Fifth Circuit Embraces Flexible Approach to Countryman Test of Executoriness in Bankruptcies Involving Multiparty Contracts
Whether a contract is "executory" such that it can be assumed, rejected, or assigned in bankruptcy is a question infrequently addressed by the circuit courts of appeals. The U.S. Court of Appeals for the Fifth Circuit provided some rare appellate court-level guidance on the question in Matter of Falcon V, L.L.C., 44 F.4th 348 (5th Cir. 2022). The Fifth Circuit affirmed lower-court rulings determining that a surety contract was not executory because the surety had already posted irrevocable surety bonds and did not owe further performance to the debtors.
In so ruling, however, the Fifth Circuit adopted a flexible approach to the "Countryman test" for executoriness in cases involving multiparty contracts. According to the Fifth Circuit, courts "should apply the Countryman test to multiparty contracts in a flexible manner that accounts for the various obligations owed to all of the parties, rather than focusing exclusively on the flow of obligations between the debtor and the creditor."
Assumption and Rejection of Executory Contracts and Unexpired Leases
Section 365(a) of the Bankruptcy Code provides that, with certain exceptions delineated elsewhere in the statute, "the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor." The trustee's power to assume or reject is also conferred upon a chapter 11 debtor-in-possession ("DIP") under section 1107(a) of the Bankruptcy Code. Rejection results in a court-authorized breach of the contract, with any claim for damages treated as a prepetition claim against the estate on a par with the claims of other general unsecured creditors (unless the debtor has posted security with the non-debtor counterparty). 11 U.S.C. § 365(g). Assumption of a contract requires, among other things, that the trustee or DIP cure all existing monetary defaults and provide adequate assurance of future performance. 11 U.S.C. § 365(b).
A bankruptcy court will generally approve assumption or rejection of an executory contract if presented with evidence that either course of action is a good business decision. See Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652, 1658 (2019) ("The bankruptcy court will generally approve [the] choice [to assume or reject], under the deferential 'business judgment' rule."). Upon assumption, most kinds of executory contracts may also be assigned by the trustee or DIP to third parties under the circumstances specified in sections 365(c) and 365(f). In chapter 11 cases, except with respect to certain kinds of contracts (such as nonresidential real property leases, aircraft lease agreements, and commitments to a federal depository institutions regulatory agency), the trustee or DIP may decide to assume or reject at any time up to confirmation of a chapter 11 plan. However, any nondebtor party to a contract may seek to compel the trustee or DIP to assume or reject the contract prior to confirmation, in which case the bankruptcy court must decide what period of time is reasonable to make the decision. 11 U.S.C. §§ 365(d)(2), (d)(4) and (o). Pending the decision to assume or reject, the trustee or DIP is generally obligated to keep current on most obligations that become due under the contract postpetition. 11 U.S.C. §§ 365(d)(3) and (d)(5).
Definition of "Executory"
The Bankruptcy Code does not define "executory." Based on the legislative history of section 365, the U.S. Supreme Court concluded in a 1984 decision that "Congress intended the term to mean a contract 'on which performance is due to some extent on both sides.'" NLRB v. Bildisco & Bildisco, 465 U.S. 513, 522 n.6 (1984) (quoting H.R. Rep. No. 95-595, 347 (1977); S. Rep. No. 95-989, 58 (1978)).
However, because nearly all contracts involve some unperformed obligations on both sides as of the bankruptcy petition date, many courts have adopted the more restrictive definition proposed by Professor Vern Countryman, who in 1973 defined an "executory" contract as "[a] contract under which the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other." See V. Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973); see also V. Countryman, Executory Contracts in Bankruptcy: Part II, 57 Minn. L. Rev. 479 (1974); see generally Collier on Bankruptcy ("Collier") ¶ 365.02 (16th ed. 2022) (citing cases).
Thus, according to this approach, unless both parties have unperformed obligations as of the bankruptcy petition date that would constitute a material breach if not performed, the contract is not executory. See In re Columbia Gas Sys. Inc., 50 F.3d 233, 239 (3d Cir. 1995); accord In re Bennett Enterprises, Inc., 628 B.R. 481 (Bankr. D.N.J. 2021) (a contract for the sale of a debtor's liquor license did not remain executory after the purchaser obtained a state court order for specific performance because, under New Jersey law, neither party had any remaining material obligations to the other under the sale contract, and to the extent either party failed to fulfill its obligations under the state court order, the state court had authority to complete, or appoint a third party to complete, those obligations); see also In re Brick House Properties LLC, 633 B.R. 410, 421 (Bankr. D. Utah 2021) (noting that, in accordance with the Tenth Circuit's ruling in In re Baird, 567 F.3d 1207 (10th Cir. 2009), the Countryman definition applies, but with the caveat that the remaining obligations must be "significant").
The U.S. Court of Appeals for the Third Circuit recently explained the rationale of the Countryman approach as follows:
To facilitate the debtor's rehabilitation, the Countryman test attempts to foolproof the debtor's choice to assume or reject contracts; thus, the debtor only has that flexibility for executory contracts—those contracts where there could be uncertainty about whether they are valuable or burdensome. A helpful perspective is to view executory contracts "as a combination of assets and liabilities to the bankruptcy estate; the performance the nonbankrupt owes the debtor constitutes an asset, and the performance the debtor owes the nonbankrupt is a liability." … Under this framework, a contract where the debtor fully performed all material obligations, but the nonbankrupt counterparty has not, cannot be executory; that contract can be viewed as just an asset of the estate with no liability… . Treating it as an executory contract risks inadvertent rejection because the debtor would in effect be giving up an asset by rejecting it… . On the other extreme, where the counterparty performed but the debtor has not, the contract is also not executory because it is only a liability for the estate… . Treating it as an executory contract risks inadvertent assumption, for the debtor would effectively be agreeing to pay the liability in full when the counterparty should instead pursue the claim against the estate like other (typically unsecured) creditors… . Only where a contract has at least one material unperformed obligation on each side—that is, where there can be uncertainty if the contract is a net asset or liability for the debtor—do we invite the debtor's business judgment on whether the contract should be assumed or rejected.
In re Weinstein Co. Holdings LLC, 997 F.3d 497, 504–05 (3d Cir. 2021) (citations omitted).
State law determines what constitutes a material unperformed obligation. Columbia Gas, 50 F.3d at 239 n.10; In re Houston, 2009 WL 3762257, at *2 (Bankr. W.D. Ky. Nov. 9, 2009) ("Whether a party's nonperformance of the remaining obligations under a contract would constitute a material breach is a factual question resolved through application of state law.") (citing In re Teligent, Inc., 268 B.R. 723, 730 (Bankr. S.D.N.Y. 2001)); Seitz v. Paul T. Freund Corp., 2009 WL 1011617, at *2 (W.D.N.Y. Apr. 15, 2009) ("Determination of whether a breach is material is a factual question resolved by resort to state law… . In New York, a material breach is one which substantially defeats the purpose of the contract, and if uncured, will operate to excuse the other party from further performance.").
Some courts have eschewed the traditional Countryman test in favor of a result-oriented or "functional" approach examining whether the bankruptcy estate will benefit from assumption or rejection of the contract instead of looking at the mutuality of unperformed material obligations. See In re Fin. Oversight & Mgmt. Bd. for Puerto Rico, 631 B.R. 559, 566 (D.P.R. 2021) (noting that the functional approach works "'backward from an examination of the purposes to be accomplished by rejection, and if they have already been accomplished then the contract cannot be executory'" (citation omitted), and ruling that a pre-bankruptcy settlement agreement was executory and could be assumed under either the Countryman or the functional test); see generally Collier at ¶ 365.02 (citing cases).
Yet another approach is a "modern contract analysis" proposed by Professor Jay L. Westbrook and Kelsi S. White in their article titled "The Demystification of Contracts in Bankruptcy," 91 Am. Bankr. L.J. 481 (Summer 2017), which is premised on the notion that the Countryman test is outmoded and confusing. This approach would abolish the "material breach" rule that embodies executoriness as a prerequisite to application of section 365. Instead, the court would engage in the following analysis to determine whether a contract should be assumed or rejected:
(1) Determine under state contract law if the contract contains some obligations that remain to be performed; and if not, it cannot be assumed or rejected;
(2) If there is nothing remaining under the contract except obligations owed by the debtor (e.g., payment), assumption or rejection is not necessary because there is nothing left to do except payment and discharge through the bankruptcy process;
(3) If some obligations remain other than mere payment, consider whether the net benefit to the estate from performance by both parties (assumption) exceeds the net benefit from the estate's breach of the contract and payment of the breach (rejection) claim; and
(4) The court should approve the course of action resulting in net benefit to the estate, unless some other specific provision in section 365 requires a different conclusion.
Id. at 489.
If a contract or agreement is not executory, it may be neither assumed nor rejected. Instead, the contract may give rise to either an estate asset or a liability—in the latter case, a claim that may be asserted against the estate by the non-debtor party. Thus, for example, if the non-debtor party has fully performed under the contract and "the only remaining obligation is the [debtors'] duty to pay," the contract is not executory. Teligent, 268 B.R. at 732; accord Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1046 (4th Cir. 1985) ("It is true that a contract is not executory as to a party simply because the party is obligated to make payments of money to the other party.").
However, like other assets of a bankruptcy estate, a contract that is not executory may be sold by the trustee or DIP as part of a chapter 11 plan or in a sale under section 363 of the Bankruptcy Code. In the event of a sale "free and clear" under section 363(f), the trustee or DIP need not cure any defaults under a non-executory contract and, unless the parties agree otherwise, the buyer would not assume any prepetition liabilities under the contract. See In re Am. Home Mortg. Holdings, Inc., 402 B.R. 87, 94 (Bankr. D. Del. 2009) ("[S]ection 363 of the Bankruptcy Code permits a debtor to transfer its rights and obligations under a non-executory contract … [and] section 363(f)(5) permits the rights and obligations under one non-executory contract to be transferred free and clear of claims arising under other contracts."); accord In re Badlands Energy, Inc., 608 B.R. 854, 874 (Bankr. D. Colo. 2019).
Because the language of section 365(a) is permissive ("the trustee … may assume or reject"), it is possible that the trustee or DIP may take no action with respect to an executory contract or unexpired lease. When that happens in a chapter 11 case, contracts may "ride through" or "pass through" the bankruptcy case because a prepetition executory contract that is not assumed in a chapter 11 case is not "deemed rejected"—but not a lease of nonresidential real property, which is deemed rejected if not assumed within a specific time frame (see 11 U.S.C. §§ 365(d)(1) and 365(d)(4)). Thus, pursuant to the "ride-through" or "pass-through" doctrine, an executory contract that is neither assumed nor rejected during a chapter 11 case or in a chapter 11 plan will ride though the bankruptcy and continue to exist thereafter. See generally Collier at ¶ 365.03[6] (citing cases).
Prohibition of Assumption or Assignment of Certain Types of Contracts and Leases
A trustee or DIP may not assume or assign certain kinds of executory contracts or unexpired leases, whether or not the contract or lease prohibits or restricts an assignment of rights or a delegation of duties. See 11 U.S.C. § 365(c). These include: (i) contracts with respect to which applicable law excuses the non-debtor party from accepting performance from, or rendering performance to, an entity other than the debtor or the DIP (e.g., personal service contracts or patent licenses), and the non-debtor does not consent to assumption or assignment; (ii) contracts "to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor"; and (iii) nonresidential real property leases that terminated under applicable non-bankruptcy law before the entry of an order for relief in the bankruptcy case. See 11 U.S.C. § 365(c)(1)-(3).
The scope of section 365(c)(2) is limited. It "applies only to extensions of credit that are 'loans,' 'debt financing' or 'financial accommodations,' and not to all contracts to extend credit." Collier at ¶ 365.07[2] (citing cases). The purpose of the provision is to prevent a trustee or DIP from requiring new advances of money from a creditor. See In re Jonesboro Tractor Sales, Inc., 619 B.R. 223, 233 (Bankr. E.D. Ark. 2020); In re Cent. Illinois Energy, L.L.C., 482 B.R. 772, 787 (Bankr. C.D. Ill. 2012), aff'd sub nom. Rafool v. Evans, 497 B.R. 312 (C.D. Ill. 2013). The term "financial accommodation" is not defined in the Bankruptcy Code. However, it has been narrowly construed to mean an extension of money or credit to accommodate another. See In re Thomas B. Hamilton Co., Inc., 969 F.2d 1013, 1018–19 (11th Cir. 1992); In re Jonesboro Tractor Sales, Inc., 619 B.R. 223, 231 (Bankr. E.D. Ark. 2020).
Falcon
Oil and gas exploration and development companies Falcon V, LLC and its affiliates (collectively, "Falcon V") entered into a "Surety Bond Program" with Argonaut Insurance Company ("Argonaut") whereby Argonaut posted four irrevocable performance bonds (the "Bonds") guaranteeing Falcon V's obligations to certain third parties related principally to the plugging, abandonment, and restoration of oil and gas wells. The Bonds provided that "regardless of the payment or nonpayment by [Falcon V] of any premiums owing with respect to this Bond, [Argonaut's] obligations under this Bond are continuing obligations and shall not be affected or discharged by any failure by [Falcon V] to pay any such premiums." In exchange, Falcon V pledged security for its payment obligations, agreed to pay premiums to Argonaut and agreed to indemnify Argonaut for any payments that Argonaut made under the Bonds (the "Indemnity Agreement").
In May 2019, Falcon V filed for chapter 11 protection in the Middle District of Louisiana. Argonaut filed a proof of claim in the case for the amount outstanding under the Bonds (approximately $10.5 million), $3.2 million of which was secured. Argonaut also asserted that the Surety Bond Program could not be assumed or assigned because it was a "financial accommodation." However, Argonaut reserved its rights to challenge any action taken by Falcon V with respect to the contracts if the court were later to find that they were executory.
The bankruptcy court confirmed Falcon V's chapter 11 plan in October 2019. The plan provided that Falcon V was "deemed to have assumed each executory contract … to which it is a party." In February 2020, Argonaut requested, in accordance with the terms of the Indemnity Agreement, that Falcon V provide $7.3 million in additional collateral to secure the Bonds. Asserting that the plan discharged Argonaut's claims, Falcon V refused.
Argonaut then asked the bankruptcy court to interpret and enforce the plan, arguing that Falcon V assumed the Surety Bond Program under the plan, and that even if the Surety Bond Program had not been assumed, it had "passed through" the bankruptcy unaffected.
The bankruptcy court ruled that the Surety Bond Program had not been assumed under the plan because it was not an executory contract. In applying the Countryman test, the court concluded that even though Falcon V had a continuing obligation to pay premiums to Argonaut and to indemnify Argonaut for any payments that it made under the Bonds, the Surety Bond Program did not satisfy the test's initial prong because Argonaut had already posted the Bonds and did not owe further performance to Falcon V. Thus, the parties' obligations flowed only in one direction, and the Surety Bond Program was not executory.
The bankruptcy court also held that Argonaut's unsecured claim against Falcon V must be disallowed under section 502(e)(1)(B) of the Bankruptcy Code as a co-obligor's contingent claim for reimbursement or contribution, but noted that Argonaut had an allowed secured claim for $3.2 million. The court did not address Argonaut's pass-through argument.
Argonaut appealed to the district court, which affirmed. In so ruling, the district court held that the bankruptcy court did not err in declining to address the pass-through argument because the doctrine applies exclusively to executory contracts. Argonaut appealed to the Fifth Circuit.
The Fifth Circuit's Ruling
A three-judge panel of the Fifth Circuit affirmed the district court's ruling.
Writing for the panel, U.S. Circuit Court Judge Stephen A. Higgenson explained that Falcon V did not assume the Surety Bond Program in its chapter 11 plan because the program was not an executory contract under the Countryman test, and therefore could not be rejected.
Judge Higgenson was unconvinced by Argonaut's argument that the Countryman test should be modified in the case of a surety contract to consider not only the obligations between the surety (Argonaut) and the principal (Falcon V), but also their obligations to the third-party obligees. According to Argonaut, because both it and Falcon V remained obligated to the various third parties for whose benefit the Bonds were issued, and because Falcon V had not fulfilled its indemnity obligation to Argonaut, the Surety Bond Program should qualify as an executory contract. Such a modification of the test, Judge Higgenson wrote, would simply elevate the rights of sureties over the rights of other creditors, rather than "further[ing] the test's goal of 'facilitat[ing] the debtor's rehabilitation' by giving debtors discretion to assume or reject those contracts 'where there can be uncertainty if the contract is a net asset or liability for the debtor.'" Falcon, 44 F.4th at 354 (citing Weinstein, 997 F.3d at 504-05).
Even so, the Fifth Circuit determined that courts "should apply the Countryman test to multiparty contracts in a flexible manner that accounts for the various obligations owed to all of the parties, rather than focusing exclusively on the flow of obligations between the debtor and the creditor." Id.
In the case before the Fifth Circuit, Judge Higgenson explained, even if the continuing obligations of the parties collectively under the Surety Bond Program satisfied the first prong of the Countryman test—continuing performance on both sides—the program did not satisfy the second prong, and was therefore not executory, because Falcon V's failure to perform its obligations under the Surety Bond Program would not excuse Argonaut from its "irrevocable" performance obligations to the obligees.
The Fifth Circuit also ruled that the Surety Bond Program did not ride through Falcon V's chapter 11 case because the doctrine applies only to executory contracts.
Finally, in light of its conclusion that the Surety Bond Program was not executory, the Fifth Circuit declined to address Argonaut's contention that the bankruptcy court erred in concluding that the program could not be assumed as a "financial accommodation."
Outlook
The Fifth Circuit's ruling in Falcon is significant for a number of reasons.
First, it embraces a nuanced and flexible approach to the Countryman test for executoriness that may expand the scope of what qualifies as an executory contract in cases involving multiparty contracts. Under this more flexible approach, for courts that apply the Countryman test, the absence of continuing obligations by one party to a contract may not preclude a determination that the contract is executory and can be rejected, assumed or assumed and assigned.
The Fifth Circuit acknowledged that, in other multiparty contract cases, it might make sense for courts to modify the Countryman test by, for example, applying the "functional approach."
Second, Falcon is the second decision in the last two years providing appellate-court guidance at the circuit level on the concept of executoriness in bankruptcy. In its 2021 ruling in Weinstein, the Third Circuit affirmed lower court rulings holding that a "work-made-for-hire" contract between a film company debtor and the producer of a motion picture was not an executory contract because the producer lacked any remaining "material obligations." In so ruling, the Third Circuit noted that the parties to a contract can override the Bankruptcy Code's intended protections for a debtor in connection with certain contracts, but only by clearly and unambiguously providing that continuing obligations are material in the text of the agreement and thereby ensuring to the maximum extent possible that the contract will be found to be executory.
It remains to be seen whether the Fifth Circuit's flexible approach to executoriness in Falcon will be applied by other courts.
