behind the defense as fairly intuitive: “permitting a preference suit on an executory contract that had been assumed would undermine the purpose of section 365 – namely, ‘to insure that a contracting party is made whole before a court can force the party to continue performing with a bankrupt debtor.’” The court further noted that the contract assumption defense is settled law in the Third, Ninth, and Eleventh Circuits. While the Fifth Circuit has not yet ruled definitively on the issue, the court pointed out that at least two bankruptcy courts within the Fifth Circuit have recognized and applied the defense, reasoning that “the estate cannot simultaneously become administratively obligated for all amounts due under an assumed contract (both pre- and post-petition) and recover for the estate payments made pursuant to the contract.”
The litigation trustee argued that the contract assumption defense is inapplicable because the engineering contract was “novated” and was never actually assumed and assigned pursuant to section 365. The court found that, on the contrary, the provisions of the plan made clear that the novation agreement was the means by which the assumption and assignment was carried out. The decision rested on unambiguous language in the plan and confirmation order, which indicated that MPF would assume and assign to COSCO all executory contracts identified on Schedule 1 of the plan, including the engineering contract, and authorized the assumption of executory contracts under section 365 pursuant to novation agreements.
The court also held that the plan provides for a release of the preference claim against Mustang under the novation agreement. Specifically, the plan carved out all “waived, settled, or released” claims, and gave effect to all settlements contained in previously executed novation agreements. The novation agreement involving Mustang’s engineering contract, in turn, settled all claims between the parties.