Compelling Nondebtor Suppliers to Perform under Executory

JOURNAL
AMERICAN
BANKRUPTCY
INSTITUTE
Issues and Information for Today’s Busy Insolvency Professional
Compelling Nondebtor Suppliers
to Perform under Executory Contracts
I
Contributing Editor:
John T. Gregg
Barnes & Thornburg LLP; Grand Rapids, Mich.
[email protected]
n the manufacturing sector,
agreements are often in the form of
purchase orders that include terms and
conditions such as pricing, but lack any
reference to a specific quantity and are
instead categorized as requirements
contracts. While some agreements may
be for a definite duration without any
extension clauses, others are for a definite
duration but subject to unilateral
automatic renewal unless notice of
nonrenewal is provided. Because parts in
the manufacturing sector and the
automotive industry in particular are
supplied on a “just-in-time” basis, a
supplier’s refusal to ship can have
catastrophic results, especially where the
supplier is a sole source supplier. One
court (in a situation where the debtor was
actually the supplier) has explained that:
Because [the debtor] was a “single
source” supplier to General
Motors Corp. (among others), it
feared that any interruption in its
production schedules might result
in a shutdown of certain assembly
lines while GM and other
customers obtained new suppliers
and made the necessary
arrangements for new production
tooling and dies. In turn, these
shutdowns might cause the layoff
of innumerable employees of GM
and debtor’s other customers...
In re A utostyle Plastics Inc., 216 B.R.
784, 788 (Bankr. W.D. Mich. 1997).
Based in part on fear of a line
shutdown and, undoubtedly, a desire for
control at the outset of bankruptcy cases,
debtors have recently become proactive by
proposing procedures as part of their first
day motions or shortly thereafter to
About the Authors
John Gregg is an attorney in the
Finance, Insolvency and Restructuring
Department of Barnes & Thornburg LLP
in Grand Rapids, Mich.
address threats or
demands of parties to
executory contracts.
Such
procedures
attempt to circumvent any potential for
line shutdowns or
other disruptions to
the debtor’s business
John T. Gregg
by, among other
things, requiring the
nondebtor supplier to continue to perform
postpetition.
For example, in the recently filed
jointly administered chapter 11 cases of
Plastech Engineered Products Inc. and its
On the Edge
affiliates, the court approved the deb-tors’
proposed proce-dures “addressing certain
unlawful de-mands that have already been
made, and that that the debtors anticipate
will continue to be made by nondebtor
parties to contracts, including purchase
orders....” In re Plastech Engineered
Products Inc., Case No. 08-42417 (Bankr.
E.D. Mich.). Granting the requested relief,
the Plastech court authorized the debtors
to immediately pay claims of suppliers
refusing to perform their post-petition
obligations under executory contracts. In
re Plastech Engineered Products Inc., Case
No. 08-42417 (Bankr. E.D. Mich. Feb.
21, 2008). Thereafter, according to the
order, the supplier is to immediately
continue or resume shipping pending a
hearing on the supplier’s alleged violation
of the automatic stay. Id. at ¶2. At such
hearing, the debtors are required to
demonstrate that the supplier has refused
to ship under an executory contract and
that such failure to ship violates the
provisions of §§362 and 365 of the
Bankruptcy Code. Id. at ¶¶6-7. In the
event that the debtors satisfy their burden,
the prior payment is deemed to have been
made on account of post-petition amounts
owed by the debtors to the supplier. Id. at
¶7. However, in the event that the debtors
are unable to satisfy their burden, the
supplier is entitled to retain the prior
payment so long as the supplier continues
to ship post-petition in exchange for cash
in advance or pursuant to other terms
negotiated between the debtors and the
supplier. Id. at ¶8.
Procedures such as those approved by
the court in Plastech are likely to become
the norm as the manufacturing sector
continues to struggle financially due to
increased competition, narrow profit
margins and increased costs for raw
materials, among other things. As such,
suppliers are likely to inquire under what
circumstances they are required to
continue to perform under various
agreements and purchase orders with a
debtor in bankruptcy. 1
Post-petition Performance
Obligations
1 As an initial matter, it is important to note that a purchase order does
not always constitute an executory contract. See In re Dana Corp., 2007
WL 4105714, *3 (Bankr. S.D.N.Y. Nov. 14, 2007) (citing Advanced
Plastics Corp. v. White Consol. Indus., 828 F. Supp. 484, 487 (E.D.
Mich. 1993), aff’d 47 F.3d 1167 (6th Cir. 1995)). Rather, “[a] blanket
purchase order is not a contract for a specific volume of parts, nor is it a
requirements contract obligating the purchaser to continue to buy parts
from the supplier.” Id. “Each time a specific release under a blanket
purchase order is fulfilled by the supplier and paid by the purchaser, the
contractual relationship in essence ends unless the purchaser issues
another release.” Id. “Thus, where no minimum duration is stated in the
contract, the general rule is that it is terminable at will by either party.”
Id. (citation omitted).
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The Code itself is silent on the rights
and obligations of the parties of an
executory contract during the period
between the filing of the petition and the
time of assumption or rejection. In re
National Steel Corp., 316 B.R. 287, 305
(Bankr. N.D. Ill. 2004) (citation omitted).
However, it is widely accepted that an
executory contract generally remains in
effect pending assumption or rejection by
a debtor. S ee, e.g., Pub. S erv. Co. of
N.H., 884 F.2d 11, 14 (1st Cir. 1989).
Most courts agree that before an
executory contract is assumed or rejected,
the contract continues to exist,
enforceable by, but not against, the debtor.
See, e.g., National Steel Corp., 316 B.R.
at 305 (citations omitted). 2 The nondebtor
party to an executory contract must
continue to perform prior to assumption
or rejection, but the debtor is not bound
by the provisions of the executory
contract unless the contract is
subsequently assumed. In re El Paso
R efinery LP, 196 B.R. 58, 72 (Bankr.
W.D. Tex. 1996); In re PittsburghCanfield Corp., 283 B.R. 231, 238
(Bankr. N.D. Ohio 2002) (nondebtor party
“cannot unilaterally elect to cease
performance on executory contract prior
to assumption or rejection”). 3
Recent decisions have continued to
recite the holding that a nondebtor is
obligated to honor and perform under an
executory contract or unexpired lease
pending assumption or rejection. In re
R hodes Inc., 321 B.R. 80, 91 (Bankr.
N.D. Ga. 2005); National S teel, 316
B.R. at 305; In re Boling Group LLC,
2002 WL 31812671 *6 (Bankr.
M.D.N.C. Dec. 13, 2002); M atter of
Travelot Co., 286 B.R. 462, 466
(Bankr. N.D. Ga. 2002). S ee also
Pittsburgh-Canfield, 283 B.R. at 238.
Injunctions to Enforce
Performance while Protecting
Nondebtor Interests
In one of the few reported decisions
2 For other secondary sources addressing this issue, see Schorling,
William H. and Simmons, Robert P., “Adequate Protection for the
Nondebtor Party to Executory Contracts and Unexpired Leases,” 64 Am.
Bankr. L. J. 297 (Summer 1990); Buschman III, Hon. Howard C.,
“Benefits and Burdens: Post-Petition Performance of Unassumed
Executory Contracts,” J. Bankr. Dev. J. 341 (1988); Olack, Neil P.,
Executory Contracts and Unexpired Leases: Right to Adequate
Protection Prior to Assumption or Rejection (1987).
3 Where a debtor postpones assumption or rejection but continues to
receive benefits under the contract, “the [debtor] is obligated to pay for
the reasonable value of those services...which, depending on the
circumstances of a particular contract, may be what is specified in the
contract....” NLRB v. Bildisco & Bildisco, 465 U.S. 513, 531 (1984). See
In re FBI Distribution Corp., 330 F.3d 36, 42-44 (1st Cir. 2003) (where
nondebtor induced by debtor to render performance pending
assumption or rejection, nondebtor entitled to administrative expense if
consideration supplied post-petition and benefits estate). But see In re
Continental Energy Assocs. Ltd. P’ship, 178 B.R. 405, 408 (Bankr. M.D.
Pa. 1995) (language in Bildisco is dictum and not controlling).
discussing the authority of a court to issue
an injunction with respect to post-petition
enforcement of executory contracts, the
court in In re Continental Energy Assocs.
Ltd. P’ship stated:
At first glance, the concept that
a contract should not be
enforceable by either side to a
contract until it has been
assumed by a debtor makes
imminent [sic] sense. If it is
accepted that the nondebtor party
to a contract is stayed from
enforcing the terms of that
contract on a debtor prior to
assumption, then fairness would
seem to suggest that the
converse should also be true.
This approach, however, minimizes the impact that nonperformance may have on a debtor.
The case at issue is a fine example
of that type of impact. If Hazleton
refuses to supply natural gas to
the Debtor
pending
the
assumption of the contract, then
the debtor is effectively prevented
from operating until such time as
it can negotiate a new source of
energy. Not only does this saddle
an ailing company with an
additional burden which it is
unlikely to overcome, it pressures
the debtor to surrender the
“breathing space” normally
allowed to it to consider the
assumption or rejection of the
contract. As a matter of its very
existence, the debtor is influenced
to immediately assume the
contract with all of the
administrative burdens...the only
reasonable conclusion is that this
court, consistent with 11 U.S.C.
§105, can issue an order that
would allow such debtor to
enforce the contract until such
time as it accepts or rejects the
contract, provided that we
diligently guard the interests of
the nondebtor party to the
contract.
178 B.R. 405, 408 (Bankr. M.D. Pa.
1995).
The Continental court further
explained that in order for it to issue an
injunction, the debtor would need to (1)
continue to make post-petition payments
to the nondebtor party in accordance with
the terms of the executory contract, (2)
demonstrate irreparable injury would occur
if the debtor lost the benefits under the
contract and (3) show a strong or
substantial likelihood of success. Id. at
409. S ee Matter of Whitcomb & Keller
Mortgage Co. Inc., 715 F.2d 375, 37880 (7th Cir. 1983) (injunction appropriate
to compel performance where payments
made by debtor and nondebtor suffers no
harm or prejudice); Matter of Central
Watch Inc., 22 B.R. 561 (Bankr. E.D.
Wis. 1982) (debtor may sue to enforce
restrictive covenant). S ee also El Paso
R efinery, 196 B.R. at 71 (if contract
breached by nondebtor prior to decision to
assume or reject, “estate has a sufficient
interest to confer standing to sue for that
breach”).
As noted above, however, the
Continental court also stated that
although continued performance is
required, the interests of the nondebtor
party must still be taken into account.
Continental, 178 B.R. at 408. S ee also
Whitcomb & Keller, 715 F.2d at 379
(noting nondebtor suffered no harm or
prejudice through continued performance). 4 The Continental court further
intimated that one such interest to
consider is the reasonable value of the
materials or services provided. Id. at 40809. Specifically, the court stated:
Nevertheless, there is ample
authority for the proposition that,
pending assumption or rejection,
the debtor may elect to enforce the
contract thereby being required to
pay for the reasonable value of the
materials or services supplied....
Often times that cost will be
measured by reference to the
contract which presumably has
been negotiated at arm’s
length...if the debtor, prior to
assumption, elects to enforce the
contract, and this court were to
condition such enforcement on
payment of the consideration in
the contract not subject to further
review for reasonableness, then
we would be placed in a position
of authorizing an administrative
expense that may be violative of
11 U.S.C. §503(b)(1).
Id. (emphasis added).
While this language in Continental
expresses the court’s reluctance to award
an administrative expense without first
determining the reasonableness of the
terms of the contract, it also arguably
works both ways, such that the terms of
the contract must be reasonable to both
the debtor and nondebtor parties during the
“limbo” period.
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Ultimately, the Continental court found
that the debtor could enforce the terms of a
contract prior to assumption or rejection.
Continental nonetheless leaves open the
possibility that a debtor might not be
entitled to enforce a contract where, for
example, the terms of that contract are
unconscionable or do not contemplate
certain demands that result in unjustified
increases in requirements. Under certain
circumstances, enforcement of such terms
might even rise to the level of irreparable
harm to the nondebtor party.
The Act of Doing Nothing: The
Right to Withhold Performance
While Continental arguably provides
at least some protection under certain
circumstances to suppliers who are
required to perform, another court has held
that a nondebtor party to an executory
supply contract may actually withhold
performance where the debtor breached the
agreement prepetition. S ee In re Lucre
Inc., 339 B.R. 648 (Bankr. W.D. Mich.
2006), aff ’d on other grounds, 471 F.
Supp. 845 (W.D. Mich. 2007) (issue
moot
when
bankruptcy
court
subsequently issued injunction precluding
nondebtor party from withholding
services). 5
In In re Lucre Inc., the nondebtor party
to an executory supply contract moved for
relief from the automatic stay in order to
(1) seek dissolution of two temporary
restraining orders entered by the state court
prepetition and (2) withhold its future
performance under the agreements due to
the debtor’s prepetition material breach.
339 B.R. at 650. The debtor argued that
because the agreement became property of
the debtor’s estate, therefore, the nondebtor
party was subject to the automatic stay
such that it was precluded from
nonperformance. Id. at 653. According to
the court, however, §541 of the Code
transfers only the interests the debtor has
in property as of the petition date. Id. at
655. The court further explained that
unless the Code itself provides greater or
different rights under an executory contract
or unexpired lease, a debtor-in-possession
(DIP) or trustee is subject to the rights
under the agreement as of the date of the
transfer. Id. Because the debtor had
defaulted prior to the petition date, the
4 Specifically, the Continental court found that because (1) the debtor
was transferring, in advance, the contract price to the nondebtor and
(2) the nondebtor did not identify any “specific harm that would befall it
by reason of” continued performance, the contract should be enforced.
Continental, 178 B.R. at 409.
5 For a comprehensive discussion of the Lucre decision, see Pum, Maria
K., “Court Explores Obligations of Nondebtor Counterparty under
Unassumed Executory Contract,” Pratt’s Journal of Bankr. L. 2006.10-6
(October 2006).
court found that the debtor was subject to
the nondebtor party’s right to withhold
performance pending cure. Id. at 652
(citing Restatement (Second) §237).
The court was also not persuaded by
the interpretation of §365 employed by
other courts, noting that “[u]nfortunately,
the courts have tended to read into §365
more than that section actually provides.
Section 365 is in fact simply a
conglomeration of various rules relating
to the post-petition assumption and
rejection of executory contracts and
unexpired leases.” Id. at 655. The court
noted that only under §365(b)(4) can the
debtor compel performance, stating that
§365(b)(4) “proves by exception that the
rule that a trustee or DIP cannot
otherwise demand performance from the
other party to the contract when the
debtor’s prepetition breach under the
contract remains uncured. In other words,
there is no reason for including
§365(b)(4) in the Bankruptcy Code if, as
[the debtor] would have it, prepetition
defaults are irrelevant to begin with.” Id.
at 658.
The debtor also advanced a second
argument by noting that any refusal to
perform by the nondebtor party to the
agreement would violate §362(a)(6)
because the nondebtor party’s reason for
doing so would be to collect on a
prepetition debt owed to it by the debtor.
Id. The court found several flaws in this
argument. The court first noted that the
nondebtor party’s refusal to perform
could be the result of, among other
things, the poor prepetition performance
of the debtor or that, in general, the
nondebtor party did not particularly relish
transactions with chapter 11 debtors. Id.
The court explained that in its view, the
language of §362(a)(6) only stays an “act
to collect, assess, or recover a claim.”
Based on the court’s definition, an act is
“the doing of a thing.” Id. Because the
debtor was not doing anything, but
rather, was doing nothing, the court
found §362(a)(6) to be inap-plicable. Id.
The court also rejected the debtor’s
argument that because adequate protection
was being provided to the nondebtor party,
the automatic stay prohibits nonperformance. Id. at 659. The court noted that:
[p]ut simply, it is not enough for
the trustee or debtor-in-possession
to adequately provide for whatever
post-petition performance the other
party is to furnish under the
executory contract if there is also a
material prepetition breach by the
debtor, for the prepetition breach in
and of itself justifies continued
nonperformance by the other party
regardless of what the debtor may
offer as post-petition “adequate
protection.” The trustee or the DIP
must also cure the pre-petition
default as part of a §365 assumption
of the executory contract if it is to
regain its right to demand
performance from the other party.
Id. at 659 (emphasis added). 6
The court recognized that the
automatic stay does in fact preclude a
nondebtor party from terminating an
executory contract or unexpired lease. Id.
at 660. However, according to the court,
because termination was not at issue, the
debtor could not require the nondebtor
party to continue to honor its
obligations under the agreement where
performance was excused due to the
debtor’s breach. Id.
Finally, the court recognized that the
nondebtor party’s refusal to perform could
have a catastrophic result with respect to
the debtor’s efforts to reorganize. Id. at
661. Nonetheless, the court explained that
not all debtors are guaranteed success under
chapter 11. Instead, “[a]ll that Congress
has done is to set up a system within
which all debtors can try.” Id.
In the event that a customer of a
supplier files for bankruptcy, the
overwhelming majority of courts requires
the supplier to continue to honor and
perform under executory contracts with
the customer. Absent some irreparable
harm to the interests of the supplier, it is
almost certain that a supplier will be
required to perform under the supply
contract with the debtor. According to the
courts, if a supplier is dissatisfied with
the “limbo” period, its most appropriate
attempt at relief would be to file a motion
to compel assumption or rejection. S ee,
e.g., Pub. Serv. Co., 884 F.2d at 15-16. 7
Conclusion
6 In support of its argument, the debtor cited several cases, all of which
the court found unpersuasive, as they all involved the actual
termination of an executory contract or unexpired lease. Id. at 660
(citing In re Mirant Corp., 440 F.3d 238 (5th Cir. 2006); In re Midway
Airlines Corp., 406 F.3d 229 (4th Cir. 2005); In re Circle K Corp., 127
F.3d 904 (9th Cir. 1997); In re Computer Communications Inc., 824
F.2d 725 (9th Cir. 1987); In re B&K Hydraulic Co., 106 B.R. 131 (Bankr.
E.D. Mich. 1989)). The debtor also cited Pittsburgh-Canfield, which the
court distinguished because it did not address the question of a
prepetition breach. Id.
7 Of course, one option for a supplier would be to demand adequate
assurance of due performance from the debtor pursuant to §2-609 of
the Uniform Commercial Code, so long as the demand is made prior to
the petition date. Such demand would require that the debtor provide
adequate assurance, and until assurance is provided, the supplier
would be entitled to suspend performance. See UCC §2-609(1).
However, as a precautionary note, the supplier’s suspension of
performance must be “commercially reasonable.” See id. If it is not
“commercially reasonable,” the supplier will itself be deemed to have
repudiated under the agreement. See Government of Rep. of China v.
Compass Comm., 473 F. Supp. 1306 (D. Colo. 1979).
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Despite the many decisions standing
for the proposition that performance must
continue during the “limbo” period, only
a few cases, such as Continental and
Whitcomb & Keller, provide a test for
determining whether a nondebtor party
should in fact be enjoined from not
performing. Based on Continental, a
debtor needs to demonstrate that it has
continued to make timely post-petition
payments to the nondebtor party and that
it also would suffer irreparable injury as
a result of the nondebtor party’s refusal to
perform. While an injunction generally
will not be issued without a finding of
irreparable harm, it is unclear from
Continental just how difficult it is for a
debtor to satisfy the irreparable harm
element in the “limbo” period context.
However, Continental arguably also
stands for the proposition that a court
may review the terms of the agreement
with the interests of the nondebtor in
mind. Without considering the underlying
facts of each situation, though, it is
difficult to speculate as to a supplier’s
defenses to enforcement of its agreement
with a debtor. Based on the limited
discussion in Continental and Whitcomb
& Keller, it is likely that a supplier would
at least need to demonstrate that it would
suffer irreparable harm if it was compelled
to perform under the agreement.
Although Lucre essentially reverses
course and allows a supplier to withhold
performance under an executory contract
where the debtor has materially breached
such contract, Lucre is without question
the minority view. Nonetheless, if other
courts find Lucre persuasive and adopt its
rationale, suppliers will have significant
leverage to demand the immediate cure of
any defaults under the contracts to the
prejudice of not only the debtor and its
estate, but also to other creditors due to
increased, albeit unnecessary, assumption
of executory contracts. Reprinted with permission from the ABI
Journal, Vol. XXVII, No. 5 June 2008.
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devoted to bankruptcy issues. ABI has
more than 11,500 members, representing
all facets of the insolvency field. For more
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www.abiworld.org.
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