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Understanding the Rejection of Executory Contracts in Bankruptcy

In the world of bankruptcy law, the treatment of "executory contracts" is both complex and crucial, often defining the future obligations and rights of debtors and creditors alike. One of the central questions around executory contracts is whether a debtor can reject these contracts in bankruptcy, and, if so, what the implications are for all parties involved. This blog post dives into the basics of executory contract rejection in bankruptcy and examines key rulings that have shaped this area of law.


What Are Executory Contracts?


An executory contract, in the context of bankruptcy, is generally defined as a contract under which both parties still have significant performance obligations. A classic example might be a lease, where the debtor (as lessee) must continue paying rent, and the landlord must continue providing access to the leased property. These contracts often contain mutual obligations that, if breached, would allow the other party to stop performing.

In bankruptcy, the debtor, who is now seeking financial relief and may be re-evaluating contracts, has the option to "reject" executory contracts to avoid these ongoing commitments. However, as you’ll see, rejecting a contract doesn’t necessarily erase all obligations tied to it.


Rejection of Executory Contracts: What Does It Mean?


When a debtor rejects an executory contract in bankruptcy, it’s considered a "breach" of that contract rather than a rescission. This means that rejection allows the debtor to stop performing under the contract, but it does not erase the existence of the contract or undo the rights already granted to the other party. The Supreme Court’s decision in Mission Product Holdings, Inc. v. Tempnology, LLC (2019) clarified that rejection is simply a breach, meaning the non-debtor party (the creditor) can assert a claim for damages caused by the breach, but they retain any rights that were already vested under the contract.


Key Takeaways from Tempnology: Rejection Is Breach, Not Rescission


In Tempnology, the debtor, Tempnology, tried to use bankruptcy to reject a contract granting Mission exclusive distribution rights and a trademark license. Tempnology argued that by rejecting the contract, it could rescind Mission’s trademark rights, allowing Tempnology to market its products under the same trademarks through other channels. The Supreme Court disagreed, holding that rejection was a breach—not a rescission. This meant that while Tempnology could avoid its ongoing obligations under the contract, it couldn’t revoke Mission’s right to use the trademarks that had been licensed.

This distinction has broad implications. By rejecting the contract, the debtor frees itself from obligations like service, support, or maintenance provisions. However, it cannot "claw back" any rights, such as property interests or licenses, that were already granted to the other party.


The Limits of Rejection in Bankruptcy: Vested Rights vs. Ongoing Obligations


Tempnology set a standard for understanding the rejection of executory contracts, especially in cases where the non-debtor has vested rights in property or intellectual property. However, this approach doesn’t resolve every issue around contract rejection in bankruptcy. For instance, when a rejected contract includes ongoing obligations (such as exclusive distribution rights or promises not to compete), it’s less clear whether rejection permits the debtor to act in ways that would breach these obligations outside of bankruptcy.

For example, if a debtor was bound by an exclusivity agreement in a distribution contract, could they then reject the contract in bankruptcy and proceed to distribute the product through other channels? Some courts have allowed this, arguing that rejection means the debtor can "escape" future performance requirements. Others, however, argue that this view conflicts with the idea that rejection is merely a breach and not a rescission, especially when state law or equitable principles would allow the non-debtor party to enforce exclusivity via injunction outside of bankruptcy.


Special Provisions for Certain Contracts: Sections 365(h), (i), and (n)


Recognizing that general rules may not address all contract types fairly, Congress has provided special protections for some executory contracts in Section 365 of the Bankruptcy Code:

  • Section 365(h): Protects lessees of real property from eviction if the debtor-lessor rejects the lease, allowing them to continue occupying the property under the lease terms.

  • Section 365(i): Allows purchasers of real property under a rejected installment contract to remain in possession of the property, even though the debtor-seller has rejected the contract.

  • Section 365(n): Protects intellectual property licensees by allowing them to retain their rights to use licensed IP even if the debtor-licensor rejects the license.

These special provisions allow non-debtor parties to enforce certain property or usage rights despite rejection, meaning they can remain in possession or continue using assets as previously agreed. In each case, the goal is to prevent the bankruptcy process from disrupting these vested rights where monetary compensation would not adequately replace access or usage.

What Happens to Claims after Rejection?

When a contract is rejected, the non-debtor party typically has the right to file a claim for damages as an unsecured creditor. This claim reflects the breach’s impact, and while it may help the creditor recoup some losses, it’s often much less valuable than continued access to the contract’s original benefits.

The non-debtor party, however, must often choose: they may either treat the contract as terminated and seek damages or, in some cases, elect to retain their rights under the contract (as allowed in Sections 365(h), (i), or (n)) if they continue performing their own obligations.


Practical Implications and the Ongoing Debate


The Tempnology decision and the provisions in Section 365 underscore the complex balancing act in bankruptcy cases involving executory contracts. Courts strive to offer relief to debtors while respecting the property rights and expectations of non-debtor parties. However, with the varying obligations found in contracts, uncertainty persists around cases where rejection impacts both parties' rights.

Bankruptcy practitioners should carefully analyze any executory contracts when advising debtors or creditors. Understanding which rights are truly “vested” and which obligations are ongoing can be the difference between effectively navigating a debtor’s reorganization and facing unexpected limitations on contract rejection.

In conclusion, while bankruptcy provides a pathway for debtors to shed burdensome contracts, Tempnology and Section 365’s specific provisions ensure that non-debtor rights remain safeguarded in many situations. As this area of law continues to evolve, businesses engaged in contractual relationships with potentially unstable partners would do well to consider how their contracts might be affected by a bankruptcy filing and whether their rights would be considered vested or contingent.

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