Rejecting Executory Contracts in a Chapter 11 Bankruptcy: Key Legal and Practical Considerations

While the primary focus of the Chapter 11 bankruptcy process is restructuring a company’s debts so that it can meet its payment obligations on an ongoing basis, companies also have the ability to reject certain contracts during the process. Rejecting executory contracts can relieve companies of their ongoing payment obligations—and help preserve their financial stability going forward. However, there are several important factors to consider before rejecting an executory contract, and company executives will need to work closely with an experienced Miami Chapter 11 bankruptcy lawyer to ensure they make informed, strategic decisions.

Here are some key considerations:

Understanding What Qualifies as an “Executory Contract”

The option for companies to reject executory contracts during the Chapter 11 bankruptcy process is established in 11 U.S.C. Section 365. Under Section 365, companies may elect to reject executory contracts at any time during the process; and, if a company does not affirmatively assume an executory contract during the process, the contract will be deemed rejected.

The rejection of executory contracts can have significant financial, legal, and practical implications for both debtors and creditors. This raises a critical question: What is an “executory contract?”

An executory contract is any contract under which both parties have continuing performance obligations. While there are several possible examples, one of the most common examples is a commercial lease. Under a commercial lease, the lessor has a continuing obligation to let the premises in accordance with the terms of the parties’ agreement, and the lessee has a continuing obligation to pay rent and otherwise comply with its contractual obligations.

Since executory contracts represent ongoing financial liabilities for debtors, they can play a central role in a debtor’s ability to meet its aggregate financial obligations post-reorganization under Chapter 11. Rejecting executory contracts provides an opportunity to reduce a debtor’s aggregate financial obligations post-bankruptcy. While this can have significant benefits in many cases, as discussed in greater detail below, there are important countervailing considerations.

Understanding What it Means to “Reject” an Executory Contract

While rejecting an executory contract during the Chapter 11 bankruptcy process eliminates the debtor’s ongoing financial responsibility under the contract, this does not mean that the debtor’s concerns related to the contract simply go away. Rather, when a debtor rejects an executory contract during a Chapter 11 bankruptcy:

• The debtor remains liable for any amounts due as a result of pre-rejection defaults; and,
• The creditor has a claim against the debtor for damages resulting from the rejection.

Thus, while rejecting an executory contract during a Chapter 11 bankruptcy alleviates the debtor of its payment (and other performance) obligations on a go-forward basis, the debtor is not absolved of its financial obligations under the contract entirely. In this scenario, the creditor may have little (if any) incentive to work with the debtor and may simply pursue litigation to collect as much as possible.

Alternatives to Rejecting Executory Contracts Under Chapter 11

With this in mind, when assessing the desirability of rejecting executory contracts in a Chapter 11 bankruptcy, company executives should also consider alternatives to rejection. Broadly speaking, the alternatives to rejecting an executory contract are:

Assuming the Contract

One option is to “assume” the debtor’s executory contracts, which means the debtor will retain them post-bankruptcy. In order to assume an executory contract during the Chapter 11 bankruptcy process, a debtor must:

• Pay outstanding amounts due under the contract (or provide “adequate assurance” that these amounts will be paid); and,
• Cure any other defaults under the contract (or provide “adequate assurance” that these defaults will be cured).

Generally speaking, choosing between rejection and assumption of an executory contract is an all-or-nothing proposition. Debtors cannot force their creditors to accept only a portion of their bargain. As discussed below, however, creditors may be willing to negotiate revised terms in order to protect their interests—and this can be a desirable approach for both parties in many cases.

If a debtor assumes an executory contract during the Chapter 11 process, the debtor’s payment obligations under the contract can be addressed as part of the debtor’s overall reorganization. If the debtor pursues a Subchapter V bankruptcy under Chapter 11, its creditors will have limited ability to challenge its proposed reorganization plan, which is one of several benefits of pursuing a Subchapter V bankruptcy for eligible businesses.

Assigning the Contract (with “Adequate Assurance”)

If a debtor assumes an executory contract in its Chapter 11 bankruptcy, the debtor may assign the contract to a third party. While rejecting executory contracts can expose debtors to claims for damages, assigning them can serve as a source of capital.

Under Chapter 11, a debtor can assign an assumed executory contract to a third party so long as the proposed assignee provides “adequate assurance” to the creditor. What constitutes “adequate assurance” will vary from case to case. While creditor approval is not required, in practice, proposed assignees will generally want to know that creditors are on board with their taking over the debtor’s contractual rights and obligations.

Negotiating with the Counterparty

A third alternative to rejecting an executory contract is to negotiate with the counterparty. Oftentimes, counterparties will prefer renegotiating to having their contracts rejected during the bankruptcy process. If an executory contract is beneficial (or necessary) to a debtor’s operations, pursuing an amicable resolution that addresses both parties’ priorities could be a viable path forward.

Discuss Your Company’s Options with a Miami Chapter 11 Bankruptcy Lawyer at Edelboim Lieberman

Do you have questions about the Chapter 11 bankruptcy process? If you have questions about your company’s ability to reject executory contracts, your company’s ability to negotiate with its creditors, or any other aspect of the process, we invite you to get in touch. To discuss your company’s options with a Miami Chapter 11 bankruptcy lawyer at Edelboim Lieberman in confidence, please call 305-768-9909 or request an appointment online today.