Fifth Circuit: Bad Faith Does Not Overcome Deferential Business Judgment Standard Applied To Assumption Or Rejection Of Contracts In Bankruptcy

• Jurisdiction: United States,Federal
• Law Firm: Jones Day
• Subject Matter: Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy
• Author: Mr Mark Cody and Mark Douglas
• Published date: 01 February 2023

The ability of a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to assume, assume and assign, or reject executory contracts and unexpired leases is an important tool designed to promote a "fresh start" for debtors and to maximize the value of the bankruptcy estate for the benefit of all stakeholders. Bankruptcy courts generally apply a deferential "business judgment" standard to the decision of a trustee or DIP to assume or reject an executory contract or an unexpired lease.

In In re J.C. Penney Direct Marketing Services, L.L.C., 50 F.4th 532 (5th Cir. 2022), the U.S. Court of Appeals for the Fifth Circuit affirmed lower court rulings approving a DIP's decision, at the behest of the purchaser of its assets, to reject a commercial ground lease, even though an agent retained by the DIP to market its shopping center leases acted in bad faith in negotiations with a sublessee intent upon acquiring the ground lessor's interest. In so ruling, the Fifth Circuit rejected the sublessee's argument that the DIP's decision to reject the lease should not receive deference under the business judgment standard due to the agent's bad faith. According to the Fifth Circuit, in the absence of evidence that the decision to reject did not enhance the bankruptcy estate or was "clearly erroneous, too speculative, or contrary to the Bankruptcy Code," the presumption created by the business judgment rule could not be overcome. Nor, the court noted, did the sublessee demonstrate that the DIP's decision was "so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice."

Assumption and Rejection of Executory Contracts and Unexpired Leases in Bankruptcy

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 contracts and leases (among other powers) is conferred upon a 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). 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). The cure obligations set forth in section 365(b)(1) do not apply to defaults triggered by the debtor's financial condition (including its bankruptcy filing) and certain other breaches. See 11 U.S.C. ' 365(b)(2).

The Bankruptcy Code does not define the term "executory." Many courts have adopted the test for executoriness articulated 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 ' 365.02 (16th ed. 2022) (citing cases). If a contract or lease is not executory, it may be neither assumed nor rejected. Instead, the...