Right Of First Refusal Not Invalid Restriction On Assignment
June/July 2004
A company trying to maximize the value of its assets and rid its balance sheet of onerous contractual obligations has the advantage in bankruptcy of being allowed to assume or reject most contracts and agreements that are executory as of the bankruptcy filing date. Rejection of an agreement relieves the debtor from continued performance. The non-debtor’s claim for damages arising from the breach becomes an unsecured pre-petition claim on a par with other unsecured debts. Assumption allows the debtor to retain favorable agreements that have value either because a contract is integral to the debtor’s overall reorganization strategy and future operations, or because the estate can raise cash by assigning the contract to a third-party.
The Bankruptcy Code eliminates most impediments to the estate’s realization of potential value from an unexpired agreement in two ways. First, it generally invalidates contract provisions (or laws) that operate to terminate or modify the debtor’s rights as a consequence of its bankruptcy filing or financial condition. The statute also allows a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to assign an executory agreement notwithstanding a contract provision that has the effect of restricting or precluding the assignment. What qualifies as an invalid restriction on assignment, however, has been the subject of considerable debate in the courts. One common kind of restriction — a right of first refusal — was the subject of a decision recently handed down by a Delaware district court. In In re The IT Group, Inc., Co., the court ruled that a right of first refusal is not an unenforceable restriction on assignment.
Assumption, Rejection and Assignment of Executory Contracts
Section 365(a) of the Bankruptcy Code allows a DIP or bankruptcy trustee, subject to court approval, to "assume" (reaffirm) or "reject" (breach) any "executory" contract or agreement. Although the term is not defined in the statute, "executory" is generally understood to mean that performance (other than the mere payment of money) remains due to some extent on both sides of an agreement as of the bankruptcy filing date. In a chapter 11 case, the DIP or trustee may make this decision at any time prior to confirmation of a plan of reorganization, unless the court orders otherwise upon request of the non-debtor contracting party. This latitude affords the DIP an opportunity to determine which of its executory contracts should be assumed because they are beneficial to the estate and which should be rejected.
Assumption is subject to certain restrictions and conditions. The first depends on whether or not the contract is in default. If so, section 365(b) provides that the contract can be assumed only if the DIP or trustee:
cures the default or provides adequate assurance that the default will be promptly cured;
compensates or provides adequate assurance that the trustee will promptly compensate the other party for any pecuniary loss resulting from the default; and
provides adequate assurance of future performance under the contract.
The cure requirements do not include the obligation to remedy a default consisting of a breach of a provision relating to the debtor's bankruptcy filing, insolvency or financial condition, the appointment of a trustee or custodian or the satisfaction of any penalty rate or failure to perform a non-monetary obligation under a contract. Such "ipso facto" clauses effecting forfeiture or modification of a debtor's rights under a contract based upon the debtor's financial condition are generally unenforceable in bankruptcy. Section 365(e) provides that such a provision will be enforced only if applicable non-bankruptcy law excuses the other party to the contract from accepting performance from or rendering performance to the trustee or an assignee, or if the contract in question involves lending or other financial accommodation or issuance of the debtor's securities.
If the DIP assumes a contract, it does so cum onere, and the liabilities incurred in performing the contract will be treated as administrative expenses. On the other hand, if the contract is rejected, it is deemed breached on the date "immediately before the date of the filing of the petition," and the non-debtor's claims for damages arising from the breach will be relegated to the same status as other pre-petition unsecured claims. Most courts apply a "business judgment" test to a DIP's determination to assume or reject a contract. As articulated by one court of appeals, "a bankruptcy court reviewing a trustee's or debtor-in-possession's decision to assume or reject an executory contract should examine [the] contract and the surrounding circumstances and apply its best 'business judgment' to determine if it would be beneficial or burdensome to the estate to assume it."
The advantages of having the ability to assume or reject contracts extend beyond relief from onerous obligations that may be instrumental to the success of a reorganization. This is so because the Bankruptcy Code allows a DIP or bankruptcy trustee to extract value from favorable contracts and leases by first assuming them and then assigning them to third parties for consideration. Like assumption, assignment is subject to various conditions and restrictions. Initially, the DIP or trustee must assume the agreement, and in doing so satisfy all of the assumption prerequisites (e.g., cure of defaults). Section 365(f) further obligates the DIP or trustee to provide adequate assurance of any assignee’s future performance under the assigned contract.
Under section 365(f)(1), assignment is permitted "notwithstanding a provision in an executory contract . . . or in applicable law, that prohibits, restricts or conditions the assignment of such contract or lease." This provision was designed to prevent anti-alienation or other clauses in contracts or leases from defeating the trustee's ability to realize the full value of the contract for the estate. However, a contract may not be assigned if, among other things, the other party to the contract objects and is not obligated under applicable law to accept performance from, or render performance to, someone other than the debtor. Contract provisions or laws that purport to terminate or modify the debtor’s rights under the contract as a consequence of assignment are inlvalid.
Controversy in the Courts
Section 365(f)(1)’s invalidation of contract provisions that "prohibit, restrict or condition" assignment of a contract has had somewhat of a troubled history in the courts. While contract provisions that prohibit assignment are relatively easy to identify, whether a particular provision acts as a prohibited restriction or condition is less clear. Many kinds of contract provisions have been deemed to run afoul of the statute, but courts sometimes reach inconsistent conclusions even when faced with the same or substantially similar provisions.
One kind of contractual provision that has engendered a fair amount of controversy is a right of first refusal. Generally defined as "[a] potential buyer's contractual right to meet the terms of a third party's offer if the seller intends to accept that offer," first refusal rights are a common feature of many shareholder agreements, commercial real estate leases, joint venture agreements and other contracts. Some courts hold that a right of first refusal is an invalid restriction on assignment, generally because it chills bidding on a debtor’s leases by removing any incentive for a prospective assignor to bid on a contract that it has little chance of obtaining. Others take the opposite view, finding that a right of first refusal does not restrict the estate's right to assign, but merely gives the counter party to the contract the right to acquire the debtor's rights under a contract on equal terms with other bidders. A Delaware district court was recently called upon to take a stand on this issue in IT Group.
IT Group, Inc. (the "debtor"), Northrop Gruman Technical Services, Inc. and Wackenhut Services, Inc. formed The Space Gateway Support, LLC sometime before the debtor filed for chapter 11 in 2002. The operating agreement executed by the members provided that a bankruptcy filing by or against any member was an event of default and gave the non-defaulting members the right to buy out the defaulting member’s economic interest at a price specified in the agreement. It also gave each member a right of first refusal in the event that any other member wanted to transfer its rights to a non-affiliated third party.
After filing for bankruptcy, the debtor sought court authority to assign its rights under the agreement to The Shaw Group, Inc. Northrup and Wackenhut objected, claiming, among other things, that their buyout rights were triggered by the debtor’s default and that they should be allowed to exercise their right of first refusal. Shaw countered that section 365(f) invalidated the right of first refusal because the provision impermissibly restricted or conditioned assignment, even though it did not prohibit assignment outright. The bankruptcy court ruled that the buyout provision was an unenforceable ipso facto clause, but that assignment of the operating agreement to Shaw was subject to the other members’ right of first refusal. Northrop and Wackenhut appealed.
The district court affirmed. Initially, it held that section 365(e)(1) invalidated the buyout rights. According to the court, those rights were unenforceable because they purported to terminate the debtor’s rights under the operating agreement as a consequence of its bankruptcy filing and the other members were not excused under applicable non-bankruptcy law from rendering economic performance to Shaw inasmuch as Delaware law provides that the members of a limited liability corporation are permitted to assign their bare economic interests to another entity.
Next, the district court examined whether the right of first refusal was an invalid restriction or condition on the debtor’s ability to assign the operating agreement. It concluded that it was not. Observing that it was not aware of any Third Circuit precedent addressing rights of first refusal under section 365(f), the district court was persuaded that decisions rendered elsewhere indicate that a bankruptcy court "does retain some discretion in determining whether provisions that do not explicitly prohibit assignment qualify as de facto anti-assignment clauses rendering them unenforceable." The court did not fault the discretion exercised by the bankruptcy court in the case before it. It was not "persuaded that enforcing the right of first refusal in this case would hamper the [debtor’s] ability to assign the property or foreclose the estate from realizing the full value of the [debtor’s] interest" in the limited liability corporation. Finally, the district court rejected Shaw's contention that the members' preemptive rights should not be enforced as a matter of public policy because the procedures implicated by the exercise of the right were too cumbersome. According to the court, the bankruptcy court did not appear to be troubled by the exercise of arriving at a reasonable value for the debtor's economic interest in the venture.
Where Do We Go from Here?
The district court’s observation concerning the absence of authority in the Third Circuit on whether a right of first refusal passes muster under section 365(f)(1) is not entirely accurate. In In re Headquarters Dodge, Inc, the Court of Appeals for the Third Circuit vacated as unripe for summary judgment a district court order ruling that an automobile manufacturer could exercise its right of first refusal in a franchise agreement that the trustee was trying to assign because the agreement was a personal services contract under applicable non-bankruptcy law and therefore could not be assigned. There is no indication, however, that the issue was ever revisited below.
What qualifies as an invalid "restriction" on assignment will doubtless continue to be a controversial issue, as parties search for new and creative ways to draft agreements containing preemptive rights and other provisions designed to insulate the parties as nearly as possible from any abridgement of their rights as a consequence of another party's bankruptcy filing. IT Group and other decisions like it indicate that the primary focus of the courts on this issue has been whether a preemptive right restricts in any meaningful way the estate's ability to realize the maximum value from its executory contracts. Most courts have examined whether the preemptive right in question chills bidding. Still, it is difficult to fathom how a right of first refusal can be deemed not to do so. Prospective assignee's can hardly be expected to make an offer on asset when they have almost no chance of prevailing. The issue then, is whether the consideration paid to the estate to exercise a right of refusal is adequate, a determination that the bankruptcy court may be ill-equipped to make without the benefit of competing offers.
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In re The IT Group, Inc., Co., 302 B.R. 483 (D. Del. 2003).
In re Headquarters Dodge, Inc., 13 F.3d 674 (3d Cir. 1994).