Circuit Court Win Sets Up Conflict over Bankruptcy Code

The ability to assume or reject “pre-petition” contracts is an important tool available to debtors in reorganization proceedings, allowing them to choose to continue only those contracts that, in a debtor's business judgment, will bring value to the estate. Thus, a debtor/lessee may reject a burdensome obligation (such as a long-term lease with a rental rate far above market value) while assuming other more favorable agreements. The benefit to the estate is balanced by the treatment of any claims of the non-debtor party. Ordinarily, a rejection of a contract under section 365 is treated as a pre-petition breach of the contract so that any claims which the non-debtor party may have under the contract are general unsecured claims. 11 U.S.C. ' 365(g). On the other hand, following an assumption, the debtor's post-petition obligations under the assumed contract or lease are treated as administrative expenses and given priority status over those of general unsecured creditors.

Of course, there are certain restrictions on the debtor's ability to assume. One to consider is when the debtor has already defaulted on the contract or lease and must undertake certain actions in order to be able to assume it. Specifically, under section 365(b)(1) of the Bankruptcy Code, the debtor must 1) cure the default, 2) compensate the non-debtor party for actual pecuniary losses resulting from the default, and 3) provide adequate assurance that the debtor will be able to perform under the contract or lease going forward.

The requirements of 365(b)(1) are not without exception however. One such exception, which was at issue in the Bankvest case, is found in section 365(b)(2)(D), which provides that: (2) Paragraph (1) [365(b)(1)] of this subsection does not apply to a default that is a breach of a provision relating to … (D) the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.

The Bankvest Case

In Bankvest, the issue was whether the above section, 365(b)(2)(D), contained only one or two separate types of defaults that would not require a cure in order for the debtor to assume a contract. Specifically, the appellants, Eagle Insurance Company and Newark Insurance Company, argued that the exception to cure applied only to a “penalty rate or [penalty] provision.” On the other hand, Bankvest maintained, and the First Circuit agreed, that the provision actually contemplates two exceptions to the cure requirements: 1) penalty rates, and 2) provisions relating to non-monetary obligations. Prior to the Bankvest case, the only other federal Court of Appeals to address this issue was the Ninth Circuit. In re Claremont Acquisition Corp., 113 F.3d 1029 (9th Cir. 1997). In Claremont, the Ninth Circuit held — consistent with Eagle and Newark's argument — that non-monetary defaults were not excepted by section 365(b)(2)(D) and must be cured prior to the debtor's assumption of an executory contract or unexpired lease pursuant to section 365(b)(1). According to this view, where the non-monetary default was incapable of being cured (eg, something which in the past that could not be changed, or a “historical default”), the contract or lease could not be assumed.

Although many of the facts in the Bankvest case were actually disputed by the parties, for procedural reasons, the court accepted all of Eagle and Newark's allegations as true for purposes of its analysis. In short, the debtor was in the business of originating, securitizing, selling, and servicing equipment leases. Eagle and Newark had entered into lease agreements with the debtor whereby the debtor agreed to lease computer equipment to Eagle and Newark for a specified term.

Under the leases, Eagle and Newark were obligated to make monthly rental payments to the debtor. Delivery of the equipment was to be made directly by the manufacturer. Because the manufacturer would not complete production of some of the leased items until after the start of the lease, the parties agreed that the manufacturer would provide loaner equipment in the interim. Before the manufacturer could deliver the new equipment, an involuntary Chapter 11 petition was filed against the debtor. The debtor's reorganization plan, which was ultimately confirmed by the Bankruptcy Court, called for a gradual liquidation of its assets. All during the bankruptcy proceedings, Eagle and Newark continued to use the leased equipment but without paying rent to the debtor, accumulating arrears of approximately $1 million.

Under the plan, the debtor was to assume the Eagle and Newark leases. Pursuant to procedures set by the plan, Newark and Eagle filed cure claims seeking to effectively prevent assumption. Eagle and Newark contended, among other things, that the debtor had defaulted on the leases by failing to replace the loaner equipment and that this non-monetary default was a historical fact not capable of cure. Because of this, Eagle and Newark maintained, the leases could not be assumed. The Bankruptcy Court dismissed Eagle and Newark's cure claims finding that section 365(b)(2)(D) of the Bankruptcy Code permitted the debtor to assume the unexpired leases without first curing non-monetary defaults. In re Bankvest Capital Corp., 270 B.R. 541, 543 (Bankr. D. Mass. 2001). As the debtor had no monetary obligations under the leases (all payments flowed to the debtor), the Bankruptcy Court found that there were no cure claims to satisfy before the debtor could assume the leases. Eagle and Newark appealed to the Bankruptcy Appellate Panel, which affirmed the lower court's holding. Eagle Ins. Co. v. Bankvest Capital Corp. (In re Bankvest Capital Corp.), 290 B.R. 443 (B.A.P. 1st Cir. 2003).

The First Circuit's Opinion

It was not disputed that the failure to deliver equipment under a lease was a “quintessential example” of a non-monetary default. The question before the First Circuit was whether section 365(b)(2)(D) excused the debtor from the obligation that it otherwise had under 365(b)(1) to cure defaults before assumption.

First, reviewing the text of 365(b)(2)(D), the court found the section ambiguous because it could reasonably be read to address either penalty rate provisions or penalty rate provisions and non-monetary default provisions. The court found the legislative history of the statute unhelpful — having virtually no mention of the issue. The court also considered proposed amendments to the Bankruptcy Code, finding that, at most, such proposals showed that “at least some members of Congress are aware that ' 365(b)(2)(D) is a problem.” Because of this, the court found the most appropriate approach to interpreting the section was to focus on the practical implications of interpreting it one way or another, and the overarching purposes of Congress in enacting the Bankruptcy Code.

The First Circuit reasoned that, like the alleged debtor's default, many non-monetary defaults are “historical facts” incapable of being cured, and that requiring cure of such defaults effectively bars the debtor from assuming any lease or contract in which such a default has occurred — no matter how essential that contract might be to the debtor's reorganization efforts. The court approvingly cited to criticisms leveled against the Claremont case, that requiring cure of non-monetary defaults poses a substantial obstacle to the successful reorganization of many bankruptcy debtors. The court stated: “[T]his cannot, in our view, be what Congress intended. To prevent a debtor from assuming a contract based on historical events that it cannot remedy undermines Congress's basic purpose in ' 365: to promote the successful rehabilitation of the business for the benefit of both the debtor and all its creditors.”

According to the court, the Bankvest case illustrated well the force of the concern: “Eagle and Newark together owe Bankvest approximately $1 million in unpaid rent. Yet they argued to the bankruptcy court that Bankvest's failure to complete delivery of the leased equipment is an “historical fact” not susceptible to cure … So rather than simply seek an offset for any pecuniary harm they may have suffered, Eagle and Newark would deny the estate all $1 million in unpaid rent by compelling Bankvest to cure what they allege is incurable … That is plainly inconsistent with Congress's purpose in the Bankruptcy Code to maximize the value of the estate for all creditors.”

Consequences of the First Circuit's Holding

• Resolution of Contract Claims in a Non-Bankruptcy Court. It is important to note one of the things which is not a consequence of the First Circuit's holding: that Eagle and Newark would have no forum for their claims. To the contrary, the upshot of the court's decision is that the parties can now litigate their respective claims in the context of an action by Bankvest to recover the $1 million in unpaid rent. Thus, as a result of permitting assumption of the leases — it is not that the non-debtor party will be precluding from asserting its rights — rather, such party will be able to raise any claims it may have on the underlying agreement in the appropriate court.
• Preservation of the Assets of the Estate for the Debtor and All Creditors. The First Circuit's interpretation of section 365(b)(2)(D) prevents the loss of valuable assets of the estate, which assets inure to the benefit of the debtor and all of its creditors. For instance, it is common practice in large retail cases for particular leases to be sold after a going out of business sale. Such leases could not be sold, however, if the lease contained a provision making it a default (non-monetary) for the store to be “dark” for a period of time. An adoption of the Claremont position would result in a forfeiture of such leases to the detriment of a debtor's estate and creditors.

In rendering its opinion, the First Circuit rejected Eagle and Newark's argument that the aim of section 365(b)(1) (to ensure that the non-debtor party to an executory contract receives the benefit of its bargain if it is forced to continue performance on an assumed contract) should outweigh the overriding concern of preserving assets of the estate. The court acknowledged the importance of 365(b)(1), but found that “[b]ankruptcy by design involves the re-ordering of debtor-creditor relationships and the adjustment of bargains negotiated under more optimistic circumstances. Neither ' 365(b)(1) nor any policy reflected therein alters the broader objective of the Bankruptcy Code to give worthy debtors a fresh start.” The First Circuit's decision safeguards an important reorganization tool that the Ninth Circuit put greatly at risk.

Editor's Note: Newark Insurance Company and Eagle Insurance Company have filed a writ of certiorari with the U.S. Supreme Court.

A recent circuit court decision regarding the interpretation of section 365 of the Bankruptcy Code has set up a conflict between two circuits. On March 15, 2004, the Court of Appeals for the First Circuit issued an opinion regarding whether bankruptcy debtors are required to cure non-monetary defaults prior to assuming unexpired leases under section 365 of the Bankruptcy Code, 11 U.S.C. ' 365. In re Bankvest Capital Corp. (Eagle Insurance Co. v. Bankvest Capital Corp.), 360 F.3d 291 (1st Cir. 2004). The First Circuit found — expressly contrary to a holding of the Ninth Circuit Court of Appeals — that debtors are not required to cure such defaults, resulting in a split in the circuits over a very widely used section of the code.

Bankruptcy Code Section 365

The Bankvest case involved interpretation of Bankruptcy Code section 365(b)(2)(D). This subsection is part of a larger provision of the Bankruptcy Code, section 365, which permits a debtor to assume or reject executory contracts or unexpired leases that the debtor had entered into prior to bankruptcy. What constitutes an executory contract (including an unexpired lease) under the Bankruptcy Code has been the subject of a great deal of litigation and commentary over the years. Perhaps the most often quoted definition is “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.” Gallivan v. Springfield Post Rd. Corp. , 110 F.3d 848, 851 (1st Cir. 1997).

The ability to assume or reject “pre-petition” contracts is an important tool available to debtors in reorganization proceedings, allowing them to choose to continue only those contracts that, in a debtor's business judgment, will bring value to the estate. Thus, a debtor/lessee may reject a burdensome obligation (such as a long-term lease with a rental rate far above market value) while assuming other more favorable agreements. The benefit to the estate is balanced by the treatment of any claims of the non-debtor party. Ordinarily, a rejection of a contract under section 365 is treated as a pre-petition breach of the contract so that any claims which the non-debtor party may have under the contract are general unsecured claims. 11 U.S.C. ' 365(g). On the other hand, following an assumption, the debtor's post-petition obligations under the assumed contract or lease are treated as administrative expenses and given priority status over those of general unsecured creditors.

Of course, there are certain restrictions on the debtor's ability to assume. One to consider is when the debtor has already defaulted on the contract or lease and must undertake certain actions in order to be able to assume it. Specifically, under section 365(b)(1) of the Bankruptcy Code, the debtor must 1) cure the default, 2) compensate the non-debtor party for actual pecuniary losses resulting from the default, and 3) provide adequate assurance that the debtor will be able to perform under the contract or lease going forward.

The requirements of 365(b)(1) are not without exception however. One such exception, which was at issue in the Bankvest case, is found in section 365(b)(2)(D), which provides that: (2) Paragraph (1) [365(b)(1)] of this subsection does not apply to a default that is a breach of a provision relating to … (D) the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.

The Bankvest Case

In Bankvest, the issue was whether the above section, 365(b)(2)(D), contained only one or two separate types of defaults that would not require a cure in order for the debtor to assume a contract. Specifically, the appellants, Eagle Insurance Company and Newark Insurance Company, argued that the exception to cure applied only to a “penalty rate or [penalty] provision.” On the other hand, Bankvest maintained, and the First Circuit agreed, that the provision actually contemplates two exceptions to the cure requirements: 1) penalty rates, and 2) provisions relating to non-monetary obligations. Prior to the Bankvest case, the only other federal Court of Appeals to address this issue was the Ninth Circuit. In re Claremont Acquisition Corp., 113 F.3d 1029 (9th Cir. 1997). In Claremont, the Ninth Circuit held — consistent with Eagle and Newark's argument — that non-monetary defaults were not excepted by section 365(b)(2)(D) and must be cured prior to the debtor's assumption of an executory contract or unexpired lease pursuant to section 365(b)(1). According to this view, where the non-monetary default was incapable of being cured (eg, something which in the past that could not be changed, or a “historical default”), the contract or lease could not be assumed.

Although many of the facts in the Bankvest case were actually disputed by the parties, for procedural reasons, the court accepted all of Eagle and Newark's allegations as true for purposes of its analysis. In short, the debtor was in the business of originating, securitizing, selling, and servicing equipment leases. Eagle and Newark had entered into lease agreements with the debtor whereby the debtor agreed to lease computer equipment to Eagle and Newark for a specified term.

Under the leases, Eagle and Newark were obligated to make monthly rental payments to the debtor. Delivery of the equipment was to be made directly by the manufacturer. Because the manufacturer would not complete production of some of the leased items until after the start of the lease, the parties agreed that the manufacturer would provide loaner equipment in the interim. Before the manufacturer could deliver the new equipment, an involuntary Chapter 11 petition was filed against the debtor. The debtor's reorganization plan, which was ultimately confirmed by the Bankruptcy Court, called for a gradual liquidation of its assets. All during the bankruptcy proceedings, Eagle and Newark continued to use the leased equipment but without paying rent to the debtor, accumulating arrears of approximately $1 million.

Under the plan, the debtor was to assume the Eagle and Newark leases. Pursuant to procedures set by the plan, Newark and Eagle filed cure claims seeking to effectively prevent assumption. Eagle and Newark contended, among other things, that the debtor had defaulted on the leases by failing to replace the loaner equipment and that this non-monetary default was a historical fact not capable of cure. Because of this, Eagle and Newark maintained, the leases could not be assumed. The Bankruptcy Court dismissed Eagle and Newark's cure claims finding that section 365(b)(2)(D) of the Bankruptcy Code permitted the debtor to assume the unexpired leases without first curing non-monetary defaults. In re Bankvest Capital Corp., 270 B.R. 541, 543 (Bankr. D. Mass. 2001). As the debtor had no monetary obligations under the leases (all payments flowed to the debtor), the Bankruptcy Court found that there were no cure claims to satisfy before the debtor could assume the leases. Eagle and Newark appealed to the Bankruptcy Appellate Panel, which affirmed the lower court's holding. Eagle Ins. Co. v. Bankvest Capital Corp. (In re Bankvest Capital Corp.), 290 B.R. 443 (B.A.P. 1st Cir. 2003).

The First Circuit's Opinion

It was not disputed that the failure to deliver equipment under a lease was a “quintessential example” of a non-monetary default. The question before the First Circuit was whether section 365(b)(2)(D) excused the debtor from the obligation that it otherwise had under 365(b)(1) to cure defaults before assumption.

First, reviewing the text of 365(b)(2)(D), the court found the section ambiguous because it could reasonably be read to address either penalty rate provisions or penalty rate provisions and non-monetary default provisions. The court found the legislative history of the statute unhelpful — having virtually no mention of the issue. The court also considered proposed amendments to the Bankruptcy Code, finding that, at most, such proposals showed that “at least some members of Congress are aware that ' 365(b)(2)(D) is a problem.” Because of this, the court found the most appropriate approach to interpreting the section was to focus on the practical implications of interpreting it one way or another, and the overarching purposes of Congress in enacting the Bankruptcy Code.

The First Circuit reasoned that, like the alleged debtor's default, many non-monetary defaults are “historical facts” incapable of being cured, and that requiring cure of such defaults effectively bars the debtor from assuming any lease or contract in which such a default has occurred — no matter how essential that contract might be to the debtor's reorganization efforts. The court approvingly cited to criticisms leveled against the Claremont case, that requiring cure of non-monetary defaults poses a substantial obstacle to the successful reorganization of many bankruptcy debtors. The court stated: “[T]his cannot, in our view, be what Congress intended. To prevent a debtor from assuming a contract based on historical events that it cannot remedy undermines Congress's basic purpose in ' 365: to promote the successful rehabilitation of the business for the benefit of both the debtor and all its creditors.”

According to the court, the Bankvest case illustrated well the force of the concern: “Eagle and Newark together owe Bankvest approximately $1 million in unpaid rent. Yet they argued to the bankruptcy court that Bankvest's failure to complete delivery of the leased equipment is an “historical fact” not susceptible to cure … So rather than simply seek an offset for any pecuniary harm they may have suffered, Eagle and Newark would deny the estate all $1 million in unpaid rent by compelling Bankvest to cure what they allege is incurable … That is plainly inconsistent with Congress's purpose in the Bankruptcy Code to maximize the value of the estate for all creditors.”

Consequences of the First Circuit's Holding

• Resolution of Contract Claims in a Non-Bankruptcy Court. It is important to note one of the things which is not a consequence of the First Circuit's holding: that Eagle and Newark would have no forum for their claims. To the contrary, the upshot of the court's decision is that the parties can now litigate their respective claims in the context of an action by Bankvest to recover the $1 million in unpaid rent. Thus, as a result of permitting assumption of the leases — it is not that the non-debtor party will be precluding from asserting its rights — rather, such party will be able to raise any claims it may have on the underlying agreement in the appropriate court.
• Preservation of the Assets of the Estate for the Debtor and All Creditors. The First Circuit's interpretation of section 365(b)(2)(D) prevents the loss of valuable assets of the estate, which assets inure to the benefit of the debtor and all of its creditors. For instance, it is common practice in large retail cases for particular leases to be sold after a going out of business sale. Such leases could not be sold, however, if the lease contained a provision making it a default (non-monetary) for the store to be “dark” for a period of time. An adoption of the Claremont position would result in a forfeiture of such leases to the detriment of a debtor's estate and creditors.

In rendering its opinion, the First Circuit rejected Eagle and Newark's argument that the aim of section 365(b)(1) (to ensure that the non-debtor party to an executory contract receives the benefit of its bargain if it is forced to continue performance on an assumed contract) should outweigh the overriding concern of preserving assets of the estate. The court acknowledged the importance of 365(b)(1), but found that “[b]ankruptcy by design involves the re-ordering of debtor-creditor relationships and the adjustment of bargains negotiated under more optimistic circumstances. Neither ' 365(b)(1) nor any policy reflected therein alters the broader objective of the Bankruptcy Code to give worthy debtors a fresh start.” The First Circuit's decision safeguards an important reorganization tool that the Ninth Circuit put greatly at risk.

Editor's Note: Newark Insurance Company and Eagle Insurance Company have filed a writ of certiorari with the U.S. Supreme Court.