Contributed by Sara Coelho
In the approach to bankruptcy, struggling businesses may experience problems performing their contracts, and counterparties often see trouble on the horizon. What can a non-debtor counterparty do to protect itself? And how are its rights impaired when the debtor finally commences a bankruptcy case? In two prior posts, we wrote about how the doctrines of adequate assurance and anticipatory breach go some distance to solve the dilemmas of counterparties who have reason to fear default. In this post, we consider what scope these state law rights may have in bankruptcy, and how the Bankruptcy Code may limit application of these state law rights against a debtor.
Doctrines of adequate assurance and anticipatory breach attempt to manage contractual relations when a party foresees default and also facilitate the mitigation of damage to parties injured by breach. The state law doctrine of adequate assurance varies by state and type of contract, but it generally provides contract counterparties that have reasonable grounds for insecurity the right to demand adequate assurance of future performance; failure to provide the demanded assurance establishes an anticipatory breach and a right for the insecure party to suspend performance. The doctrine of anticipatory breach allows a non-repudiating party to elect to withhold performance, terminate a contract, and sue for damages immediately upon an unequivocal repudiation of the contract by a counterparty.
Bankruptcy law, on the other hand, is concerned with preserving valuable contractual rights for the debtor’s estate — including under defaulted contracts — while generally reducing burdensome contractual rights against the estate to claims that can be addressed in the bankruptcy case. It replaces these state law remedies with procedures under section 365 of the Bankruptcy Code that allow a debtor to either assume or reject its contracts at any time before confirmation of a plan. Moreover, the automatic stay instituted by commencement of the bankruptcy case generally prohibits counterparties from terminating contracts, even defaulted (or anticipatorily breached) contracts. Together these rights provide a breathing spell that enables a debtor to take time to evaluate the merits of its assumption and rejection choices.
Contract termination rights arising as the result of an anticipatory breach do not sit well with the framework for contracts under the Bankruptcy Code. Cases treating the doctrine under the prior Bankruptcy Act varied. Sometimes, they treated the bankruptcy filing as an anticipatory breach, but still suspended counterparty rights (such as termination rights) that could impair the contract while the debtor decided whether to assume it. Contemporary bankruptcy cases treating anticipatory breach by a debtor are hard to come by, and litigants and courts largely ignore the doctrine as irrelevant or superseded by the assumption and rejection framework under section 365. Vestiges of this state law right appear, however, in section 365’s requirements to cure defaults, compensate pecuniary losses resulting from defaults, and provide adequate assurance of future performance where the contract has suffered a default or is subject to assignment.
It is less clear, however, that exercise of state law rights to demand assurance, including prior to default, or to suspend performance following a failure to provide assurance should be prohibited. The Bankruptcy Code provides no right to contract counterparties to demand assurance in the absence of a default, but does not specifically prohibit demands for assurance under state law either. Some courts have at least acquiesced to a postpetition assurance demand or to the postpetition operation of rights established by a prepetition assurance demand, albeit without analysis of what types of assurance demands could violate the automatic stay or the extent to which various rights arising as a result of a debtor’s failure to provide assurance can be exercised against a debtor.
For example, in Beech, a nondebtor contract counterparty claimed to have made a postpetition assurance demand by letter. The court did not raise any concerns with the party having made such a demand while the automatic stay was in effect, but also found the demand letter unjustified and insufficient to function as an assurance demand. Accordingly, the court found that the debtor did not anticipatorily breach the contract by failing to respond to the demand. In JW Aluminum, a court held that a supplier’s pre- and postpetition state law assurance demands were proper. It also found that a debtor’s offer of an administrative expense as assurance was insufficient to prevent its breach given that the “mortality rate in Chapter 11 cases is quite high.” In that case, the court had also ordered the debtor to pay its expenses promptly and may have had reason to believe that an administrative expense was poor security, leaving open the possibility that different economics could have produced a different holding on the use of administrative expenses as assurance. The court did not comment on the supplier’s refusals to ship to the debtor while its assurance demands were pending, implying that it was acceptable for the supplier to resort to this remedy.
Some courts have tolerated assurance demands — at least implicitly by finding a demand was made or purportedly made and failing to comment that the demands or purported demands violated the automatic stay — but required relief from the stay before a party could resort to remedies. In Hitachi, a district court, in the course of deciding a dispute between two non-debtor parties, interpreted the effects of pre- and postpetition demands for adequate assurance against a third-party that was a debtor, as well as a postpetition cancellation of that debtor’s contract after it failed to respond to those demands. There the court found that the inadequate response to the assurance demands gave rise to a right of cancellation, but that the automatic stay deprived the non-debtor party of authority to unilaterally cancel or terminate the contract. It also found, however, that the automatic stay “did not . . . change the fact that [the debtor] had anticipatorily breached . . . giving [its counterparty] the option to cancel” and that the stay “simply required [the nondebtor party] to get formal approval of the bankruptcy court” to replace the debtor under the contract with another party. Similarly, in Coast Trading, a bankruptcy court held that postpetition cancellation of a contract for failure to provide assurance would violate the stay and that the counterparty’s only remedies under the facts of that case were to seek a modification of the stay or move in the bankruptcy court to compel the debtor to assume or reject. Allowing postpetition assurance demands while prohibiting exercise of remedies may be a sensible way to mesh state law and bankruptcy rights because demands are an efficient way for parties to bring disputes to a head and hopefully resolve them. The requirement of court approval for exercise of remedies ensures an orderly remedial process and the protection of estate assets from self-help.
Bankruptcy courts also have made use of assurance concepts in fashioning other kinds of relief. For example, one court required assurance of payment, in the form of an advance or contemporaneous cash payment, when it compelled a party to perform contracts with a debtor in bankruptcy. Another used its equitable powers to condition assumption of a lease on the posting of an adequate assurance deposit, even though there was no default under the lease. The facts in that case gave the lessor “reason to believe that the debtor will not adequately perform” and the lessor was itself at risk of defaulting on a debt secured by property leased to the debtor if the debtor did not timely perform.
Cases treating state law adequate assurance demands on a debtor subject to rights and duties under the Bankruptcy Code are hard to find, but the above cases indicate that some courts are allowing this state law right to operate in bankruptcy, at least where it doesn’t wreak havoc with estate assets. Therefore, in some circumstances, adequate assurance demands may be an appropriate protection for contract counterparties, even outside of the context of assumption of defaulted contracts, when the Bankruptcy Code expressly provides for it. Indeed, courts may favor allowance of assurance demands against debtors because the laudable objectives advanced by this right – causing counterparties to communicate, address disputes without judicial intervention, prevent breach, and mitigate damages – are as important in bankruptcy as outside of it. If a demand is tailored to avoid causing any immediate change in the parties’ position, a court may say, what’s the harm? The debtor may always protect its interests after receiving a demand by seeking relief in the bankruptcy court, including assuming the contract or seeking to enforce the stay.
These cases do not analyze the circumstances under which demands may violate the automatic stay, however, and it easy to imagine circumstances that would constitute a stay violation. Demands for assurance are adaptable to circumstance and can take many potentially objectionable forms. For example, requesting a debtor to bring current a past-due account consisting of prepetition debts falls within the automatic stay against “any act to collect” a prepetition claim against the debtor. A request for a deposit is a request to add a new security feature to an existing contract. Even a request for simple verbal assurances impinges on a debtor’s right to use the full length of the time provided to debtors under the Bankruptcy Code for deciding to assume or reject a contract. Moreover, as the first step in establishing an anticipatory breach and a right to resort to remedies, a court could determine that even a benign form of assurance demand initiates the compromise of a debtor’s contract rights and violates the stay. Perhaps that’s why in one case, a party sought adequate assurance by moving for it in the bankruptcy court, coupled with a motion to compel early assumption or rejection of its contract.
The cases also offer little guidance on the range of remedies that may be subject to the automatic stay, and there may be room for exercise of very basic remedies, such as suspending performance, as occurred in the JW Aluminum case, without violating the stay. Courts have allowed exercise against debtors of other, equivalent remedial rights provided to insecure parties under the Uniform Commercial Code. For example, in a future Throwback Thursday post, we’ll discuss a case allowing a seller to stop postpetition delivery of goods in transit to an insolvent debtor under sections 2–702 and 2–705 of the UCC, even after title passed to the bankruptcy estate. Exercise of rights under these sections of the UCC can effectively enable a contract counterparty to withhold performance because of a debtor’s insolvency and seize estate property. If permitted in this context, should suspending performance under other provisions of the UCC, including 2-610, which provides a right of performance suspension upon anticipatory breach, be permitted? What if the right to suspend arises under common law? How about exercise of other state law contract remedies for breach that do not impinge on estate assets other than rights under the contract subject to remedial measures?
Although adequate assurance and anticipatory breach may be relatively simple and efficient enforcement tools outside of bankruptcy, their operation and utility are more limited in the bankruptcy context, where competing law and policy either trump them or make it very difficult to predict when and how they may be exercised. Nonetheless, one can find examples of state law adequate assurance demands operating in bankruptcy, and parties willing to navigate the murky bounds between this right and the Bankruptcy Code may find it a useful tool in sorting out contractual relations with a debtor.