In re Mirant Corp., 299 B.R. 152 (Bankr. N.D. Tex. 2003) (Mirant I), the court enjoined the Federal Energy Regulatory Commission (FERC) from even considering whether the public interest would require Mirant to comply with its power-supply contracts after "rejecting" them. The court stated flatly that "[t]he benefit of rejection of a contract is that performance by the debtor (trustee) is no longer required. Rather, through breach as a matter of law, the rights of other parties to the contract are converted to...claims." Id., 299 B.R. at 164. There could be no ongoing obligation to perform under a rejected contract, unless explicitly provided for in the Code (as with ¥365(h), (i), (n) and (o)). The breach of any other contract, it held, only created a monetary claim. Id., 299 B.R. at 162-63. Since rejection absolutely privileged a debtor to refuse to perform, the court held it could bar FERC from impinging on that freedom in any way, despite the exemption for police and regulatory actions from the automatic stay.

Conversely, in State of New York v. Mirant New York Inc., 2003 WL 22349679, p. 7 (S.D.N.Y. Oct 15, 2003) (Mirant II), the court held that it could enter judgment on a pre-petition settlement agreement requiring $100 million of environmental remediation. It rejected Mirant's argument that the settlement was an executory contract on which judgment could not be entered unless and until the bankruptcy court allowed the debtor to assume it and comply therewith.

Mirant ignores the full implications raised by its argument that ¥365 applies to the consent decree and requires Mirant to get approval from the bankruptcy court... [R]ejection would be treated as a breach of contract, and the state would be left with a claim against the estate. See 11 U.S.C. ¥365(g)(1). Not only would such a result be an end run around the exception to the automatic stay in ¥362(b)(4), it would also conflict with the decision by the court of appeals in In re Chateaugay Corp., 944 F.2d 997 (2d Cir. 1991), that the state's order to a debtor to end or ameliorate pollution does not constitute a "claim" that is dischargeable in bankruptcy. See Id. at 1008; see, also, In re Torwico Electronics Inc., 8 F.3d 146, 151 (3d Cir. 1993).

Accordingly, the court held that judgment could be entered without bankruptcy court approval. While the analysis is somewhat unclear, the court appears to find that it would be improper to allow the possibility of rejection to bar enforcement of an injunctive order that is not a "claim" for monetary damages and is not subject to the stay.

Are Government Settlements Special?

So, what is the answer? Does ¥365 generally trump enforcement of statutory orders and consent decrees to the extent they deal with any contractual rights? Or may the government enforce its laws and decrees where they do not run afoul of the automatic stay or the definition of a claim (and keeping in mind the debtor's duty, under 28 U.S.C. ¥959(b), to obey the laws of the state during the case)? If the latter is true, is it because (1) governmental agreements aren't contracts at all, or (2) aren't executory, or (3) can't be rejected, or (4) because the legal effect of rejection, in the unique context of governmental regulatory settlements and judgments, will generally not release debtor-defendants to ignore the obligations they had taken on? I suggest that the latter answer—which is not quite what either Mirant court held—is usually the correct one. (A particular agreement may also fall under categories 1, 2 or 3, but many may not, and it is those latter agreements that I suggest will likely still be enforceable, despite their rejection.) Reaching that conclusion requires a nuanced review of both how governmental regulatory agreements are enforced and the actual effect of "rejection" of a contract. Applying the Code's rejection provisions as actually written, I suggest, does not create a conflict between the two provisions.

Knowing the effect of bankruptcy on settlements and consent judgments is critical for governmental regulators; most of their cases are settled, and such agreements, unlike litigated court judgments, are generally viewed as having substantially contract-like aspects. In re Columbia Gas System Inc., 50 F.3d 233 (3d Cir. 1995), has an extensive discussion of this issue. Thus, while governmental entities have a visceral certainty that debtors cannot be allowed to resolve statutory charges, file bankruptcy and then be allowed to violate those undertakings with impunity,¹ they cannot easily avoid being forced under ¥365 merely by asserting that their settlement agreements aren't "contracts."

Alternatively, they could argue that their settlements are not executory because only the debtor has obligations thereunder. This works sometimes, but not always. Even if the government's only obligation is to provide a release, that has been held to be enough to make a contract executory.² In addition, many courts have been convinced to adopt the "functional approach" to "executoriness" and look only to the benefit to the debtor for ceasing compliance with an agreement. (And, concededly, it would be a rare regulatory agreement that would benefit a debtor.) Thus, any settlement/consent judgment would likely be a candidate for rejection.

Next, the government might focus on whether there is a bar on rejecting their contracts—a difficult prospect in the absence of any Code language so providing. While the Supreme Court in N.L.R.B. v. Bildisco and Bildisco, 465 U.S. 513 (1984), did require that somewhat stricter scrutiny be given to rejecting labor contracts, and Mirant I suggests that the court might similarly use a stricter standard in light of the public interest related to the energy contract, these decisions do not provide a great deal of comfort. They require public interest concerns to be taken into account despite, not because of, the Code's language. As such, they undermine the general notion that the Code should be applied as written, and they provide parties with no clear standard as to how to judge and apply the public interest to the otherwise broad discretion of the debtor.

Thus, if governments are to protect their settlements, they may need to make their arguments squarely from within the confines of ¥365 as written. However, with a proper understanding of the enforcement of governmental orders in non-bankruptcy cases, ¥365 poses far fewer concerns for governmental settlements than may be widely thought. The bottom line is substantially closer to the Mirant II decision, although for reasons somewhat different than what the court there stated.

Government EnforcementIs Different

Governmental entities have additional powers in enforcing regulatory orders providing for monetary damages. Private parties usually may not use contempt proceedings to enforce monetary judgments, but government orders enforcing statutory obligations are different.³ Whether the orders require the defendant to pay money in the future, or to remedy a denial of proper payments in the past, they are viewed as equitable remedies to enforce the public's interest in correcting statutory violations. As such, they are not mere "money judgments" and can be enforced by contempt proceedings. Federal labor agencies routinely use contempt actions to enforce backpay settlements or consent judgments under the Fair Labor Standards Act, the National Labor Relations Act and the like, or for settlements of securities fraud and similar cases. See Pierce v. Vision Investments Inc., 779 F.2d 302, 307-09 (5th Cir. 1986), for an extensive discussion of these principles and cites to virtually all relevant case law.

The treatment of such remedial orders as equitable, injunctive relief, rather than the mere collection of a debt, has obvious resonance in bankruptcy cases under the definition of a claim.⁴ And of course, if the order does not order money to be paid to the government, but merely compliance with injunctive orders, albeit ones that cost money to obey, the courts are virtually unanimous in holding that such orders are not claims.⁵ Thus, much or all of what a government judgment will order will not fall within the definition of a bankruptcy "claim." As such, it will not trigger stay provisions applicable to collecting a claim, and it will not be dischargeable.

What Happens When a Contract Is Rejected?

With that background, we can now see what actually occurs when a debtor "rejects" a contract under ¥365. The Code does not define the term, but its verbal resemblance to "rescind" and "revoke" has surely contributed to the confusion.⁶ The National Bankruptcy Review Commission recommended that the term "reject" be replaced by the more descriptive "elect to breach" (Report, pp. 459-63), noting that "[r]ejection does not "nullify," "rescind" or "vaporize" the contract or terminate the rights of the parties; it does not serve as an avoiding power separate and apart from the express avoiding powers already provided in the Bankruptcy Code."⁷ The closest the Code comes to defining "rejection" is in ¥365(g), which states that rejection "constitutes a breach of such contract or lease...immediately before the date of the filing of the petition." The Code does not generally purport to define the nature or effect of that decision to breach the contract or lease. It clearly does not state that a breach will automatically create a claim, or that it will convert a non-claim injunctive obligation into a claim for monetary damages.

Thus, one must look to non-bankruptcy law to determine what the remedies are for breach of a particular type of contract. One can then determine whether those remedies are claims (and most will be, for reasons discussed below), but that result is not dictated by ¥365(g). As it turns out, the results that emerge from analyzing contract remedies are largely what one expects from ¥365 (but for the proper reasons). But because governmental remedies are different, the result is that their agreements often will be protected in ways that private agreements are not.

"Rejection" of a contract is often intuitively seen as a termination of the contract and a bar on enforcing it (as the judge in Mirant I suggested) because the practical effect of breaching most contracts is indistinguishable from termination—after the breach, the defaulting party is not obligated to perform thereunder. However, this is so not because rejection provides a special defense to performance or because the contract has been made to disappear; rather it is the fact that non-bankruptcy law rarely requires any party to perform their contracts. Whether because of Thirteenth Amendment-type concerns or a pragmatic recognition of the difficulty of making someone do what they don't want to do, specific performance is the exception, not the rule. Thus, a party that breaches a contract, in or outside of bankruptcy, normally will not have to perform and will only be subject to a claim for damages.

In short, ¥365(g) is not necessary to ensure that debtors generally will not have to perform their contracts. Instead, the section can be seen to be useful for several other, relatively modest purposes. By requiring an explicit process to breach a contract, the section obviates any arguments about whether the debtor's actions are merely an "anticipatory" breach and not a "real" breach that allows the other party to terminate the contract. It also sets a definitive date for the breach (i.e., the date of approval of the rejection motion), which is relevant to the determination of the compensation owed to the other party during the pre-rejection period. And finally, it does avoid any arguments about whether monetary claims from a breach are administrative expenses. (This effect is somewhat less than earth-shattering, though, since most cases already hold that damages from post-petition breaches of pre-petition contracts are pre-petition claims. See, e.g., In re Remington Rand Corp. Inc., 836 F.2d 825, 830 (3d Cir. 1988); In re Airlift International, 761 F.2d 1503, 1509 (11th Cir. 1985); In re Chateaugay Corp., 102 B.R. 335 (Bankr. S.D.N.Y. 1989). Thus, at most, ¥365(g) largely only reiterates and clarifies the existing treatment of claim accrual under the Code.

Does it have the further effect of converting all contract remedies into claims or barring specific performance remedies? The Mirant court believed that conversion was implicit in the entire structure of ¥365, noting that some parts of ¥365 (i.e., ¥¥365(h), (i) and (n)), do explicitly require the debtor to continue to abide by certain obligations in a rejected contract.⁸ Conversely, the court concluded, this must mean that any other performance rights must be disallowed. Yet, is that the right extrapolation from those sections? In fact, the salient feature of these sections is that they limit what would otherwise be the specific performance rights that a creditor would otherwise have. In ¥365(n)(1)(B), for instance, the licensee is allowed to enforce its rights under a rejected licensing agreement, including a right to enforce exclusivity provisions in the license "but excluding any other right...to specific performance of such contract." Thus, rather than giving a party greater rights to specific performance than might otherwise exist under ¥365, these provisions could equally be read as leaving non-debtor parties with a right to specific performance, but limiting that right in certain regards.

If so, then ¥365 does not purport to change non-bankruptcy law on available remedies except as specifically provided therein. Thus, the proper analysis would be as follows: Would applicable non-bankruptcy law provide specific performance of the particular contract? If not, then the rejecting (breaching) debtor cannot be required to perform in any event, and the damages are treated as a pre-petition claim.⁹ If there is a right to specific performance, though, it would not give rise to a claim for money damages. Section 365 would still provide that a breach will be treated as if it occurred pre-petition, but the timing of a breach is usually irrelevant to the injunctive relief that would be ordered. Thus, the debtor could be forced to perform, regardless of rejection, just as one may require any party breaching a contract enforceable by specific performance to actually comply therewith. This has the same effect as finding that the contract is not executory or cannot be rejected, but without the need to do violence to the statutory language.

What Do the Cases Say?

Is this analysis reflected in the law? While not uniform by any means, there plainly are a large number of cases that point in this direction. One of the most prominent is In re Udell, 149 B.R. 898, 901-02 (Bankr. N.D. Ill. 1992), aff'd., 18 F.3d 403 (7th Cir. 1994). The district court and the Seventh Circuit analyzed the nature of the relief for the violation of a covenant not to compete and concluded that state law would allow for specific performance of the covenant and would not leave the non-debtor party with merely a claim for damages. In turn, they held that the provision would be enforced despite rejection of the agreement, noting that the right was not a claim.

Many cases have dealt with contracts relating to real estate, for which there is typically a right to specific performance.¹⁰ In In re Walnut Associates, 145 B.R. 489, 494 (Bankr. E.D. Pa. 1982), for instance, the court held that the effect of rejection is that the party is "limited in its claims for breach to the treatment accorded to a debtor's unsecured creditors... It also means that, unless specific performance is available to the non-debtor party under applicable state law, the debtor cannot be compelled to render its [required] performance... However, if state law does authorize specific performance...it means that the non-debtor should be able to enforce the contract against the debtor, irrespective of his rejection of it. Id., 145 B.R. at 495.

The court in In re Lewis (Lewis v. Maloon), 94 B.R. 789, 795 (Bankr. D. Mass. 1988), held that a right of, specifically, performance made a contract non-executory, but most courts would not go that far (and this would not be necessary under the analysis herein). Many courts, though, have held that once a real estate contract has been reduced to judgment, the order is entitled to specific performance and, hence, is not an executory contract. See, e.g., Roxse Homes Inc. v. Roxse Homes Limited Partnership, 83 B.R. 185 (D. Mass.), aff'd. without opinion, 860 F.2d 1072 (1st Cir. 1988) (contested judgment cannot be "rejected," and right to specific performance was not a "claim"); In re Ter Bush, 273 B.R. 625, 628 (Bankr. S.D. Cal. 2002); In re Smith, 269 B.R. 629, 633 (Bankr. E.D. Tex. 2001). Cf. In re Indian River Estates Inc., 293 B.R. 429, 433-35 (Bankr. N.D. Ohio 2003) (pre-petition judgment for specific performance was not a claim and not subject to discharge; issues not litigated in context of rejection).

Where the issue has not been reduced to judgment, though, some courts have held that a real estate contract is still executory and can be rejected—but without clearly considering what the effects are of that rejection. See, e.g., In re Butler, 241 B.R. 37 (D. R.I. 1999) (absent a judgment, contract is executory and can be rejected even if specific performance was allowed under state law). One court did go as far as Mirant I, allowing a debtor to reject a land purchase option even if it could be specifically enforced under non-bankruptcy law (basing its decision on a very broad view of claims and the right to convert injunctive relief to money damages) and held that ¥365 inherently subordinated specific performance rights to a debtor's right of rejection. In re A.J. Lane & Co. Inc., 107 B.R. 435 (Bankr. D. Mass. 1989). The discussion above would suggest that Lane was wrong and that Butler stopped its analysis too soon.

What Happens to Settlements?

So, what happens to settlements? First, as noted above, one must distinguish between governmental settlement and those involving private parties. In addition, one must consider the state to which the settlement has actually advanced. In Level Propane, supra, a private class action had reached a tentative settlement with both injunctive and monetary relief. The court had not yet considered the fairness objections, as required by class-action law, and so had not yet created an enforceable obligation. Thus, it held the agreement was executory and could be rejected. On the other hand, in non-class actions, a party can reach a full agreement—and be forced to adhere thereto—even if it seeks to back out before the agreement is put into writing or a court approves it. See, e.g., American Sec. Vanlines Inc. v. Gallagher, 782 F.2d 1056, 1060 (D.C. Cir. 1986) ("An agreement to settle litigation is a contract and may not be unilaterally rescinded unless principles of contract law would authorize rescission.) and other cases cited therein; Apple Corps Ltd. v. Sony Music Entertainment Inc., 1993 WL 267362 (S.D.N.Y. 1993); BTA Inc. v. Atlantic Mut. Ins. Co., 1999 WL 430751 (N.D. Cal. 1999); U.S. v. Lightman, 988 F. Supp. 448, 463, (D. N.J. 1997); George Banta Co., 236 NLRB 1559, 1978 WL 7651 (1978) (respondent that had agreed to settlement terms with general counsel could not withdraw unilaterally therefrom while the board and appeals court formally approved settlement).

Whether a court will order specific performance of a settlement agreement, standing alone—prior to entry of a consent judgment—is a separate issue of state law, but where judgment has been entered, the cases cited above make clear that governmental entities would be able, under non-bankruptcy law, to use contempt to force compliance by the defendant even with the monetary terms thereof. Thus, under the analysis above, even if a debtor "rejects" a government settlement or contempt decree, the government can still specifically enforce it, unless the Code specifically bars that action.

Plainly, even under ¥365(g), the government could enforce injunctive provisions of the settlement because the obligation to comply would not change, whether the violation was deemed to have occurred pre-petition or not. But the interesting question is what to do with monetary obligations. Even though its right to collect damages can be specifically enforced under non-bankruptcy law, it is still a "claim" under the Code, and hence, under ¥365(g), would be deemed to accrue prior to the petition date. In most cases, as noted above, this would make little difference to the accrual date, since whether the right to payment is based on the underlying violation itself, or the settlement payment rights are clearly linked to the pre-petition events, even if the payment is made in installments that continue into the bankruptcy.

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Federal labor agencies routinely use contempt actions to enforce backpay settlements or consent judgments under the Fair Labor Standards Act, the National Labor Relations Act and the like, or for settlements of securities fraud and similar cases.

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There are at least a few situations, though, that warrant further thought. For instance, in employment cases, a reinstatement order obligates the employer to rehire the employee, and in addition, to pay all lost wages until the reinstatement is complete. Where the failure to reinstate the employee is a continuing violation (particularly where it violates a settlement ordering that remedy), should the newly accruing backpay during the case be treated only as damages that relate back to the original settlement date and, thereby, be denied administrative status? With all due respect to the Ninth Circuit,¹¹ it seems obvious that if the employer can relegate this accruing cost to a pre-petition, unsecured status, it will have a strong incentive to continue its recalcitrance.

Another area of deep interest to the states is the cottage industry of predicting how the tobacco Master Settlement Agreement (MSA) will be treated if a major tobacco manufacturer files bankruptcy.¹² The MSA requires yearly payments into perpetuity, measured by the number of cigarettes sold in the prior year. Thus, while the obligation arises out of a pre-petition agreement, the duty to make payment accrues each year and could be eliminated entirely if a debtor stopped selling tobacco. If the debtor attempts to reject the MSA, are all amounts owing thereunder (until the end of time) a pre-petition claim? Is it in the best interests of the state or the debtor for it to have a current claim of tens of billions of dollars when the only amount the debtor is currently liable for is the next year's payment? Are these problems best solved under the rejection provisions—or should these special cases be addressed by tailored legislation? The employment issue is addressed in pending bankruptcy legislation, which makes wages coming due during the case administrative expenses. Perhaps a similar approach should be taken for MSA payments?

And, to return full circle, what has happened with the FERC cases? FERC took a similar approach in the NRG Energy bankruptcy (where it was not enjoined), and it issued several decisions in which it explained its reconciliation of the right of a bankruptcy court to allow the contract to be rejected, with its right to decide whether the public interest might still allow it to require a debtor to perform under that contract. See Richard Blumenthal, Attorney General of the State of Connecticut, and Connecticut Dept. of Public Utility Control v. NRG Power Marketing Inc., 2003 WL 21480251 (F.E.R.C. June 25, 2003), and 2003 WL 21963033 (F.E.R.C., Aug 15, 2003). The district court, in turn, held that, in light of FERC's exclusive jurisdiction over the Federal Power Act, it had no jurisdiction to enjoin FERC from carrying out its regulatory duties. Any appeal of decisions FERC made must be directed to the appeals court. In re NRG Energy Inc. (NRG Power Marketing Inc. v. Blumenthal), 2003 WL 21507685 (S.D.N.Y. 6/10/03). FERC's most recent action in the NRG case was its approval of the debtor's proposal to issue stock in aid of a reorganization¹³—suggesting that FERC involvement is not necessarily the death knell for such prospects, as the court feared in Mirant I. Hopefully the same will be true if the limits on rejecting governmental settlement agreements proposed herein are accepted.

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Footnotes

¹ After all, as the courts have often noted in the context of the automatic stay, "the policy behind this 'police or regulatory exception' to the automatic stay is to prevent the bankruptcy court from becoming a haven for wrongdoers." Commodity Futures Trading Comm. v. Co Petro Marketing, 700 F.2d 1279, 1283 (9th Cir. 1983). Allowing rejection to obliterate the obligation to comply with settlement agreements would create just such a haven. Return to article

² In re Level Propane Gases Inc., 297 B.R. 503, 508-09 (Bankr. N.D. Ohio 2003). Return to article

³ Bowen v. Massachusetts, 487 U.S. 879 (1988), discusses this issue in a dispute between the state and the federal government over the latter's duty to make Medicare payments to the state. In the private context, or where a government is not acting as prosecutor, the distinction tends to be between past damages (which must be collected by execution) and future injunctive orders to make proper payments, which are treated as equitable relief and may be enforced by contempt actions. Otherwise, the general rule is that a private party may not use contempt to enforce a money judgment. Combs v. Ryan's Coal Co. Inc., 785 F.2d 974 (11th Cir. 1986). Return to article

⁴ It is not precisely analogous because a "claim" is a "right to payment," a standard that is broader than a money judgment, but the different enforcement rights of governmental orders will be significant when determining how what effect a rejection "breach" has thereon. Return to article

⁵ The most well-known example is Penn Terra v. Dept. of Env. Prot., 733 F.2d 267, 274-78 (3rd Cir. 1984). Virtually the only case that holds to the contrary is U.S. v. Whizco Inc., 841 F.2d 147 (6th Cir. 1988), a curious case that held that the debtor-owner of a polluting facility could not be required to do the clean-up since he couldn't do it himself and would have to spend money to comply, even though the same circuit has routinely upheld NLRB orders that require debtors to reinstate employees or comply with union contracts—both items that could obviously require the payment of money. In any case, Whizco stands virtually alone in the case law. Return to article

⁶ There is a similar problem with the term "abandonment," which leaves the impression that a debtor can merely walk away from a contaminated piece of property, for instance, and leave it like an unwanted suitcase by the side of the road. That concept is equally fallacious, but that discussion must await a separate article. Return to article

⁷ See, also, Medical Malpractice Ins. Assoc. v. Hirsch (In re Lavigne), 114 F.3d 379, 386 (2d Cir. 1997) (rejection is breach, not termination, of contract and does not eliminate right to enforce contractual provisions that are explicitly meant to apply after contract term ends); In re Austin Dev. Co., 19 F.3d 1077, 1081 (5th Cir. 1994); In re Continental Airlines, 981 F.2d 1450, 1459 (5th Cir. 1993); In re Western Real Estate Fund Inc., 922 F.2d 592, 601 (10th Cir. 1990); and Leasing Services Corp. v. First Tennessee Bank National Ass'n., 826 F.3d 434, 437 (6th Cir. 1987) ("rejection...determines only the status of the creditor's claim—i.e., whether it is merely a pre-petition obligation...or [has] priority as an expense of administration... The extent to which a claim is secured is wholly unaffected"). Return to article

⁸ Section 365(o) requires that certain contracts of federal depository institutions must be assumed and obligations paid. It is irrelevant as to what happens when a contract can be rejected. Return to article

⁹ In In re Brown, 1997 WL 786994 (E.D. Pa., Nov. 26, 1997), for instance, the court carefully examined applicable state law to determine whether a no-compete covenant in a personal services contract would be enforced. Since state law would not enforce that language, the court held that damages rights under the contract were dischargeable monetary claims. Return to article

¹⁰ Indeed, it is likely precisely because such contracts are usually both of substantial importance for the debtor and specifically enforceable that the Code steps in and dictates in more detail in §365 how they are to be treated. Return to article

¹¹ In re Palau Corp., 18 F.3d 746 (9th Cir. 1994) (rejecting argument that such wages fell under §503(b)(1)(A) and discounting idea that treating backpay as unsecured claim would reduce incentives for compliance). Return to article

¹² The states have their own view of whether the MSA is executory at all, but for purposes of this discussion, it is assumed that the MSA is executory, and the question becomes, "so what?" Return to article

¹³ NRG Energy Inc., 105 FERC P 62,037, 2003 WL 22411063 (F.E.R.C., Oct 22, 2003). Return to article