The Metamorphosis of Assignment Clauses in Bankruptcy

Sunterra is a resort management business with over 150 subsidiaries and related entities. In the 1990s, Sunterra launched a program that allowed timeshare owners at its resorts around the world to trade their timeshare rights with each other. In order to manage the timeshare information, Sunterra needed an integrated computer system. It entered into a nonexclusive license agreement with RCI Technology Corp. (RCI) for the development and use of software that would allow Sunterra as licensee to manage the system (the “Agreement”). The Fourth Circuit noted that over time, Sunterra invested over $38 million in developing the computer technology with the copyrighted software from RCI. Sunterra, 361 F.3d at 261. Any enhancements to the RCI software that were made by Sunterra were owned by it, but the Agreement also provided that such enhancements would automatically be licensed to RCI. Id.

In May 2000, Sunterra filed for Chapter 11 bankruptcy protection, and in 2002 filed its plan of reorganization. Prior to confirmation of the Plan, RCI filed a motion to have the Agreement deemed rejected on the grounds that the Agreement was an executory contract that Sunterra, as licensee, was prohibited from assuming or assigning without RCI's consent pursuant to section 365(c) of the Bankruptcy Code. Sunterra countered: 1) that the Agreement was not an executory contract; 2) that if it were an executory contract, Sunterra was assuming the Agreement not assigning it, therefore Sunterra's assumption was not prohibited by section 365(c); and 3) RCI had impliedly consented to assumption by Sunterra through the Agreement's consensual assignment provision. Id. at 261.

The Ruling of the Fourth Circuit

The pertinent Bankruptcy Code section in Sunterra, section 365(c), provides that a debtor in possession “may not assume or assign any executory contract … [if] applicable law excuses a party, other than the debtor, to such contract … from accepting performance from or rendering performance to an entity other than the debtor,” and such counter-party does not consent to the “assumption or assignment.” 11 U.S.C. ' 365(c)(1) (emphasis added). The “hypothetical test,” now followed by four Circuits, provides that a debtor in possession may not assume an executory contract over the objection of the counter-party to the contract if applicable law would bar assignment to a hypothetical third party — even where the debtor in possession does not intend to assign the contract to any third party. See In re Catapult Entm't, Inc., 165 F.3d 747 (9th Cir.), cert. dismissed, 528 U.S. 924 (1999); In re James Cable Partners, 27 F.3d 534, 537 (11th Cir. 1994); In re West Elecs., Inc., 852 F.2d 79, 83 (3d Cir. 1988). Only one Circuit has rejected the hypothetical test. See Institute Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493 (1st Cir.), cert. denied, 521 U.S. 1120 (1997) (rejecting the hypothetical test in favor of the “actual test” wherein the practical considerations of the assumption of a contract by a debtor in possession are considered and the “or” of section 365(c)(1) is construed as an “and”).

In applying the Countryman definition of an executory contract, the Fourth Circuit Court of Appeals quickly determined that the Agreement was an executory contract, since each party “possessed an ongoing obligation to maintain the confidentiality of the source code of the software developed by the other” under the Agreement. Id. at 264; see also Countryman V: Executory Contracts in Bankruptcy, Part I. 57 Minn. L. Rev. 439, 450 (1974). The court then considered RCI's argument that the plain language of section 365(c) of the Bankruptcy Code prohibited the assumption or assignment of the Agreement.

In Sunterra, the applicable non-bankruptcy law that prohibited the assignment of the Agreement without RCI's consent was federal copyright law. While Sunterra urged the Fourth Circuit to understand the impractical ramifications of utilizing the hypothetical test, the court continued to focus on the disjunctive nature of the phrase “assume or assign,” emphasizing that the Code does not say “assume and assign.” Id. at 265. In evaluating the plain meaning of the statute, the Fourth Circuit concluded it was bound by the use of the word “or” in section 365(c) and that the statute plainly contemplated “two distinct events” be dealt with in section 365(c): (i) assumption; or (ii) assignment. Id. at 268. Therefore, the hypothetical test – or the “literal tes,t” as the court termed it — was followed by the Fourth Circuit. Sunterra was unable to assume the Agreement over RCI's objection because applicable law barred assignment to a hypothetical third party — even though Sunterra was not going to assign the contract.

No other Circuit following the hypothetical test has analyzed a contract that contains a clause allowing assignment. What is most surprising and most disconcerting about the Sunterra expressly decision is the Circuit Court's total disregard of the express assignability provision in the Agreement. The Agreement contained the following consent provision (the “Transfer Provision”):

The provisions of this section shall not preclude the transfer of this license to a successor in interest of substantially all of [Sunterra's] assets if the assignee agrees in writing to be bound by this license.

Sunterra, 361 F.3d at 271 n. 15 (brackets in original). Sunterra contended that through the Transfer Provision, RCI impliedly consented to the assumption of the Agreement by the debtor in possession. RCI, on the other hand, asserted that any consent contained in the Transfer Provision was irrelevant because the pertinent question for the court was whether applicable non-bankruptcy law prohibited assignment, not the agreement itself. To this end, RCI pointed out that the language of section 365(c)(1) applies “whether or not such contract … prohibits or restricts assignments of rights … ” 11 U.S.C. ' 365(c)(1)(A). The court quickly disposed of RCI's argument, noting that the Transfer Provision did nothing to “prohibit or restrict” assignments, but instead endorsed them by giving Sunterra the right to assign under certain circumstances. Sunterra, 361 F.3d at 271. Therefore, section 365(c)(1)(A) was inapplicable.

RCI next argued that the Transfer Provision only applied to assignments and Sunterra was trying to assume the Agreement. Therefore, the Transfer Provision was inapplicable. The Fourth Circuit agreed with RCI's reasoning on this point and opined as follows:

The Transfer Provision, however, does not apply to assumption of the Agreement by a Chapter 11 debtor in possession. Because the terms assumption and assignment described “two conceptually distinct events,” and because the Transfer Provision pertains to an assignment rather than an assumption, RCI did not consent to Sunterra's assumption of the Agreement. Without RCI's consent, Sunterra was precluded from assuming the Agreement. Id. at 271 (internal citation to Catapult, 165 F.3d at 752 omitted). In light of this reasoning, the court held that Sunterra could not assume the Agreement pursuant to the Transfer Provision.

Next month, we discuss “The Debtor's Paradox”: If a debtor is prohibited from assuming an agreement which it could not hypothetically assign it, why can't the debtor assume the agreement when the agreement contains consent to assignment?

How is this scenario for a debtor's nightmare?

You negotiate a license agreement that provides for the assignment of the agreement to successors in interest so long as they agree to be bound by the terms of the agreement. You then file a Chapter 11 bankruptcy and as a debtor in possession, seek to assume that license agreement. The other party to the contract objects to such assumption and the Bankruptcy Court says that in light of such objection you cannot assume the license agreement. You cannot reorganize without the license. You are dead.

This nightmare unfortunately is a reality. Recently, the Fourth Circuit Court of Appeals joined the Ninth, Third and Eleventh Circuits in adopting the “hypothetical test” in denying a debtor in possession's assumption of an executory contract under section 365(c) of the Bankruptcy Code despite an express assignability provision in the contract. In RCI Tech. v. Sunterra Corp. (In re Sunterra Corp.), 361 F.3d 257 (4th Cir. 2004), the Fourth Circuit not only became the fourth Circuit Court of Appeals to follow the Catapult Test, as the hypothetical test is referred to in light of the Ninth Circuit Court of Appeals decision in In re Catapult Entm't., Inc., 165 F.3d 747 (9th Cir. 1999), but expanded the Catapult decision to deny assumption where the contract contained the objecting party's express consent to the assignment of the contract to successors in interest of the debtor.

Sunterra is a resort management business with over 150 subsidiaries and related entities. In the 1990s, Sunterra launched a program that allowed timeshare owners at its resorts around the world to trade their timeshare rights with each other. In order to manage the timeshare information, Sunterra needed an integrated computer system. It entered into a nonexclusive license agreement with RCI Technology Corp. (RCI) for the development and use of software that would allow Sunterra as licensee to manage the system (the “Agreement”). The Fourth Circuit noted that over time, Sunterra invested over $38 million in developing the computer technology with the copyrighted software from RCI. Sunterra, 361 F.3d at 261. Any enhancements to the RCI software that were made by Sunterra were owned by it, but the Agreement also provided that such enhancements would automatically be licensed to RCI. Id.

In May 2000, Sunterra filed for Chapter 11 bankruptcy protection, and in 2002 filed its plan of reorganization. Prior to confirmation of the Plan, RCI filed a motion to have the Agreement deemed rejected on the grounds that the Agreement was an executory contract that Sunterra, as licensee, was prohibited from assuming or assigning without RCI's consent pursuant to section 365(c) of the Bankruptcy Code. Sunterra countered: 1) that the Agreement was not an executory contract; 2) that if it were an executory contract, Sunterra was assuming the Agreement not assigning it, therefore Sunterra's assumption was not prohibited by section 365(c); and 3) RCI had impliedly consented to assumption by Sunterra through the Agreement's consensual assignment provision. Id. at 261.

The Ruling of the Fourth Circuit

The pertinent Bankruptcy Code section in Sunterra, section 365(c), provides that a debtor in possession “may not assume or assign any executory contract … [if] applicable law excuses a party, other than the debtor, to such contract … from accepting performance from or rendering performance to an entity other than the debtor,” and such counter-party does not consent to the “assumption or assignment.” 11 U.S.C. ' 365(c)(1) (emphasis added). The “hypothetical test,” now followed by four Circuits, provides that a debtor in possession may not assume an executory contract over the objection of the counter-party to the contract if applicable law would bar assignment to a hypothetical third party — even where the debtor in possession does not intend to assign the contract to any third party. See In re Catapult Entm't, Inc. , 165 F.3d 747 (9th Cir.), cert. dismissed , 528 U.S. 924 (1999); In re James Cable Partners, 27 F.3d 534, 537 (11th Cir. 1994); In re West Elecs., Inc., 852 F.2d 79, 83 (3d Cir. 1988). Only one Circuit has rejected the hypothetical test. See Institute Pasteur v. Cambridge Biotech Corp. , 104 F.3d 489, 493 (1st Cir.), cert. denied , 521 U.S. 1120 (1997) (rejecting the hypothetical test in favor of the “actual test” wherein the practical considerations of the assumption of a contract by a debtor in possession are considered and the “or” of section 365(c)(1) is construed as an “and”).

In applying the Countryman definition of an executory contract, the Fourth Circuit Court of Appeals quickly determined that the Agreement was an executory contract, since each party “possessed an ongoing obligation to maintain the confidentiality of the source code of the software developed by the other” under the Agreement. Id. at 264; see also Countryman V: Executory Contracts in Bankruptcy, Part I. 57 Minn. L. Rev. 439, 450 (1974). The court then considered RCI's argument that the plain language of section 365(c) of the Bankruptcy Code prohibited the assumption or assignment of the Agreement.

In Sunterra, the applicable non-bankruptcy law that prohibited the assignment of the Agreement without RCI's consent was federal copyright law. While Sunterra urged the Fourth Circuit to understand the impractical ramifications of utilizing the hypothetical test, the court continued to focus on the disjunctive nature of the phrase “assume or assign,” emphasizing that the Code does not say “assume and assign.” Id. at 265. In evaluating the plain meaning of the statute, the Fourth Circuit concluded it was bound by the use of the word “or” in section 365(c) and that the statute plainly contemplated “two distinct events” be dealt with in section 365(c): (i) assumption; or (ii) assignment. Id. at 268. Therefore, the hypothetical test – or the “literal tes,t” as the court termed it — was followed by the Fourth Circuit. Sunterra was unable to assume the Agreement over RCI's objection because applicable law barred assignment to a hypothetical third party — even though Sunterra was not going to assign the contract.

No other Circuit following the hypothetical test has analyzed a contract that contains a clause allowing assignment. What is most surprising and most disconcerting about the Sunterra expressly decision is the Circuit Court's total disregard of the express assignability provision in the Agreement. The Agreement contained the following consent provision (the “Transfer Provision”):

The provisions of this section shall not preclude the transfer of this license to a successor in interest of substantially all of [Sunterra's] assets if the assignee agrees in writing to be bound by this license.

Sunterra, 361 F.3d at 271 n. 15 (brackets in original). Sunterra contended that through the Transfer Provision, RCI impliedly consented to the assumption of the Agreement by the debtor in possession. RCI, on the other hand, asserted that any consent contained in the Transfer Provision was irrelevant because the pertinent question for the court was whether applicable non-bankruptcy law prohibited assignment, not the agreement itself. To this end, RCI pointed out that the language of section 365(c)(1) applies “whether or not such contract … prohibits or restricts assignments of rights … ” 11 U.S.C. ' 365(c)(1)(A). The court quickly disposed of RCI's argument, noting that the Transfer Provision did nothing to “prohibit or restrict” assignments, but instead endorsed them by giving Sunterra the right to assign under certain circumstances. Sunterra, 361 F.3d at 271. Therefore, section 365(c)(1)(A) was inapplicable.

RCI next argued that the Transfer Provision only applied to assignments and Sunterra was trying to assume the Agreement. Therefore, the Transfer Provision was inapplicable. The Fourth Circuit agreed with RCI's reasoning on this point and opined as follows:

The Transfer Provision, however, does not apply to assumption of the Agreement by a Chapter 11 debtor in possession. Because the terms assumption and assignment described “two conceptually distinct events,” and because the Transfer Provision pertains to an assignment rather than an assumption, RCI did not consent to Sunterra's assumption of the Agreement. Without RCI's consent, Sunterra was precluded from assuming the Agreement. Id. at 271 (internal citation to Catapult, 165 F.3d at 752 omitted). In light of this reasoning, the court held that Sunterra could not assume the Agreement pursuant to the Transfer Provision.

Next month, we discuss “The Debtor's Paradox”: If a debtor is prohibited from assuming an agreement which it could not hypothetically assign it, why can't the debtor assume the agreement when the agreement contains consent to assignment?