Contributed by Joshua Nemser
Texas is home to the Friday night lights of high school football, the Astrodome, the Alamo, and, of course, some interesting bankruptcy case law. Last month, Judge Barbara Houser of the United States Bankruptcy Court for the Northern District of Texas in In re Superior Air Parts, Inc. held that a prepetition contract indemnity provision gave rise to a dischargeable claim. The contract itself remained in effect post-confirmation, but the indemnity provision within the contract did not.
Many of today’s pilots learn to fly on yesterday’s aircraft. The author, for example, earned his wings on a 1977 Cessna 177B powered by a Lycoming O-360 engine. Learning to fly on decades-old equipment is safe because the parts on such aircraft are inspected, repaired, and replaced at very regular intervals. It is no surprise, therefore, that aftermarket parts manufacturers such as Superior Air Parts, Inc. cropped up to meet the growing demand spurred by an aging fleet of training aircraft. “Aftermarket” in this context means that the same replacement pistons, cylinders, and so forth that may be sold directly by the original engine manufacturer are also produced and sold by Superior. Although the business model has been generally successful, Superior became involved with the insolvency of its German parent company in 2008 and filed for relief under chapter 11 of the Bankruptcy Code in the Northern District of Texas at the end of that year.
In the decades leading up to its bankruptcy, Superior produced many of its parts under a licensing agreement with various engine manufacturers. In 1999, after a lengthy history of litigation over previous licensing agreements, Superior and Lycoming Engines, an engine manufacturer, executed a settlement and a licensing agreement that formed the basis of the litigation at issue in Superior Air Parts. The licensing agreement “required Superior to indemnify Lycoming against any liability resulting from any alleged defect in design of” certain parts that were originally designed by Lycoming.
The agreement was never mentioned in the 2008 case, which was confirmed approximately 8 months after filing. Because the agreement was not listed as “executory,” there was no need for Superior to assume or reject it, but the story doesn’t end there. Several years after confirmation, Lycoming was sued in tort by a third party for a design defect in one of its parts. Pursuant to the licensing agreement, Lycoming sought, yet failed to obtain, indemnification from Superior. Shortly thereafter, Lycoming filed a state court lawsuit against Superior seeking indemnification under the licensing agreement and alleging, among other things, breach of the agreement. Then, nearly four years after the case had been closed, Superior filed a motion to reopen the bankruptcy case and remove the state court action to bankruptcy court. The bankruptcy court granted Superior’s motion in order to determine the following issue: was the 1999 license agreement between Lycoming and Superior breached, or was Superior’s indemnification obligation a prepetition claim that dropped out of the contract? Lycoming alleged that it could properly terminate the license agreement once Superior refused to make good on its indemnification obligation. Superior countered that Lycoming never filed a proof of claim for the indemnification obligation, and thus, it was discharged in bankruptcy.
Section 101(5) defines a claim as a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.” This is a rather broad definition, and issues relating to the timing of claim accrual have been the subject of several landmark cases. As Judge Houser noted, courts across the nation have struggled to determine when a claim arises, and numerous determinative tests have evolved, including the “accrued state law” test, the “conduct” test, and the “prepetition relationship” test. Applying Fifth Circuit law, the court employed the pre-petition relationship test, which states that in order for a claim to accrue, “the debtor’s conduct must take place pre-petition, but the future claimant must also have some pre-petition relationship with the debtor.” As the court noted, the test was satisfied because execution of the 1999 license was prepetition conduct of the debtor, and was also evidence of Lycoming’s prepetition relationship with Superior. The court found the right to indemnification contained in the licensing agreement to be a prepetition claim, notwithstanding that the “facts giving rise to actual liability did not occur until after the discharge.”
In an analysis of how the agreement survived but the indemnity obligation did not, the court found that Lycoming had ample opportunity to assert a claim in 2008; it had notice of the case because it made several appearances during its pendency. Nevertheless, neither the agreement nor the indemnity provision was addressed during Superior’s bankruptcy proceedings. Perhaps Lycoming assumed the entire agreement rode through the bankruptcy unaffected. Indeed, the court found that “when a contract is non-executory, the debtor remains bound to its obligations under that contract after the bankruptcy filing.” Still, the court held that the indemnification provision was not an obligation, but rather, a claim. This finding destroyed the merits of Lycoming’s argument, as its “claim” was discharged upon confirmation of the plan.
Because the court found that indemnification obligation within the Superior-Lycoming contract was discharged in bankruptcy, the fact that the rest of the licensing agreement remained in place is of particular interest. The agreement was essentially severed. After bankruptcy, Superior had the right to use the license granted to it by Lycoming to manufacture aircraft parts, but it no longer had the obligation to indemnify Lycoming for any design defect lawsuits. In other words, the benefit of being able to manufacture Lycoming-designed parts was in full force whereas an obligation—one that may have been material to granting the license in the first place—dropped out. Therefore, when Superior refused to indemnify Lycoming on a post-confirmation lawsuit, Lycoming had no right to terminate the license.
Creditors should not assume that a debtor’s obligations contained in non-executory prepetition contracts will survive in bankruptcy unaffected. If there is any doubt, creditors are better served by seeking clarification of their rights and duties prior to confirmation, or they may risk a result like the one in Superior Air Parts.