When the Other Party to Your Contract Files for Bankrtupcy

When you have a contract with a party who files for bankruptcy, the issues are more complex than prosecuting a claim for a simple book account.  The rights of both the debtor and non-debtor party to a contract are limited by 11 U.S.C. §§ 101 et seq., otherwise known as the Bankruptcy Code.  Certain provisions of the Bankruptcy Code directly impact the rights of parties to executory contracts and unexpired leases.

Executory contracts are those in which performance is due from both sides; i.e., a party will be in material breach if it fails to perform its remaining obligations under the contract.  Many contracts are executory, including those that involve ongoing services.  Examples of contracts that are not executory include previously expired contracts, promissory notes, and non-competition contracts.

I.     Terminating the Contract

A debtor’s rights under a contract are considered property of the estate, and therefore any attempt to terminate the contract or modify the debtor’s contractual rights absent court approval may be considered a violation of the automatic stay.

Many contracts include a termination provision upon a bankruptcy filing by one party.  Such a provision, known as an “ipso facto” clause, is unenforceable in an executory contract pursuant to the Bankruptcy Code.  Certain courts have extended this limitation to non-executory contracts.  Regardless of the existence of an ipso facto clause, terminating or refusing to perform under an executory contract with a debtor violates the Bankruptcy Code unless one of a few exceptions applies (i.e. intellectual property licenses and financing commitments).

II.    Payment and Enforcement

The automatic stay bars the non-debtor party to a contract from seeking payment from the debtor for amounts due thereunder and incurred prior to the date of the bankruptcy filing.  Absent court approval, the debtor (or a trustee) is prohibited from paying its pre-petition debts during the course of the bankruptcy proceeding.  A creditor should seek payment of pre-petition debts by timely filing a proof of claim.  If the claim is not objected to, the creditor will receive its pro rata share of payments distributed to unsecured creditors, which is typically low.  However, discussed below, if an executory contract is assumed, or assumed and assigned, the debtor is obligated to cure all contractual defaults, including pre-petition and post-petition monetary obligations.

A debtor is not permitted to enhance its contractual rights by filing for bankruptcy, and thus is expected to pay those post-petition monetary obligations arising under the contract, although such payment is not necessarily guaranteed.  If the non-debtor party provides post-petition goods or services that provide a necessary benefit to the debtor’s estate, that party can seek payment for the full amount due for those goods or services as an administrative expense claim.  A non-debtor party to a contract may also seek relief from the automatic stay to terminate the contract in the face of a post-petition monetary default.

III.    Assumption and Rejection

The Bankruptcy Code provides the debtor with several options to affect executory contracts during and after bankruptcy.  A debtor may assume an executory contract, assume and assign an executory contract, or reject an executory contract.

Assumption of an executory contract requires cure of all defaults (with certain exceptions for specific non-monetary defaults), and adequate assurance of future performance.  When the debtor assumes a contract, it agrees to be bound by the terms of the agreement going forward.  If the debtor assumes an executory contract, it may then assign it to a third party.  With limited exception, the debtor has the authority to assume any executory contract and assign it a third party regardless of any contractual anti-assignment provision or other party’s consent, as long as the above requirements have been met.

Rejection of an executory contract is similar to, but not the same as, termination of a contract.  If a contract is rejected, the debtor is deemed to have breached the contract as of the date of the bankruptcy filing and is relieved from its obligation to perform under the contract.  Any amounts due under the contract, or which may become due through the term of the contract (with limitations applicable to leases of real property), constitute a general unsecured claim against the debtor’s estate unless those amounts qualify for priority treatment as, for example, administrative expense claims.

A fourth option, known as “ride-through,” occurs when the debtor neither assumes nor rejects an executory contract, it is unaffected by the bankruptcy proceeding.  No discussion of ride-throughs is found in the Bankruptcy Code, but courts have recognized the doctrine.  Ride-throughs are extremely rare for a variety of reasons beyond the scope of this discussion.

Depending on the chapter of the Bankruptcy Code that the case is filed under and the type of contract in question, certain provisions may impact the timing of assumption or rejection.  In order to protect its rights under a contract with a bankrupt debtor, a party should be cognizant of claim filing deadlines, asset sales, confirmation proceedings, and notices of assumption or rejection.

Businesses and individuals that would like legal counsel to review this issue are welcomed to contact any member of the Bankruptcy and Creditors’ Rights group here at Brown & Connery, LLP via e-mail or call 856-854-8900.  Also, please visit the Brown and Connery website at to learn more about our legal services.

By:  Julia Montgomery, Partner at Brown & Connery, LLP