Dueling Debtors: Missouri Bankruptcy Court says Debtor Can Reject Contract That Counterparty (Who is Also a Debtor) Sought to Assume

What happens when the counterparties on both sides of a contract are debtors in separate bankruptcy cases and their estates have contrary views about whether to reject or assume a contract?  This was exactly the issue faced by the Bankruptcy Court for the Eastern District of Missouri in In re Noranda Aluminum, Inc.  There, the Bankruptcy Court heard debtor Noranda Bauxite Ltd.’s motion to reject a sales agreement under which it was required to provide bauxite, a raw material used to make aluminum, to the counterparty (the “Bauxite Agreement”).  The counterparty to the Bauxite Agreement was Sherwin Alumina Co., LLC, a debtor with its own chapter 11 case before the Bankruptcy Court for the Southern District of Texas.  Sherwin, in its own bankruptcy case, had moved to assume the Bauxite Agreement, and it objected to Noranda’s rejection motion in Noranda’s bankruptcy case, arguing that rejection could force it out of business and cause its 575 employees to lose their jobs.  What was the Missouri Bankruptcy Court to do?  
Appropriate Standard for Rejection
As an initial matter, the Missouri Bankruptcy Court needed to decide the appropriate legal standard to apply in reviewing Noranda’s decision to reject.  The applicable standard could greatly influence the final determination to grant or deny the rejection motion.  Should the Bankruptcy Court (as Noranda argued) apply the business judgment test, under which the court would apply a presumption that the decision to reject the agreement was a sound one and should not be disturbed by the court absent bad faith or a “gross abuse of discretion”?  Or, should the Bankruptcy Court (as Sherwin argued) apply a “balancing of the equities test,” which would require the court to weigh the anticipated impact of rejecting the agreement on both Noranda’s estate and Sherwin’s estate?
Sherwin argued that because both parties to the Bauxite Agreement were debtors, the Missouri Bankruptcy Court should eschew the usually applicable business judgment test and instead apply a “balancing of the equities test.”  In support of its position, Sherwin relied upon several decisions issued twenty-eight or thirty years ago that were non-binding authority on the Missouri Bankruptcy Court, including Midwest Polychem, Ltd., In re H.M. Bowness, Inc., and In re Sun City Investments, Inc.  The Bankruptcy Court noted that in Midwest Polychem, the court determined that it did not need to choose between the business judgment test or the balancing of the equities test because the results under both tests were the same.  To the extent that the court applied the balancing of the equities test, the Missouri Bankruptcy Court respectfully disagreed with that position.  Furthermore, the Bankruptcy Court held that “upon careful review,” the two other decisions cited by Sherwin actually applied the business judgment test.
Sherwin further argued that, even if the business judgment test applied, the Bankruptcy Court must weigh the potential harm to Sherwin against the potential benefit to Noranda’s estate.  Here, again, Sherwin cited to cases that the Bankruptcy Court characterized as “not binding” and “not current” authority that had been repudiated by other courts and would directly contradict authority binding on the Missouri Bankruptcy Court.
Lastly, Sherwin argued that a heightened standard for rejection should apply to the Bauxite Agreement.  It cited in support of its position N.L.R.B. v. Bildisco & Bildisco and Mirant Corp. v. Potomac Elec. Power Co. (In re Mirant Corp.), which both applied a heightened standard to a debtor’s decision to reject an executory contract.  The Bankruptcy Court, however, found that both Bildisco and Mirant applied a heightened standard because section 365 of the Bankruptcy Code conflicted with policies designed to protect the national interest underlying other federal regulatory schemes implicated in those cases, such as where there was an overriding public interest or when rejection would pose a particular danger to public health or safety.  It determined that Sherwin’s interest in preserving the Bauxite Agreement to ensure the survival of its private business did not constitute a public interest meriting a heightened rejection standard, and no other federal schemes were implicated that would have likewise required applying a heightened rejection standard.
The Bankruptcy Court ultimately held that the appropriate test to apply was the business judgment test.  In doing so, it concluded that the fact the counterparty to a contract is also a debtor should not influence a bankruptcy court’s decision to approve a motion to reject the contract.  It also rejected (no pun intended), Sherwin’s arguments in support of its position.
The Bankruptcy Court further noted that while it was sympathetic to Sherwin’s position, it would not read into section 365 of the Bankruptcy Code special treatment for the rejection of agreements when debtors appeared on both sides of a contract.  Where Congress intended special treatment for specific types of executory contracts, specific statutory provisions were included in the Bankruptcy Code, such as sections 365(n) (intellectual property licenses), 1113 (collective bargaining agreements), 1110 (aircraft leases) and 1169 (railroad lines).  No special provision was applicable here.
Application of the Business Judgment Standard
In applying the business judgment standard, the Bankruptcy Court determined that Noranda met its burden to prove that the rejection of the Bauxite Agreement was in the best interest of its estate and that there was no evidence of bad faith or abuse of business discretion.
Noranda’s evidence demonstrated that Noranda was projected to lose approximately $16.5 million in 2016 if the contract was not rejected.  If rejected, Noranda’s loss would decrease by $6.8 million.  Noranda also presented evidence that the Bauxite Agreement was not integral to its business and that rejection might actually help it attract new customers.  Furthermore, the financial benefit to Noranda from rejecting the agreement would accrue regardless of whether or not Noranda was able to secure an alternate agreement with another third party buyer for the bauxite Noranda mined.
The Bankruptcy Court concluded that Sherwin was unable to discredit Noranda’s calculations, either through conflicting documents or the testimony of its expert witness, who appeared to have based his conclusions largely on his personal experiences, “without additional research or support, and often, without fully understanding the situation or considerations involved in each category of [Noranda’s] analysis.”  The Bankruptcy Court also disagreed with Sherwin’s argument that the process behind Noranda’s decision to reject required additional formal steps, such as an independent committee to analyze the decision, taking a vote of the board of directors, or performing an analysis of the rejection damages.
Furthermore, the Bankruptcy Court found the support of the Committee of Unsecured Creditors and the debtors’ lenders affirmed that Noranda had exercised sound business judgment in rejecting the Bauxite Agreement.
Conclusion
The Bankruptcy Court’s decision in Noranda demonstrates that if you are a debtor seeking to assume an agreement that another debtor seeks to reject, you may find yourself out of luck.  On the other hand, if you are a debtor seeking to reject an agreement that another debtor seeks to assume, you may be in luck.  A debtor in such a position may consider leveraging this luck to its advantage if renegotiating the terms of the contract remains one of the options on the table.  Whether the Noranda decision has long-term staying power, however, is not yet a certainty.  Sherwin has appealed the decision and the appeal is still pending.
Jessica Liou is an Associate at Weil Gotshal & Manges, LLP in New York.