A recent Ninth Circuit decision has generated much concern in the affected bankruptcy community regarding continuation of executory contracts in a chapter 11 reorganization. The decision rendered in Perlman v. Catapult Entertainment Inc. (In re Catapult Entertainment Inc.), 165 F.3d 747 (9th Cir. 1999), restricts the ability of a debtor, after having filed chapter 11, to assume certain executory contracts that may be critical to the operation of the debtor's business. In Catapult, the court joined three other circuits in adopting the "hypothetical test" as the proper approach to making determinations under §365(c) of the Bankruptcy Code. The test essentially provides that where applicable non-bankruptcy law renders an executory contract non-assignable because the identity of the non-debtor party is material, a debtor cannot assume the contract without the consent of the non-debtor party. The type of contracts potentially affected generally fall under categories of personal contracts such as certain franchise agreements, employment contracts or partnership agreements; certain intellectual property licenses such as non-exclusive patent and copyright licenses; and government contracts (collectively referred to here as "personal contracts").¹

The anxious reaction to Catapult can be attributed at least in part to the common presumption among many bankruptcy practitioners that the only way a reorganized debtor can retain an executory contract through a chapter 11 proceeding is to formally assume it under §365. This of course leads to the perception in some cases, upon the filing of a chapter 11, that the successful reorganization of the business is completely dependent on the debtor's ability to obtain the consent of all non-debtor parties to those essential personal contracts—a prospect often far from certain. Therefore, debtors seeking to simply retain valuable personal contracts to ensure a successful reorganization have been reluctant to file chapter 11. In fact, the concern has risen to such a level that new legislation has been passed by the House of Representatives to negate the effects of the Catapult decision. The House version of the Bankruptcy Reform Act of 1999 (H.R. 833) addresses §365(c) with respect

to the right of a trustee or debtor-in-possession to assume the debtor's contracts within a chapter 11.² Of course, there is no certainty that the legislation will be enacted in its current form, as the Senate companion bill (S. 625) does not deal with the issue.

In any event, legislation may not be needed to address the perceived Catapult dilemma, especially in the form proposed by the House. There is another option that should be considered. This article will revisit the idea of neither assuming nor rejecting an executory contract but permitting it to "ride through" the bankruptcy, essentially retaining the contract without assumption.³

The "Hypothetical Test" and Its Ramifications

In its modern form, the "hypothetical test" was delimited more than 10 years ago by the Third Circuit in In re West Electronics Inc., 852 F.2d 79 (3rd Cir. 1988). The opinion drew significant criticism.⁴ Despite these criticisms, three other circuits have adopted the "hypothetical test" and followed the literal interpretation of the words of §365(c),⁵ although one circuit has definitively adopted a different approach deemed the "actual test."⁶

In Perlman v. Catapult Entertainment Inc., the Ninth Circuit court reviewed the cases and development of the "hypothetical test" application of §365.⁷ The court also addressed old and new objections to a literal interpretation, ultimately dismissing them all.⁸ The court held, "...where applicable non-bankruptcy law makes an executory contract non assignable because the identity of the non-debtor party is material, a debtor-in-possession may not assume the contract absent consent of the non-debtor party."⁹ Thus, the debtor in Catapult could not assume non-exclusive patent licenses over the objection of the licensor because non-bankruptcy law makes non-exclusive patent licenses personal and not assignable.

The impact of this view of executory contract assumption is significant. Many businesses rely heavily on ongoing personal contracts, especially in the booming entertainment and technology industries.¹⁰ Therefore, in chapter 11 the retention of these contracts would be vital to a successful reorganization. But if it is suspected that the requisite consent to assumption cannot be acquired or can only be acquired by the payment of a large premium or the forced undertaking of some other distasteful obligation, the filing of a chapter 11 could appear an unattractive option, if an option at all.¹¹ Accordingly, bankruptcy practitioners have advised clients to postpone, if not completely abandon, plans to reorganize their businesses under chapter 11 for fear of losing certain contracts vital to their business.¹²

The "Ride-through" Option

The authors here assert that there is an alternative to the formal assumption of certain executory contracts by which the contract and its benefits can be retained. This is simply to permit the executory contract to pass or "ride through" the reorganization and continue on unaffected by the reorganization. Thus, the debtor retains the contract without formally assuming it under the Code.

Courts generally attribute the beginnings of this doctrine to the early case of Consolidated Gas, Electric Light and Power Co. of Baltimore v. United Railways and Electric Co. of Baltimore, 85 F.2d 799 (4th Cir. 1936).¹³ The court held that an executory contract, if not rejected, "passes through with other property of the debtor to the reorganized corporation."¹⁴ This precept continues to this day since legal theories developed under the Act apply to cases decided under the Code, and when Congress doesn't change pre-Code law, courts should interpret the Code as continuing Bankruptcy Act principles.¹⁵ Accordingly, there are numerous contemporary case and commentator formulations of the rule.¹⁶ Several circuit courts have adopted ride-through or continuing-contract principles.¹⁷ It has been referred to as a "carry through" when a chapter 11 plan does not deal either way with an executory contract.¹⁸ The Collier treatise also recognizes the theory: "The plan may provide for the assumption or assignment of an executory contract. On the other hand, the contract may 'ride through' the plan without being affected."¹⁹ In addition, commentators have also been supportive of the existence and use of ride through.²⁰

Recently, the National Bankruptcy Conference published recommendations for reforming the Bankruptcy Code and specifically addressed the subject of executory contracts.²¹ On the subject of "ride through," the conference acknowledged that in many reorganizations there are contracts that would ride through without needing to be scheduled and without notice to the other party as the parties expect to perform the contracts without formality. In this light, and in the absence of a clear consensus of the conference, no action was recommended on this issue.²² In essence, after full consideration of the matter, the conference left ride through intact.

The conference's report was also the basis of comments by David G. Epstein and Steven H. Nickles in a recent analysis of proposed Code changes. These authors acknowledge the ride-through case law under the Bankruptcy Act, and although not supportive, they "...do support the practice of ride through, at least in chapter 11, and would urge Congress to follow the review commission's non-review of this concept."²³

At this point, it is important to emphasize what the ride-through option is not. It is not some form of automatic assumption of an executory contract based on inaction.²⁴ Richard F. Broude succinctly stated, "The doctrine of implied assumption is probably dead."²⁵ A court order is needed for an assumption or rejection—it does not happen automatically.²⁶ Therefore, the thought that taking no action could result in an assumption or a rejection conflicts with the statutory requirement of court approval of either an assumption or rejection.²⁷

There Is No Requirement to Choose Assumption or Rejection

The existence of the ride-through option is largely based on the lack of a requirement in the Code that a chapter 11 debtor formally assume or reject an executory personal contract within any court proceeding. Section 365(a) specifically states that subject to the court's approval, a trustee "may assume or reject any executory contract or unexpired lease of the debtor." (emphasis added) Likewise, §356(d)(2) provides: "In a case under chapter 9, 11, 12 or 13 of this title, the trustee may assume or reject an executory contract..." (emphasis added) Also, under §1123(b), "a plan may...(2) subject to §365 of this title, provide for the assumption, rejection or assignment of any executory contract..." Cases also support the optional nature of this election.²⁸

Advantages of Formally Assuming Executory Contracts and Potential Limitations of Ride Through

Although the ride-through option should be considered when addressing issues involving the debtor's executory contracts, it should not be seen as the primary option. There are several advantages of formally assuming an executory contract in lieu of allowing a contract to ride through the bankruptcy. For instance, an executory contract must be assumed in a chapter 11 before it can be assigned to a third party.²⁹ Also, it may be advantageous for a debtor to treat any defaults under an executory contract within a §365 bankruptcy proceeding where the concerns of all interested parties are considered when deciding the manner by which the defaults might be cured.³⁰ In addition, formal assumption by motion provides a level of certainty for all parties regarding the status of the contract. Specifically, the parties can be assured that all the defaults have been addressed and the means by which the debtor will continue its performance have been provided.³¹

There also may be some inherent difficulties with electing ride through, such as when the reorganized debtor is the product of a merger. In such a case, the attempt to allow a contract to ride through to the surviving entity may be a de facto transfer in violation of the initial contract or applicable law.³² A debtor should also be required, either by way of the court's own motion or a motion to compel assumption or rejection filed by another party to the contract, to give adequate assurance of future performance of any contract that is to be ridden through.³³ Accordingly, the ride-through election would not be appropriate in conjunction with a liquidating plan.³⁴

Also, Epstein and Nickles raise the issue of the very broad, current definition of "claim" under the Bankruptcy Code.³⁵ They assert that an executory contract would meet the definition of "claim," and if not dealt with in the plan, it would be extinguished or otherwise discharged under §1141.³⁶ Whether or not this is the case, this matter may be addressed by placing a provision in the plan that excludes from discharge all executory contracts not assumed or rejected.

Finally, if there is an ipso facto clause terminating or modifying the contract upon a bankruptcy filing or the event of insolvency, ride through could be lost as an option should the court choose to follow certain precedents. Typically, such clauses are unenforceable pursuant to §365(e)(1). However, an exception to this provision is set forth in §365(e)(2). The circumstances under which the exception applies are subject to interpretation. However, the authors believe that if §365(e) is interpreted properly, the ipso facto clauses will be deemed unenforceable unless the entity attempting to retain the personal contract would not be allowed to retain it under non-bankruptcy law.³⁷ The proposed amendments to §365, referenced earlier, also propose changes to §365(e) regarding ipso facto clauses.³⁸ If these proposed amendments are passed, ipso facto clauses will be enforceable in all cases where the debtor-in-possession cannot assume under the new subdivision (c). This would have the effect of rendering the ride-through option almost valueless, especially in non-chapter 11 cases.

Conclusion

Ride-through remains a viable alternative when dealing with certain executory contracts on behalf of reorganizing debtors. It is a means to retain a personal contract without formal assumption, which could prove valuable in circuits that have adopted the hypothetical test. The proper implementation of retention without assumption could greatly increase the chances of a successful reorganization or out-of-court workout because it provides the financially troubled debtor with much-needed bargaining leverage when negotiating with its creditors.

Perhaps the most intriguing aspect of the ride-through doctrine is how courts of the Third Circuit have treated executory personal contracts. The Third Circuit has been the longest proponent of the hypothetical test or literal interpretation of §365(c). As seen above, Third Circuit courts also frequently apply the ride-through option.

Whether coincidental or not, these opinions lead to the conclusion that perhaps by using the hypothetical test and ride through in concert, many of the harsh results anticipated by the hypothetical test can be avoided. Although no case marries the two specifically, with these tools a balance may be struck between remaining true to the actual words of the Bankruptcy Code and also furthering the bankruptcy objectives of rehabilitation and reorganization. At the very least, courts have the means to do equity—the heart of bankruptcy policy and practice.

As a final word, this article is an overview of the subject. The authors' extensive research has uncovered several areas of difficulty that, if not anticipated and properly handled, could certainly cause more problems than ride-through could solve. The advice of counsel experienced in these areas should be sought, and a careful strategic plan must be employed to make the most out of the ride-through option in the personal contract context.

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Footnotes

¹ See, e.g., The City of Jamestown v. James Cable Partners (In re James Cable Partners), 27 F.3d 534 (11th Cir. 1994) (cable television franchise agreement); Continental Country Club Inc. v. Burr (In re Continental Country Club Inc.), 114 B.R. 763 (Bankr. M.D. Fla. 1990) (employment contract); Skeen v. Harms (In re Harms), 10 B.R. 817 (Bankr. D. Colo. 1981) (partnership agreements); Rieser v. Dayton Country Club Co. (In re Magness), 972 F.2d 689 (6th Cir. 1992) (country club membership agreement); In re Access Beyond Technologies Inc., 237 B.R. 32 (Bankr. D. Del. 1999); Everex Systems Inc. v. Cadtrak Corp. (In re CFLC Inc.), 89 F.3d 673 (9th Cir. 1996) and Perlman v. Catapult Entertainment Inc., supra (non-exclusive patent license agreements). Return to article

² The proposed amendments to §365(c) generally retain the prohibition of the assumption and assignment of personal contracts but add that "in a case under chapter 11 of this title, a trustee in a case in which a debtor is a corporation or a debtor-in-possession may assume an executory contract or unexpired lease of the debtor, whether or not the contract or lease prohibits or restricts assignment of rights or delegation of duties." H.R. 833, Bankruptcy Reform Act of 1999, §305 (Permitting Assumption of Contracts). Return to article

³ "Assuming" a pre-bankruptcy contract has been simplified (or oversimplified) as synonymous with the decision to continue performing the contract. Westbrook, J. Lawrence, "A Functional Analysis of Executory Contracts," 74 Minn. L. Rev. 227, 231 (1989). The authors here prefer the more accurate term "retention" of executory contracts through the reorganization. This article will assume that there are no issues of pre-petition termination or expiration of the executory contract, nor any issues of post-petition status of the contract with reference to performance of the contract or categorizing the contract as a certain type of claim on the bankruptcy estate. Return to article

⁴ King, Brett W., "Assuming and Assigning Executory Contracts: A History of Indeterminate 'Applicable Law'," 70 Am. Bankr. L.J. 95, 115 (Spring 1996). Return to article

⁵ Fourth Circuit—Breeden v. Catron (In re Catron), 158 B.R. 629 (E.D. Va. 1993), aff'd without op., 25 F.2d 1039 (4th Cir. 1994); United States v. Techdyn Systems Corp. (In re Techdyn Systems), 235 B.R. 857 (Bankr. E.D. Va. 1999); Ninth Circuit—Perlman v. Catapult Entertainment Inc. (In re Catapult Entertainment Inc.), 165 F.3d 747 (9th Cir. 1999); Eleventh Circuit—The City of Jamestown v. James Cable Partners (In re James Cable Partners), 27 F.3d 534 (11th Cir. 1994). Return to article

⁶ See Institut Pasteur and Pasteur Sanofi Diagnostics v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1997). Under the "actual test," §365 would bar assumption by the trustee only when the assumption would result in the non-debtor actually having to accept performance from a third party. Return to article

⁷ Catapult Entertainment Inc., supra at 749-750. Return to article

⁸ Id. at 751-754. Return to article

⁹ Id. at 754-755. Return to article

¹⁰ See Walper, Thomas B. and Shinderman, Mark, "Ninth Circuit Weighs In; Conflict Regarding Interpretation and Application of Sec. 365(c)(1)," The Bankruptcy Strategist (March 1999). Return to article

¹¹ "The ability of the licensors to prohibit the assumption of non-exclusive patent licenses may, in certain circumstances, render reorganization impossible for a debtor at the expense of other creditors." Hesse, Gregory G., "Ninth Circuit Slams Shut the 'Back Door' Access to Patented Technology," ABI Journal at 18 (April 1999); see, also, King, supra note 3, at 113. Return to article

¹² Courts have also recognized the harsh results of this interpretation. For example, the court in United States v. Techdyn Systems Corp., supra 235 B.R. at 864, stated the problem quite frankly: "The court is sympathetic with such concerns and recognizes that a blanket refusal to permit a reorganizing debtor to assume valuable government contracts over the government's objection may well represent poor bankruptcy policy. Certainly, where a debtor's sole or primary assets consist, as here, of government contracts, application of the 'hypothetical test' effectively gives the government a veto over any reorganization. Nevertheless, bad policy does not justify a judicial rewrite of the Bankruptcy Code. Catapult, 165 F.3d at 754 ('Policy arguments cannot displace the plain language of the statute...'). The court must presume that Congress means what it says and says what it means through the passage of statutes. This court's duty is to apply the statute as written, and if the unfortunate result is to hinder reorganization efforts that ought to succeed, the appropriate forum in which to raise those concerns is the halls of Congress." See, also, King, supra note 3 at 112, note 79 ("As a consequence, the debtor-in-possession would often be denied valuable assets that were owned by the debtor pre-petition, a result clearly contrary to the rehabilitative goals of the Bankruptcy Code"). "...[A]ll sorts of contracts that bankruptcy lawyers have long presumed may be assumed by the debtor, even if not assignable, may not be assumable at all." Walper & Shinderman, supra. Commentators have also recognized serious problems that could occur in the context of real estate partnerships if the ability to assume or assume and assign a partnership agreement pursuant to §365 was impeded. Goldberg, Thomas D., "Assumption and Assignment of Partnership Agreements: Recent Developments," 94 ABI Journal (April 1994). In addition, the stigma of the vulnerability of personal executory contracts could affect financial relationships. For example, the uncertainty of the ability to retain such executory contracts could have a negative effect on the ability of a business to obtain financing. To the extent a lender evaluates license agreements, such as security or collateral for a loan, as well as the potential of bankruptcy for the borrowing business, the tenuous nature of the ability to retain these valuable contracts in a reorganization could cause lenders to be less likely to provide funds to such businesses for startup or expansion. Return to article

¹³ See Continental Country Club Inc. v. Burr (In re Continental Country Club Inc.), 114 B.R. 763 (Bankr. M.D. Fla. 1990). Return to article

¹⁴ Consolidated Gas, supra 85 F.2d at 805. Return to article

¹⁵ See Polysat Inc. v. Union Tank Car Co. (In re Polysat), 152 B.R. 886, 890 (Bankr. E.D. Penn. 1993); The Travelers Insurance Co. v. Cambridge Meridian Group Inc. (In re Erin Food Services Inc.), 980 F.2d 792 (1st Cir. 1992): "When confronted with an alleged ambiguity in the Bankruptcy Code, courts may consult pre-Code law for appropriate guidance, based on the presumption that Congress did not intend to effect substantive changes in the prior bankruptcy law unless its intent is clearly expressed in the Code." Id. at 800. Return to article

¹⁶ See In re Taylor, 198 B.R. 142 (Bankr. S.C. 1996), where the court recognized the continued utility of the ride-through option. See, also, In re Day, 208 B.R. 358, 368 (Bankr. E.D. Penn. 1997); In re Bacon, 212 B.R. 66, 73 fn. 13 (Bankr. E.D. Penn. 1997). Return to article

¹⁷ Public Service Co. of New Hampshire v. New Hampshire Electric Cooperative Inc. (In re Public Service Co. of New Hampshire), 884 F.2d 11 (1st Cir. 1989) (debtor neither assumed nor rejected a contract with utility, thus it continued in effect and the utility had no provable claim against the bankrupt estate); Phoenix Mutual Life Ins. Co. v. Grey Stone III Joint Venture (In re Matter of Grey Stone III Joint Venture), 948 F.2d 134 (5th Cir. 1991); Boston Road Limited Partnership v. FDIC (In re Boston Road Limited Partnership), 21 F.3d 477 (2nd Cir. 1994) (passed through contract's effect on determination of claims status). Return to article

¹⁸ Broude, Richard F., "Executory Contracts and Unexpired Leases in Bankruptcy," ALI-ABA Course of Study Materials, Course SE33, Real Estate Defaults, Workouts and Reorganizations (August 1999). Return to article

¹⁹ 7 Collier on Bankruptcy, §1123.02[2] (15th Ed. Rev. 1999); see, also, 3 Collier on Bankruptcy, §365.04[2][d] (15th Ed. Rev. 1999). Return to article

²⁰ Countryman, "Executory Contracts in Bankruptcy," 58 Minn. L. Rev. 479, 561-62 (1974); see, also, Bordewieck, "The Post-petition, Pre-rejection, Pre-assumption Status of an Executory Contract," 59 Am. Bankr. L. J. 197, 200, 211-213 (1985) (recognizing the continuing duty of a lessee to pay rent to a debtor-in-possession when a lease has been neither assumed nor rejected and the consequences in the form of an injunction for failure to perform). Return to article

²¹ Reforming the Bankruptcy Code: National Bankruptcy Conference Code Review Project (Rev. ed. 1997). Return to article

²² Id. The conference members' concerns appear aimed at "accidental" or unknowing obligations undertaken via a contract when not addressed in the bankruptcy. These are legitimate concerns. However, the authors propose managed ride through, done knowingly to avoid the potential bar to assumption of the "hypothetical test." Return to article

²³ Epstein, David G. and Nickles, Steve H., "