Contributed by Frank Grese
When a debtor either assumes a prepetition executory contract or enters into a postpetition contract and subsequently breaches that contract through rejection or otherwise, damages suffered by the counterparty are often afforded administrative expense priority pursuant to section 503(b). What happens, however, when a contract is entered into postpetition pursuant to a plan of reorganization by a chapter 11 debtor whose case is subsequently converted to a case under chapter 7? The United States Bankruptcy Court for the Northern District of Texas recently addressed this issue in a memorandum opinion in In re Texas Wyoming Drilling, Inc., holding that the counterparty’s damages under the contract would not necessarily be entitled to administrative priority.
On April 16, 2007, Texas Wyoming Drilling, Inc. filed for bankruptcy protection under chapter 11 of the Bankruptcy Code with the goal of continuing its business operations and restructuring its debt. On November 13, 2008, the court confirmed the debtor’s plan of reorganization, which was to be funded from the debtor’s post-reorganization business operations. The plan became effective on December 15, 2008. Pursuant to the order confirming the plan, the debtor was authorized to enter into an employment agreement with Charles Lawrence, pursuant to which Lawrence agreed to serve as the debtor’s president and chief operating officer from December 15, 2008 through December 15, 2014. Under the employment agreement, which became effective the date the plan became effective, Lawrence was to receive a base salary of $130,000 annually, a bonus to be paid at the discretion of the reorganized debtor’s board of directors, and 25% of all outstanding shares of the reorganized debtor issued pursuant to the plan. In addition, the employment agreement provided that Lawrence was permitted to participate in all general employee benefit plans and programs. As provided for in the confirmation order and the plan, Lawrence and the debtor entered into, and implemented, the agreement without further court approval and without the court’s approval of the specific terms of the agreement. The employment agreement provided that Lawrence could be terminated voluntarily, involuntarily, or for cause, and each type of termination had different consequences.
In early 2009, after encountering economic difficulties and failing to make a payment to the IRS under the plan, the debtor entered into an auction agreement to sell certain of its drilling rigs, the sale of which would have left the debtor unable to perform its remaining obligations under the plan. Lawrence was one of the debtor’s representatives that authorized this action. Upon learning of the debtor’s default under the plan, the court converted the debtor’s chapter 11 case sua sponte to a case under chapter 7 of the Bankruptcy Code, pursuant to section 1112, because of the debtor’s attempt to auction off its assets without timely informing creditors.
Immediately after the conversion, a chapter 7 trustee was appointed, and Lawrence stopped working for the debtor. Lawrence was never officially informed by the debtor’s board of directors, any officer of the debtor, or the chapter 7 trustee that he was terminated under the agreement. On October 13, 2009, Lawrence filed a proof of claim in the amount of $232,750, which he asserted was entitled to administrative expense priority because the conversion constituted an “involuntary termination” of his employment agreement. The chapter 7 trustee objected to Lawrence’s claim.
After determining that the agreement was an executory contract at the time of the conversion within the meaning of section 365 of the Bankruptcy Code, the court examined whether the agreement, which was a postpetition contract, should be treated as an assumed contract, as are most postpetition contracts. The court determined that it should not, finding that the agreement was different from the typical postpetition contract because it was entered into after entry of the confirmation order, but before the conversion of the debtor’s case.
First, the court noted that at the time the employment agreement was entered into, the bankruptcy estate was no longer in existence because the estate ceased to exist upon confirmation of the plan. In other words, at the time the agreement was entered into post-confirmation, there was no estate to assume the agreement. Second, the court considered whether the agreement was entered into by the debtor in the “ordinary course of business” pursuant to section 363(c)(1) or, if it was outside the ordinary course, whether the debtor received court approval to enter into the agreement. The court found that the agreement was entered into outside the ordinary course of business because hiring a new president/chief operating officer is a major business decision. The court also found that the debtor did not obtain court approval of the agreement, notwithstanding that the plan and confirmation order clearly contemplated and expressly authorized the debtor to enter into an employment agreement with Lawrence, because the court was never asked to approve the specific terms of the agreement.
After concluding that the agreement was not the type of postpetition contract that should be treated as an assumed contract, the court concluded that the agreement was rejected by default because the chapter 7 trustee did not assume it within 60 days of the conversion as provided in section 365(d)(1). Therefore, the court determined that Lawrence had a valid claim as a result of the debtor’s breach of the agreement.
In valuing Lawrence’s claim, the court rejected Lawrence’s argument that he was terminated involuntarily under the employment agreement and, therefore, entitled to the specific damages contemplated by the agreement for such a termination. The court determined that it was not bound to interpret and effectuate the termination provisions of the agreement because none applied given that the breach occurred as a result of the chapter 7 trustee’s failure to assume the agreement following the conversion of the debtor’s case. As a result, the court looked to the Bankruptcy Code to determine the amount of damages to which Lawrence was entitled in the event of a breach. The court then concluded that Lawrence’s claim was allowed to the extent of the cap set forth in section 502(b)(7), which applies to claims of an employee for damages resulting from the termination of an employment contract. Applying section 502(b)(7), the court found that Lawrence was entitled to a year’s worth of salary ($130,000) plus up to one year’s worth of benefit pay ($32,500).
Finally, the court considered the priority of Lawrence’s claim and found that it was not entitled to administrative expense priority under section 503(b). While acknowledging that the agreement was a contract that Lawrence and the debtor had entered into pursuant to the plan and that a claim for the breach of a postpetition contract is often afforded administrative priority, the court employed reasoning similar to that which it used in determining that the agreement was not the type of postpetition contract that should be treated as an assumed contract. Specifically, the court found that because the bankruptcy estate was no longer in existence (i.e., the estate ceased to exist upon confirmation of the plan) at the time the agreement was entered into, Lawrence’s services to the debtor could not possibly have benefited the estate. In addition, the court stated that the agreement was never formally approved by the court and that the debtor did not enter into it within the ordinary course of business. Therefore, the court concluded that Lawrence’s claim should be treated as a general unsecured claim.
Although confirmed chapter 11 cases do not usually convert to chapter 7 liquidations, this decision serves as a reminder that a court may not be inclined to treat a claim arising under a pre-conversion agreement as an administrative expense of the chapter 7 estate. Notably, even if the court had found that the claim was entitled to administrative expense priority, under section 726(b) of the Bankruptcy Code, the claim would have been entitled to payment only after all chapter 7 administrative expense claims were satisfied.