Restructuring

Contributed by Damon P. Meyer
It is well known that section 365 of the Bankruptcy Code authorizes a debtor to assume or reject unexpired leases and executory contracts.  Although the term “executory” is not defined in the Bankruptcy Code and different courts have adopted definitions which vary slightly, the most widely used definition is known as the Countryman definition, which provides that an executory contract is one “under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.”  If, however, a debtor breaches a contract prepetition, does that contract cease to be executory because the failure of the non-debtor party to perform would no longer constitute a material breach of the contract?  Recently, in In re Kemeta, LLC, Judge Sontchi in the United States Bankruptcy Court for the District of Delaware faced this question in the context of section 365(n) rights and held that a prepetition breach by the debtor did not make an intellectual propery license non-executory.
Section 365(n) provides, that if a debtor rejects an executory contract under which it is a licensor of intellectual property, the licensee can treat the contract as terminated, or retain its rights to enforce its exclusive license for the duration of the contract (including any period for which the contract may be extended by the licensee as of right under applicable nonbankruptcy law).
Prior to its chapter 7 filing, debtor Kemeta entered into an exclusive license agreement with Invoy Technologies, LLC, pursuant to which Kemeta licensed to Invoy rights to certain intellectual property.  Once the debtor filed bankruptcy, the licensee sought to enforce its rights pursuant to section 365(n) of the Bankruptcy Code.  The chapter 7 trustee objected and asserted that section 365(n) was inapplicable because the contract was no longer executory based on the debtor’s prepetition breach of the agreement.  It was undisputed that the debtor did breach license by failing to deliver to Invoy the intellectual property, and that the breach discharged the licensee’s obligation to continue to perform under the contract under the applicable state law.  The licensee’s continued obligations would have included a post-delivery payment of $130,000.  Because the debtor did not cure the breach prior to the petition date, and therefore the licensee’s obligations under the contract were discharged under state law, the debtor asserted that the contract was no longer executory.
Judge Sontchi, however disagreed and held that notwithstanding the breach, the license agreement was executory as of the petition date.  In so ruling, Judge Sontchi found that although a bankruptcy filing cannot revive a contract that has been terminated prepetition, most debtors have breached at least certain executory contracts prepetition, and section 365(b) of the Bankruptcy Code expressly provides debtors with the ability to cure those breaches and provide adequate protection of future performance.  Further, section 365(b) provides the debtor with a statutory right to cure default with no limitation related to either the passage of time or the materiality of the default.  If a debtor is allowed to cure a material breach prior to assuming a contract, and only executory contracts can be assumed, Judge Sontchi reasoned that a prepetition material breach did not render a contract non-executory.
Additionally, Judge Sontchi looked to the reasoning behind the Countryman definition of an “executory contract.”  As other courts had noted, in formulating his definition, Professor Countryman exempted only those contracts under which the debtor has already received its full benefit from the non-debtor party prior to the bankruptcy filing.  Here, there remained obligations owing to both parties to the license – the debtor was obligated to deliver the property and the licensee was obligated to pay for it.  Thus, the debtor did not receive the full benefit of the contract prior to the bankruptcy filing and the contract continued to fit into the Countryman definition of “executory.”
The distinction between a prepetition breach, which will allow a contract to remain executory, and a prepetition termination can have important consequences.  If a contract is terminated prepetition, the debtor cannot revive the contract, and therefore, the debtor will not be able to assume or assign the contract.  Conversely, if the contract is merely breached prepetition, that breach can be cured and the contract can be assumed and assigned.  A non-breaching party to a contract which desired to rid itself of its obligations under the contract would be wise to officially terminate the contract quickly, especially if it is concerned about a bankruptcy filing by the breaching party.