Restructuring

In a recent decision, the U.S. Bankruptcy Court for the District of New Jersey denied a debtor’s motion to reject a contract as executory under section 365 of the Bankruptcy Code, holding that the prepetition entry of a court order which required specific performance of a contract rendered the contract non-executory and, therefore, non-rejectable.  In re Bennett Enters., Case No. 20-23761 (JNP), 2021 Bankr. LEXIS 625 (Bankr. D.N.J. 2021) (“Bennett Enterprises”).

Background

The dispute in Bennett Enterprises arose from a prepetition contract, pursuant to which Bennett, a motel and bar operator, agreed to sell its liquor license to the purchaser.  After entering into the sale contract, Bennett filed a consent to transfer its liquor license with the City Council in order to obtain municipal approval, as required under New Jersey law.  Prior to the City Council’s consideration of the transfer, however, Bennett revoked its consent to the transfer.

Subsequently, the purchaser filed a complaint in state court and obtained an order (the “Order”) requiring specific performance and directing the purchase price for the license to be released to Bennett at closing.  As required under the Order, Bennett re-filed its consent to transfer the liquor license with the City Council.  Bennett filed for relief under Chapter 11 three days prior to the City Council’s consideration of the re-filed transfer consent.  A few days after filing for bankruptcy, Bennett withdrew its transfer consent again and filed a motion seeking to reject the sale contract under section 365.¹

The purchaser opposed Bennett’s motion, arguing that the sale contract was not executory because no material obligations remained unperformed as of the petition date on either side.  The purchaser noted that, not only was Bennett’s transfer consent in place with the City Council as of the petition date, but the purchaser had itself placed the purchase price in escrow to be released at closing, as required by the Order.  Bennett disagreed, asserting that the sale contract was still executory, given that it was contingent on the City Council’s approval of the transfer, among other things.

The Court’s Reasoning

Relying on the Third Circuit’s definition of an executory contract,² the Court determined that the sale contract was not so far unperformed as of the petition date that the failure of either party to perform its outstanding obligations would be a material breach of the contract.  The Court reasoned that a court order requiring specific performance of a contract functionally renders the remaining obligations of the parties under the contract non-material or ‘ministerial’ acts – acts through which the parties simply effectuate the court’s mandate or directive.

Explaining the rationale behind the cited cases in its decision, the Court emphasized the ability of courts to enforce their own orders if the parties fail to perform as required.  In other words, an order of specific performance essentially eliminates any outstanding material duties of the parties under the contract.  Once a court orders the parties to a contract to specifically perform the contract, the parties are no longer left with any material obligations under that contract, thereby making the contract non-executory.  Since only executory contracts can be assumed or rejected pursuant to section 365, the sale contract could not be rejected.

The Court held that, even absent the Order, the contract would not be deemed executory because, as of the petition date, neither party had any obligations so far unperformed that failure to perform would constitute a material breach.  In particular, the Court indicated that the purchaser’s material obligations were satisfied when it deposited the entire purchase price into escrow.  The purchaser’s remaining obligation to release the escrow funds at closing was deemed purely ministerial and, therefore, insufficient to render the sale contract executory.  The Court further noted that conditions in a contract predicated on third party acts do not render the contract executory.  Given that the City Council’s required approval of the transfer was not a material obligation owed by either party to the contract, it did not make the sale contract executory.

Interestingly, the Court also noted that even if the sale contract were executory, it would deny Bennett’s motion because the purchaser would not be entitled to assert a rejection damage claim.  The Court noted that in ordering specific performance, the state court had determined that money damages were an inadequate remedy for the purchaser.  Given that such a finding would preclude the purchaser from establishing a bankruptcy “claim” (as defined under section 101(5) of the Bankruptcy Code),³ the purchaser would be unable to receive a distribution in Bennett’s chapter 11 case.  Therefore, if the Court were to allow Bennett to reject the sale contract, the purchaser would lose its liquor license and would not be able to recover as a creditor during Bennett’s bankruptcy proceeding – a result that it deemed inequitable.

Implications and Takeaways

Debtors in bankruptcy, as well as plan sponsors, need to be careful in analyzing which prepetition contracts will be assumable or rejectable pursuant to the unique powers afforded to debtors under section 365.

Although a debtor’s rejection powers are considered very broad, there are a variety of factors that may limit rejection.  As the Bennett Enterprises decision reflects, a prepetition court order mandating specific performance may preclude rejection.  Similarly, if the only material acts require performance by third parties, a contract may be considered non-executory.  And even though payment of the purchase price for an asset might be thought of as a material contract term, certain arrangements between parties, such as the escrow arrangement in Bennett Enterprises, may have a probative effect on the determination of whether a contract is executory.  Notably, the result in Bennett Enterprises demonstrates that courts will also take into account the ramifications of a contract’s rejection in determining whether equitable considerations preclude rejection.

As always though, much will depend on the operative facts of any given case and we encourage you to contact your Weil team for further discussion.