It is well recognized that pursuant to §365 of the Bankruptcy Code, a trustee or debtor may assume or reject executory contracts and unexpired leases. While it is not unusual for a debtor to have a variety of separate and distinct executory contracts and unexpired leases, there are situations where the debtor has multiple intertwined executory contracts or leases. For example, the debtor may have entered into a series of real estate leases or an equipment lease with multiple schedules.

It is clear that the debtor has the right to examine each executory contract and unexpired lease and to make an independent business judgment regarding the assumption or rejection of each agreement. However, it is not as clear with multiple intertwined executory contracts whether the debtor may assume some of the contracts while rejecting others. If two parties execute a series of related leases, and the lessee subsequently files for bankruptcy protection, is the debtor permitted to assume one lease and reject the others, or must the debtor either assume or reject the leases as a whole?

Courts have reached differing results on this issue; some courts have found that multiple agreements constitute a single contractual agreement that must be assumed or rejected in total, while others have found that a single written instrument actually includes several separate agreements and have permitted the assumption of some and rejection of others.

Whether a series of executory contracts or unexpired leases are treated as an indivisible unit will not only influence a debtor's bankruptcy case, but may limit a debtor's chances for successful reorganization. Section 365 establishes a structure under which a debtor may evaluate the advantages and disadvantages of an executory contract or unexpired lease. If the net performance on both sides would benefit the estate, the contract or lease should be assumed and either performed or assigned. On the other hand, if the net performance on both sides would be detrimental to the debtor's bankruptcy estate, the contract or lease should be rejected. 2 Norton, William L. Jr., Bankruptcy Law and Practice 2d. §39.1 (1997). Consequently, the characterization of contracts or leases as indivisible units or separate agreements will affect the net advantages or disadvantages of assumption or rejection of the agreements on a debtor's bankruptcy estate, thus making such characterization of significant importance. This article discusses the current state of the law concerning the ability of a trustee, or debtor, to assume or reject executory contracts and unexpired leases where the contracts or leases are comprised of multiple, and possibly related, agreements.

An Executory Contract or Unexpired Lease Must Be Assumed or Rejected in Its Entirety

It is generally recognized that a debtor must assume or reject an executory contract or unexpired lease in toto. A debtor may not pick and choose among contractual provisions, rejecting those it deems burdensome and accepting those it views as beneficial. Rather, a debtor must assume or reject an executory contract or unexpired lease in its entirety. In re Plitt Amusement Co. of Washington Inc., 233 B.R. 837 (Bankr. C.D. Ca. 1999); In re Diamond Head Emporium Inc., 69 B.R. 487 (Bankr. D. Ha. 1987); In re Atlantic Computer Systems, 173 B.R. 844 (S.D.N.Y. 1994); In re Café Partners/Washington, 90 B.R. 1 (Bankr. D.C. Cir. 1988). This does not mean, however, that a debtor cannot assume one executory contract and reject another, nor does this "all or nothing" requirement mean that every document denominated as a "contract" or "lease" must be treated as a single, indivisible whole. Rather, as the case law demonstrates, a contract or lease may actually consist of several distinct contractual agreements subject to independent assumption or rejection by a debtor. Id. at 5.

Unfortunately, few courts have established a definitive test to effectively determine whether a contract or lease in question should be treated as an indivisible unit or a severable agreement. Only the Eleventh Circuit Court of Appeals in In re Gardinier, 831 F.2d 974 (11th Cir. 1987) has developed a test to determine the composition of an executory contract or lease. In Gardinier, the court considered whether a provision to pay a brokerage commission, contained within a purchase and sale agreement, constituted a separate and distinct agreement subject to assumption or rejection pursuant to §365. In holding that the brokerage commission provision constituted a separate agreement between the parties, the court identified three factors it considered in determining severability: (i) whether the nature and purpose of the obligations differ, (ii) whether the consideration for the obligations is separate and distinct, and (iii) whether the obligations of the parties are interrelated.

In the matter of In re Atlantic Computer Systems Inc., 174 B.R. 844 (S.D.N.Y. 1994), the court was asked to approve a debtor's motion to reject the burdensome parts of equipment leases with multiple schedules, while at the same time assuming the profitable leases. On June 30, 1988, the debtor, the lessor of computer equipment, entered into a master lease agreement together with the first equipment schedule. At separate times during 1989, the parties entered into five additional equipment schedules. At the time each additional equipment schedule was executed, the parties also entered into separate "flexlease" agreements. The flexlease agreements gave the lessee certain rights to early termination and upgrade of equipment. The lessee, prior to the bankruptcy filing, had requested the debtor honor its obligation under the flexlease. The debtor proposed a plan seeking to affirm the master lease and schedules, but reject the provisions of the flexlease agreements. The bankruptcy court construed the various leases to be separate contracts and confirmed the debtor's plan. On appeal to the district court, the lessee argued that the lease agreements cannot be separated. The district court reversed the bankruptcy court, relying on the established principles of New York contract law that "instruments executed contemporaneously by the same parties, for the same purpose and in the course of same transactions, are to be read and interpreted together." In confirming its decision, the court also applied the three-part test set out in In re Gardinier and concluded that the flexleases were not separate agreements. It is interesting to note that the court, in looking at the transaction, specifically concluded that the master lease, the five separate equipment schedules and the attached flexlease agreements were not one transaction. Instead, the court concluded there were five transactions, comprised of the master lease, each schedule and the accompanying flexlease agreement. Thus, in making its decision, the court looked at each schedule, etc. as a separate group of contracts that it concluded was one agreement.

Numerous other courts have cited Gardinier and its three-factor test in determining the severability of contractual provisions. Unfortunately, most courts have failed to uniformly apply its factors, thus leading to disparate results. See In re Pollack, 139 B.R. 938 (Bankr. 9th Cir. 1992) and In re T&H Diner Inc., 108 B.R. 448 (D. N.J. 1990). Rather than decisions based on the three-factor test, what has emerged is case law focusing on the intentions of the parties at the time of contracting and, interwoven therein, a focus on the contemporaneous execution of agreements as a manifestation of the parties' intent.

The Intent of the Parties at the Time of Contracting

The intent of the parties at the time of contracting is the most outcome-dispositive factor in determining whether a contract or lease, consisting of several related agreements, should be construed independently or as an indivisible whole for assumption and rejection purposes under the Bankruptcy Code. An examination of case law evidences an emphasis by the courts on the issue of whether, at the time of contracting, the parties to the contract or lease intended its related agreements to be inextricably intertwined or inherently distinct from one another.

For example, recently, in In re Plitt Amusement Co. of Washington Inc., the bankruptcy court was confronted with the issue of whether an unexpired lease constituted an independent lease agreement such that it could be rejected by the trustee pursuant to §365. In Plitt, the parties entered into a transaction involving six documents: a purchase agreement, a promissory note, a security agreement and three non-residential real property leases. Following the debtor's voluntary filing for relief under chapter 7, the trustee filed a motion seeking to reject one of the three unexpired non-residential real property leases. In opposition to the trustee's motion, a party asserted that the three leases, the purchase agreement and the promissory note constituted one indivisible, non-severable transaction that the trustee must assume or reject in its entirety. In determining that the non-residential real property lease qualified as a separate lease that could be independently assumed or rejected by the trustee, the court began its analysis by focusing on the six instruments in order to determine the intentions of the parties.

Following the same reasoning, the court in In re Harrell, 619 S.W.2d 528 (Tenn. 1981) considered whether two agreements, executed simultaneously by the same parties, constituted a single indivisible contractual agreement. In determining that the agreements were distinct, the court focused on the intention of the parties at the time of contracting, stating that if the parties truly intended the agreements to be construed together, all they had to do was say so in the agreements. Their failure to do so evidenced a clear intention that the agreements be viewed independently of one another.

Similarly, in In re Dynamics Corp. of America, 429 F. Supp. 341 (S.D.N.Y. 1977), the court also focused on the intentions of the parties. Here, two parties simultaneously executed a purchase agreement and a sales agreement. The purchase agreement set out the terms and conditions for the transfer of land, buildings and manufacturing equipment. The sales agreement addressed the production, sale and purchase requirements of the parties. A dispute arose between the parties, calling into question whether the documents constituted a single contract or separate contractual agreements. In holding that the agreements must be viewed as a whole, the court stated that the issue of whether separate documents should be treated as a single contract is governed by the intent of the parties manifested at the time of contracting. The court found that in light of the circumstances prior to and contemporaneous with the execution of the two documents there was no doubt that the parties intended that the documents constitute a single, indivisible contract.

In In re Gardinier, the court emphasized the intent of the parties as well, employing its three-factor test to ascertain whether at the time of contracting the parties intended the two agreements in question to be construed conjunctively or independently of one another. In doing so, the court noted that the fact that the terms of the transaction are set forth in one instrument is not conclusive evidence that the parties intended to make only one contract; it is only a factor in determining intent.

Contemporaneous Execution of Documents

An interwoven factor often used as evidence demonstrating the intentions of the parties to an agreement at the time of contracting is the contemporaneous execution of documents. Numerous courts have focused on the execution of agreements, holding that documents executed contemporaneously by the same parties and for the same purpose must be construed as a single contractual agreement. In re Carvel Corp., 930 F.2d 228 (2d Cir. 1991); In re Clayton, 954 F.2d 645 (11th Cir. 1992); In re Ameritrust Co. N.A, 73 F.3d 1553 (11th Cir. 1996).

In In re Clayton, the court was confronted with the issue of whether a license agreement and a restaurant lease, executed by the same parties at the same time, constituted two separate, independent contracts or whether they were part of a single overall agreement. Following the execution of the agreements, relations between the parties deteriorated, leading to the filing of a lawsuit questioning whether the license and restaurant were separate agreements or component parts of a franchise agreement. On appeal, the court of appeals determined that the license and lease constituted one agreement, reasoning that where two or more documents are executed by the same parties at or near the same time in the course of the same transaction, and concern the same subject matter, they will be read and construed together. The court further provided that such factors demonstrate that the parties intended the two documents be considered together.

In addition to the courts' desire to ascertain the intent of the parties, courts, as always, are mindful of insuring that the results obtained comport with the principles of fair play and justice for all involved. For example, in In re East Hampton Sand & Gravel Co. Inc., 25 B.R. 193 (E.D.N.Y. 1982), the debtor, prior to its chapter 11 filing, had entered into an agreement with a creditor to lease a parcel of real estate and purchase a concrete manufacturing business located on the real estate. The debtor agreed to pay for the business with a portion in cash and the balance evidenced by a promissory note. The lease agreement for the real estate provided that non-payment of the note was an event of default. The debtor then sought to assume the lease without paying the note. The court, in rejecting the debtor's position, stated: "The debtor asserts that the rehabilitative spirit of the Bankruptcy Code allows for the severance of two obligations upon assumption of the lease. The debtor argues that lease termination conditions, which are unrelated to the payment of rent, frustrate federal bankruptcy policy by unnecessarily encumbering a valuable asset which plays an important role in the debtor's reorganization. This argument is not convincing. While it is recognized that within the context of the reorganization this court has the equitable power to modify lease provisions if it would benefit the estate and not significantly prejudice the lessor [citations omitted], equity will not countenance the debtor's exercise of §365 to relieve itself of conditions which are clearly vested by the contracting parties as an essential part of the bargain and which do not contravene overriding federal policy."

The continued emphasis by the courts in ascertaining the intent of the parties, as part of its analysis in determining whether or not multiple intertwined executory contracts or leases may be assumed or rejected in whole or part, places a significant burden on the drafting of the agreements. Therefore, careful drafting that takes into consideration the impact of the provisions of §365 is critical.