Restructuring

On February 28, 2019, the United States Bankruptcy Court for the Northern District of Texas issued an opinion in In re TM Village, Ltd. (Bankr. N.D. Tex. Feb. 28, 2019), holding that an unintentional, duplicate obligation remaining under a contract can render the contract executory, even if perhaps in contravention of the plain language of the contract. 

The TM Village opinion framed the issues as whether the parties’ prepetition settlement agreement was an executory contract, and if so, whether the debtor could reject it in its business judgment (the court held in the affirmative on both issues).  The court reaffirmed that the plain language of a contract may be read in a broader context to avoid an “unreasonable, inequitable and oppressive outcome.” The case serves as a cautionary tale that even a simple clerical error may have unintended and prolonged consequences.

Background

The debtor, TM Village, Ltd. (the “Debtor”), was in the process of constructing a mixed-use real estate project in Carrolton, Texas.  Prior to filing for chapter 11, the Debtor entered into a Compromise and Settlement Agreement and Release (the “Settlement Agreement”), which anticipated resolution of a lawsuit against the Debtor and others (collectively, the “Defendants”) filed by certain plaintiffs (the “Plaintiffs”), with Richard Yao (“Yao”) as the Plaintiffs’ successor in interest.

The Settlement Agreement imposed several material obligations upon all parties.  On the one hand, the Defendants agreed to complete and obtain the appraisal of certain condominium units, transfer such units to the Plaintiffs after completion of the appraisal, and pay the Plaintiffs the balance of a $4.25 million settlement amount after a set-off of the appraised value of the transferred units.  On the other hand, the Plaintiffs agreed to cause the release of the lis pendens — or a written notice that a lawsuit has been filed concerning real property — relating to Yao’s lawsuit by executing a form release attached to the Settlement Agreement (the “Form Release”) immediately upon execution of the Settlement Agreement.  The Form Release specifically referenced the lis pendens “[f]iled on February 13, 2017, as Document ID 201700043496.”  Yao’s counsel executed the Form Release on June 20, 2017 and filed it in the public record on June 21, 2017. 

Due to a clerical error, however, two identical lis pendens related to the lawsuit were filed: the one identified in the Settlement Agreement — which was released — and a second lis pendens filed on February 15, 2017 (the “Duplicate Lis Pendens”).  Although both lis pendens were in the public record when the parties signed the Settlement Agreement, the Debtor only learned of the Duplicate Lis Pendens a year later, when it attempted to sell other condominiums from the same development. 

Upon learning of the Duplicate Lis Pendens, the Debtor contacted Yao to inform him of the same and asked that Yao release the Duplicate Lis Pendens.  Prepetition email exchanges between the parties’ counsel showed that the parties understood the Duplicate Lis Pendens to be an unintentional duplicate filing.  Nevertheless, Yao refused to release the Duplicate Lis Pendens until after he received the closing statement for the transferred condominium units and the settlement amount from the Debtor. 

By the time the Debtor filed for chapter 11, Yao had not released the Duplicate Lis Pendens, and the Debtor had not paid Yao the settlement amount.  After filing for chapter 11, the Debtor moved to reject the Settlement Agreement under section 365(a) of the Bankruptcy Code, while Yao sought relief from the automatic stay to enforce the Settlement Agreement.

Analysis

Section 365(a) of the Bankruptcy Code permits a debtor, subject to court approval, to assume or reject executory contracts or unexpired leases to which it is a party.  The Fifth Circuit holds that a contract is executory if “performance remains due to some extent on both sides” and if “at the time of the bankruptcy filing, the failure of either party to complete performance would constitute a material breach of the contract, thereby excusing the performance of the other party.”¹ The Debtor argued that the Settlement Agreement was executory because both it and Yao had material obligations that remained unperformed at the time the Debtor filed for chapter 11 — specifically, Yao had not yet released the Duplicate Lis Pendens and the Debtor had not paid the settlement amount.  Yao, in contrast, contended that the Settlement Agreement was not executory because he had fulfilled all of his obligations; the plain language of the Settlement Agreement only required him to release the one specifically identified lis pendens, which he already done.  Yao further submitted that to require anything further would constitute an impermissible rewriting of the Settlement Agreement.

The court ultimately sided with the Debtor, holding that the release of the Duplicate Lis Pendens remained a material unperformed obligation on Yao’s part, and therefore the prepetition Settlement Agreement was an executory contract.  In arriving at that conclusion, the court stated: “[t]hough the Settlement Agreement expressly references a release of only the first lis pendens, it is appropriate to construe the parties’ agreement to avoid an unreasonable, inequitable and oppressive outcome.”²  The court then pointed to the exchanges between Yao and the Debtor’s counsel highlighting Yao’s attempts to use the accidental duplicate lis pendens filing as undue leverage against the Debtor.  Within that context, the court noted that “Yao is too clever by half.”

The court further bolstered its conclusion by referencing section 12 of the Settlement Agreement — a catchall provision titled “Additional Documents or Actions” — requiring that “[a]ll parties agree to cooperate fully and to execute any and all supplementary or additional documents and to take any additional action which may be necessary to give full force and effect to the basic terms and conditions of this [Settlement] Agreement.”  The court found that the text of section 12 anticipated any unforeseeable circumstances and requires the parties to cooperate to effectuate the basic terms and conditions of the Settlement Agreement, which in this case, included releasing the Duplicate Lis Pendens.

Absent the email correspondence evidencing Yao’s intention to use a clerical error to his unfair advantage, however, it is unclear whether section 12 would have been a sufficient basis for the court to find that the Settlement Agreement required Yao to release the Duplicate Lis Pendens.  As a matter of contract interpretation, specific language will typically control over the general.³ Here, then, perhaps the court could have found that the Settlement Agreement, by expressly requiring the release of one specific lis pendens, did not require the release of any other unidentified lis pendens.

Nevertheless, the facts here made clear that such an interpretation would lead to an inequitable result. Yao had a decision to make prepetition: either release the Duplicate Lis Pendens prepetition consistent with the spirit of the Settlement Agreement (satisfying his material obligations thereunder), or hold on to the Duplicate Lis Pendens as leverage and bear the risk of rejection if the Debtor filed for chapter 11.  But here, Yao was asking to have his cake and eat it, too, which the court was unwilling to allow.

Conclusion

The TM Village opinion raises interesting implications for how far a court may go in finding that contractual obligations exist outside of the express terms of the agreement.  The decision illustrates the need for contract counterparties to think, prior to bankruptcy, about how their actions may color the way that a court will interpret contractual provisions in bankruptcy, with an eye toward equitable outcomes.