Non-Debtor Contract Counterparties in Bankruptcy

The case law in this area is scarce, but the common arguments and requested relief come in two forms. Counterparties argue that: 1) the automatic stay should be lifted or modified for lack of adequate protection to allow the counter-party to cancel the Contract; and 2) adequate protection should be provided to the counterparty to protect against potential economic loss under the Contract. See In re Lucre, 339 B.R. 648, 651 (Bankr. W.D. Mich. 2006) (requesting relief from the automatic stay); B & G Realty v. 159th & Harlem P'ship, No. 96 C 2842, 1997 U.S. Dist. LEXIS 3694, at *8-10 (N.D. Ill. 1997) (requesting adequate protection). The essence of the argument is that without relief the counterparty should not be required to continue to perform because the debtor's default would cause substantial damage.

Counterparties may argue that although there is no current default under the Contract, the automatic stay should be lifted so that the counterparty can terminate the Contract now, or at a later date if the debtor defaults under the Contract. These counterparties argue that the economic risk involved in continued performance under the Contract is, by itself, a lack of adequate protection, and grounds to lift or modify the automatic stay.

A second argument is that adequate protection should be granted for the potential harm that could arise from the debtor's breach. Adequate protection is appropriate, the argument goes, because the debtor could default under the Contract causing considerable economic harm to the counterparty. For example, the counterparty might have to expend a significant amount of money in advance to perform services for the debtor, before the debtor pays for the services. Although counterparties may make these two distinct arguments, courts have resolved both arguments in essentially the same manner; by looking to the terms of the underlying agreement, and whether a contractual default exists.

The Law

Under Bankruptcy Code section 365(a) the debtor-in-possession or trustee may assume or reject any executory contract or unexpired lease. 11 U.S.C. ' 365(a). If the debtor assumes the Contract, then it must cure any defaults at the contract rate. Id. at 365(b). If the debtor rejects the Contract, the loss to the counterparty for any breach by the debtor is treated as a general unsecured claim. Id. at 365(g). If the debtor has continued to receive a benefit from the Contract before rejection, the counterparty will be entitled to an administrative claim for services or goods rendered post-petition. See In re Thompson, 788 F.2d 560, 563 (9th Cir. 1968). The amount of the administrative claim, however, will be measured at the fair and reasonable value of the benefit received by the estate and not strictly by the terms of the Contract. See Id; NLRB v. Bildisco & Bildisco, 465 U.S. 513, 531 (1984). Notably, the debtor may not have the cash to pay administrative claims in full, or at all, and the counterparty runs the risk that the administrative claim is worthless.

In order to avoid this situation, counterparties resort to Bankruptcy Code section 362(d), which permits the court to modify the automatic stay “for cause, including the lack of adequate protection of an interest in property.” 11 U.S.C. ' 362(d). Similarly, Bankruptcy Code section 363(e) entitles a party to adequate protection for “an interest in property used, sold, or leased or proposed to be used, sold, or leased by the trustee [or debtor-in-possession].” Id. at ' 363(e). The term “adequate protection” appears three times in the Bankruptcy Code: first, under Bankruptcy Code section 362, providing adequate protection when the automatic stay is not lifted where cause has been shown to exist; second, under Bankruptcy Code section 363, providing for adequate protection when the trustee uses or proposes to use the property of a creditor; and third, under Bankruptcy Code section 364, providing adequate protection for post-petition financing. See id at ” 362, 363, 364. Generally, a party is entitled to adequate protection when some mechanism under the Bankruptcy Code affects the rights of the party in and to its property.

Counterparties justify their right to stay relief and adequate protection by arguing that their rights are affected by the filing of the petition because the counterparty incurs considerable business risk by having to perform under the Contract until the debtor assumes or rejects the Contract, and cannot terminate the Contract by the automatic stay in the event that the debtor defaults under the Contract. In essence, counterparties argue that the allocation of risk is unfair. While the language under Bankruptcy Code section 363 could permit adequate protection for Contract counterparties in certain situations, assuming that the debtor has complied with the Contract, the filing of the bankruptcy case itself does not alter the contractual rights of the counterparty, or create a need for adequate protection, as demonstrated in the case of B & G Realty v. 159th & Harlem Partnership.

In B & G Realty, a lessee entered into a lease for unimproved land. Under the terms of the lease, the lessee was to erect a building on the land and pay rent to the debtor. See B & G Realty v. 159th & Harlem P'ship, No. 96 C 2842, 1997 U.S. Dist. LEXIS 3694, at *1 (N.D. Ill. 1997). Several mortgages existed on the land. Before the building was constructed, one of the mortgagees brought a foreclosure action, leading the debtor to file Chapter 11, which was eventually dismissed. Id. at *3. After dismissal, an involuntary bankruptcy was filed against the debtor, and a Chapter 11 trustee was appointed. After the trustee filed a motion for turnover of unpaid back rent, the lessee filed a motion for adequate protection in the form of relief from paying rent until the bankruptcy was resolved. Id. at *4.

The lessee argued that the trustee would be using the lessee's property interest and therefore under Bankruptcy Code section 363, adequate protection was appropriate. The court rejected this argument and denied the lessee's motion for adequate protection because the debtor had not defaulted under the lease agreement. The court noted that the lessee was asking for adequate protection to essentially protect against the business risk of constructing a building on the land, a requirement under the lease, while the debtor was in bankruptcy and the land was subject to possible foreclosure actions. Id. at *8-10. The automatic stay did not prevent the lessee from constructing a building, but, as a practical matter, the economic risk was too great for the lessee. The court concluded, however, that absent a default by the debtor, adequate protection is not required to protect against the economic risk which is inherent in the underlying agreement.

B & G Realty

shows that counterparties that seek adequate protection must show more than just potential economic risk that is inherent in the underlying agreement. Requiring adequate protection to the lessee under these circumstances would have the same effect as an impermissible ipso facto clause, granting relief to the lessee for the sole reason of the bankruptcy filing. See In re Seattle S. Pac., 268 F.3d 712, 715'46 (9th Cir. 2001).

Courts are clear that if a counterparty is to receive any relief, there must be some form of a default, or provision in the Contract that gives the counterparty the right to take action against the debtor. The counterparty's right to relief is essentially based on the underlying Contract.

If the Contract gives the counterparty a remedy against the debtor then the counterparty may obtain relief. If not, the counterparty is bound by the terms of the Contract as they exist. The counterparty holds the same rights under the Contract during the bankruptcy, as it did the minute before the bankruptcy petition was filed. See In re Penn Traffic Co., 524 F.3d 373, 383 (2d Cir. 2008). This notion is consistent with the bankruptcy principle that a debtor's property rights are governed by applicable state law, unless otherwise specified in the Bankruptcy Code. See Butner v. United States, 440 U.S. 48, 55 (1979) (asserting that property rights in bankruptcy are governed by and limited to the rights granted in property under state law).

In re Lucre, Inc

. is representative of the idea that the counterparty to the Contract is only entitled to the rights and remedies that it has in the Contract. 339 B.R. 648, 650 (Bankr. W.D. Mich. 2006). In Lucre, the lessee, a telecommunications company, was party to an interconnection agreement with the debtor, another telecommunications company. Idat 651.

Prior to the bankruptcy filing, a number of litigations existed between the debtor and the counterparty. Id. The first litigation was resolved before the filing, and concluded with the debtor obtaining an injunction against the counterparty from terminating services owed to the debtor. Id. The second litigation was commenced to recover payment from the debtor for services rendered to the debtor by the counterparty under the interconnection agreement. Id. The counterparty received a $1,336,561 judgment against the debtor at the conclusion of that litigation. Subsequent to entry of the judgment, the counterparty moved in state court to have the injunction against it terminated. Id. Prior to the hearing on the injunction issue, the debtor filed its Chapter 11 petition.

After the filing, the counterparty moved to lift the automatic stay and permit the state court to dissolve the injunction in order to terminate the interconnection agreement and setoff both pre- and post-petition obligations owed to the debtor against obligations the debtor owed it. Id. In response, the debtor sought to compel the counterparty to perform. Ultimately, the bankruptcy court granted the counterparty's motion and lifted the stay to permit the counterparty to seek to dissolve the injunctions in state court. Id. at 664. The bankruptcy court, however, did not lift the stay to permit the counterparty to terminate the Contract completely. Id.

In its opinion, the Lucre court noted that the parties to the Contract have the same rights under the Contract in bankruptcy and outside of bankruptcy, subject to certain exceptions under Bankruptcy Code section 365. Id. at 655-56. While the counterparty was the party seeking relief, the court couched its language from the perspective of the debtor. The court pointed out that nowhere in the Bankruptcy Code, with the exception of Bankruptcy Code section 365(b)(4), does it permit the trustee or debtor-in-possession compel the counterparty to perform prior to assumption of the Contract if the debtor has breached the Contract pre-petition, and has yet to cure the default. Id. at 657. Bankruptcy Code section 365(b)(4) permits the trustee or debtor-in-possession to compel a lessor to perform under a breached but unexpired lease if the debtor pays for the performance under the terms of the lease. 11 U.S.C. '365(b)(4). Although not discussed by the Lucre court, Bankruptcy Code section 365(d)(3) also requires the debtor to perform under a nonresidential lease prior to assumption or rejection of the lease. 11 U.S.C. '365(d)(3).

Even though the Lucre court viewed the contract from the debtor's point of view, the negative implication of the court's ruling is that the counterparty has grounds to argue that it is excused from performing until the debtor cures its own pre-petition breach under the terms of the Contract. Prior to the assumption and rejection decision, the counterparty's rights under the Contract remain unchanged, subject to the automatic stay and certain provisions in Bankruptcy Code section 365. In re Penn Traffic Co., 524 F.3d 373, 383 (2d Cir. 2008). Thus, a debtor that defaulted or breached a Contract pre-petition, and could not compel the counterparty to perform pre-petition, also cannot compel the counterparty to perform post-petition without curing the breach. Similarly, although the counterparty may be excused from performance by the debtor's pre-petition breach, cause likely does not exist for the counterparty to obtain relief from the stay to terminate the Contract or receive adequate protection unless the debtor has breached the Contract post-petition. See Lucre, 339 B.R at 663. See also 11 U.S.C. ' 362(d) (allowing relief from stay for “cause”).

While the Lucre opinion spans dozens of pages explaining the intricacies of executory contract law in bankruptcy, the moral of the opinion is simple. Parties to an executory contract in bankruptcy have the right to perform and right to refuse to perform based on the terms of the Contract. Absent a breach of a provision in the Contract, or a right granted in the Contract, aside from an ipso facto clause, a Contract counterparty has no right to lift the stay or to adequate protection based solely on the debtor entering bankruptcy. In Lucre, the debtor breached the Contract pre-petition, and thus the court permitted the counterparty to lift the stay and terminate injunctions compelling it to perform. In B & G, the debtor did not breach the Contract, and therefore, the court did not grant the counterparty relief.

Pre-Petition Protective Measures

While dealing with a debtor in bankruptcy may pose many business risks for Contract counterparties, careful drafting of a Contract can help to reduce risks after a bankruptcy is filed. If the Contract requires the counterparty to outlay significant capital upfront, before being paid by the debtor, the counterparty should attempt to include stricter default provisions in the Contract to give itself protection, should the debtor spiral into bankruptcy. With stricter default provisions, if the debtor defaults pre-petition, the counterparty has the ability to terminate the Contract pre-petition, avoiding the economic risks of performing under the Contract with a debtor in bankruptcy. Additionally, stricter default provisions increase the likelihood of a default by the debtor post-petition, giving the counterparty additional grounds to cease performance, seek modification of the stay, or seek adequate protection.

Counterparties to these Contracts may also want to consider including provisions in their Contracts that entitle them to monitor the financial health of the debtor and declare a default if certain financial benchmarks are not met. Finally, counterparties can limit their potential liability, if at all possible, by entering into Contracts that do not require considerable upfront capital expenditures, securing the payments under the Contract through a letter of credit, proceeds of which are not property of the estate, and requiring advanced payments before services are rendered by the counterparty. See In re Oakwood Homes Corp., 342 B.R. 59, 67 (Bankr. D. Del. 2006). (holding proceeds from letters of credit are not property of the estate).

Post-Petition Protective Measures

Counterparties dealing with a debtor in bankruptcy that has yet to default on a Contract should consider seeking a consensual resolution with the debtor in order to protect itself from the risks of post-petition performance. As stated above, the court is unlikely to grant any relief from the automatic stay or adequate protection based solely on business risk. One option for counterparties is to set up a monitoring system with the debtor, which allows the counterparty to take action should certain events occur.

For example, the counterparty could agree with the debtor that the counterparty will receive periodic financial statements and updates from the debtor. Under the agreement, if counterparty feels insecure with the debtor's position, the counterparty has the right to schedule a hearing on shortened notice to resolve the issue. The counterparty should also have the right to schedule a hearing on shortened notice if the debtor misses a payment under the Contract. Finally, the counterparty should attempt to include in the agreement a provision providing for grounds to lift the automatic stay should the debtor default. Thus, if a payment is missed, the debtor would likely be in default, an emergency hearing would scheduled, and, per the terms of the agreement, the judge would likely lift or modify the automatic stay for the counterparty.

Another option for counterparties is to move the court to set a deadline for assumption or rejection of the Contract. Bankruptcy Code section 365(d)(2) permits the court to set a deadline for the debtor-in-possession to assume or reject of Contract. 11 U.S.C. ' 365(d)(2). Although this option may not completely eliminate the economic risks inherent in the Contract, especially if administrative claims are not paid in full, it limits the amount of economic risk moving forward.

By taking preventative measures such as these, the counterparty can limit the risks associated with dealing with a debtor in bankruptcy, and the potential liability associated with that risk. The ability to monitor the debtor and act proactively before damage can be caused to the counterparty rather than reactively after losses have been incurred, allows the counterparty to protect itself from the hazards of dealing with debtors in bankruptcy, without seeking extraordinary relief from the court.

Conclusion

Unfortunately, Bankruptcy Code section 365 puts counterparties to executory contracts and unexpired leases at considerable risk. Although counterparties can attempt to obtain relief from dealing with a debtor in bankruptcy through lifting of the automatic stay or by obtaining adequate protection, courts are reluctant to grant such relief if the sole reason for the relief is exposure to economic or business risks from dealing with a debtor in bankruptcy. Rather, courts will only grant relief if a default exists and the Contract itself provides a remedy. Counterparties can, however, take preventative steps pre-petition, as well as post-petition, to protect themselves from liability stemming from the risks associated with dealing with debtors in bankruptcy.

Adam L. Rosen is a partner and Christopher J. Rubino is a law clerk awaiting admission at SilvermanAcampora LLP in Jericho, NY. Mr. Rosen is a member of this newsletter's Board of Editors.

Bankruptcy Code section 365 primarily concerns whether a debtor-in-possession or trustee may assume or reject executory contracts and unexpired leases (collectively, the “Contracts”) for the benefit of the estate, but the section often places the counterparties to those Contracts in the precarious position of being required to perform while running the risk that a debtor or trustee might not do so. Until a debtor decides whether to assume or reject a Contract, the terms of the Contract continue to bind the debtor and the counterparty. If the counterparty performs, it bears the risk that the debtor will reject the Contract and the debtor will be unable to pay the administrative claim owing to the counterparty for its post-petition performance. Courts generally struggle with this tension between protecting counterparties and protecting the bankruptcy estate prior to the assumption or rejection decision.

Counterparties have several available options depending on whether a pre-petition default exists under the Contract, and depending on the terms of the Contract. This article discusses how counterparties, as well as courts, react to situations where a counterparty seeks protection from the risks inherent in continued performance under a Contract with a debtor in bankruptcy.

The Arguments

The case law in this area is scarce, but the common arguments and requested relief come in two forms. Counterparties argue that: 1) the automatic stay should be lifted or modified for lack of adequate protection to allow the counter-party to cancel the Contract; and 2) adequate protection should be provided to the counterparty to protect against potential economic loss under the Contract. See In re Lucre, 339 B.R. 648, 651 (Bankr. W.D. Mich. 2006) (requesting relief from the automatic stay); B & G Realty v. 159th & Harlem P'ship, No. 96 C 2842, 1997 U.S. Dist. LEXIS 3694, at *8-10 (N.D. Ill. 1997) (requesting adequate protection). The essence of the argument is that without relief the counterparty should not be required to continue to perform because the debtor's default would cause substantial damage.

Counterparties may argue that although there is no current default under the Contract, the automatic stay should be lifted so that the counterparty can terminate the Contract now, or at a later date if the debtor defaults under the Contract. These counterparties argue that the economic risk involved in continued performance under the Contract is, by itself, a lack of adequate protection, and grounds to lift or modify the automatic stay.

A second argument is that adequate protection should be granted for the potential harm that could arise from the debtor's breach. Adequate protection is appropriate, the argument goes, because the debtor could default under the Contract causing considerable economic harm to the counterparty. For example, the counterparty might have to expend a significant amount of money in advance to perform services for the debtor, before the debtor pays for the services. Although counterparties may make these two distinct arguments, courts have resolved both arguments in essentially the same manner; by looking to the terms of the underlying agreement, and whether a contractual default exists.

The Law

Under Bankruptcy Code section 365(a) the debtor-in-possession or trustee may assume or reject any executory contract or unexpired lease. 11 U.S.C. ' 365(a). If the debtor assumes the Contract, then it must cure any defaults at the contract rate. Id. at 365(b). If the debtor rejects the Contract, the loss to the counterparty for any breach by the debtor is treated as a general unsecured claim. Id. at 365(g). If the debtor has continued to receive a benefit from the Contract before rejection, the counterparty will be entitled to an administrative claim for services or goods rendered post-petition. See In re Thompson, 788 F.2d 560, 563 (9th Cir. 1968). The amount of the administrative claim, however, will be measured at the fair and reasonable value of the benefit received by the estate and not strictly by the terms of the Contract. See Id; NLRB v. Bildisco & Bildisco , 465 U.S. 513, 531 (1984). Notably, the debtor may not have the cash to pay administrative claims in full, or at all, and the counterparty runs the risk that the administrative claim is worthless.

In order to avoid this situation, counterparties resort to Bankruptcy Code section 362(d), which permits the court to modify the automatic stay “for cause, including the lack of adequate protection of an interest in property.” 11 U.S.C. ' 362(d). Similarly, Bankruptcy Code section 363(e) entitles a party to adequate protection for “an interest in property used, sold, or leased or proposed to be used, sold, or leased by the trustee [or debtor-in-possession].” Id. at ' 363(e). The term “adequate protection” appears three times in the Bankruptcy Code: first, under Bankruptcy Code section 362, providing adequate protection when the automatic stay is not lifted where cause has been shown to exist; second, under Bankruptcy Code section 363, providing for adequate protection when the trustee uses or proposes to use the property of a creditor; and third, under Bankruptcy Code section 364, providing adequate protection for post-petition financing. See id at ” 362, 363, 364. Generally, a party is entitled to adequate protection when some mechanism under the Bankruptcy Code affects the rights of the party in and to its property.

Counterparties justify their right to stay relief and adequate protection by arguing that their rights are affected by the filing of the petition because the counterparty incurs considerable business risk by having to perform under the Contract until the debtor assumes or rejects the Contract, and cannot terminate the Contract by the automatic stay in the event that the debtor defaults under the Contract. In essence, counterparties argue that the allocation of risk is unfair. While the language under Bankruptcy Code section 363 could permit adequate protection for Contract counterparties in certain situations, assuming that the debtor has complied with the Contract, the filing of the bankruptcy case itself does not alter the contractual rights of the counterparty, or create a need for adequate protection, as demonstrated in the case of B & G Realty v. 159th & Harlem Partnership.

In B & G Realty, a lessee entered into a lease for unimproved land. Under the terms of the lease, the lessee was to erect a building on the land and pay rent to the debtor. See B & G Realty v. 159th & Harlem P'ship, No. 96 C 2842, 1997 U.S. Dist. LEXIS 3694, at *1 (N.D. Ill. 1997). Several mortgages existed on the land. Before the building was constructed, one of the mortgagees brought a foreclosure action, leading the debtor to file Chapter 11, which was eventually dismissed. Id. at *3. After dismissal, an involuntary bankruptcy was filed against the debtor, and a Chapter 11 trustee was appointed. After the trustee filed a motion for turnover of unpaid back rent, the lessee filed a motion for adequate protection in the form of relief from paying rent until the bankruptcy was resolved. Id. at *4.

The lessee argued that the trustee would be using the lessee's property interest and therefore under Bankruptcy Code section 363, adequate protection was appropriate. The court rejected this argument and denied the lessee's motion for adequate protection because the debtor had not defaulted under the lease agreement. The court noted that the lessee was asking for adequate protection to essentially protect against the business risk of constructing a building on the land, a requirement under the lease, while the debtor was in bankruptcy and the land was subject to possible foreclosure actions. Id. at *8-10. The automatic stay did not prevent the lessee from constructing a building, but, as a practical matter, the economic risk was too great for the lessee. The court concluded, however, that absent a default by the debtor, adequate protection is not required to protect against the economic risk which is inherent in the underlying agreement.

B & G Realty

shows that counterparties that seek adequate protection must show more than just potential economic risk that is inherent in the underlying agreement. Requiring adequate protection to the lessee under these circumstances would have the same effect as an impermissible ipso facto clause, granting relief to the lessee for the sole reason of the bankruptcy filing. See In re Seattle S. Pac., 268 F.3d 712, 715'46 (9th Cir. 2001).

Courts are clear that if a counterparty is to receive any relief, there must be some form of a default, or provision in the Contract that gives the counterparty the right to take action against the debtor. The counterparty's right to relief is essentially based on the underlying Contract.

If the Contract gives the counterparty a remedy against the debtor then the counterparty may obtain relief. If not, the counterparty is bound by the terms of the Contract as they exist. The counterparty holds the same rights under the Contract during the bankruptcy, as it did the minute before the bankruptcy petition was filed. See In re Penn Traffic Co., 524 F.3d 373, 383 (2d Cir. 2008). This notion is consistent with the bankruptcy principle that a debtor's property rights are governed by applicable state law, unless otherwise specified in the Bankruptcy Code. See Butner v. United States , 440 U.S. 48, 55 (1979) (asserting that property rights in bankruptcy are governed by and limited to the rights granted in property under state law).

In re Lucre, Inc

. is representative of the idea that the counterparty to the Contract is only entitled to the rights and remedies that it has in the Contract. 339 B.R. 648, 650 (Bankr. W.D. Mich. 2006). In Lucre, the lessee, a telecommunications company, was party to an interconnection agreement with the debtor, another telecommunications company. Idat 651.

Prior to the bankruptcy filing, a number of litigations existed between the debtor and the counterparty. Id. The first litigation was resolved before the filing, and concluded with the debtor obtaining an injunction against the counterparty from terminating services owed to the debtor. Id. The second litigation was commenced to recover payment from the debtor for services rendered to the debtor by the counterparty under the interconnection agreement. Id. The counterparty received a $1,336,561 judgment against the debtor at the conclusion of that litigation. Subsequent to entry of the judgment, the counterparty moved in state court to have the injunction against it terminated. Id. Prior to the hearing on the injunction issue, the debtor filed its Chapter 11 petition.

After the filing, the counterparty moved to lift the automatic stay and permit the state court to dissolve the injunction in order to terminate the interconnection agreement and setoff both pre- and post-petition obligations owed to the debtor against obligations the debtor owed it. Id. In response, the debtor sought to compel the counterparty to perform. Ultimately, the bankruptcy court granted the counterparty's motion and lifted the stay to permit the counterparty to seek to dissolve the injunctions in state court. Id. at 664. The bankruptcy court, however, did not lift the stay to permit the counterparty to terminate the Contract completely. Id.

In its opinion, the Lucre court noted that the parties to the Contract have the same rights under the Contract in bankruptcy and outside of bankruptcy, subject to certain exceptions under Bankruptcy Code section 365. Id. at 655-56. While the counterparty was the party seeking relief, the court couched its language from the perspective of the debtor. The court pointed out that nowhere in the Bankruptcy Code, with the exception of Bankruptcy Code section 365(b)(4), does it permit the trustee or debtor-in-possession compel the counterparty to perform prior to assumption of the Contract if the debtor has breached the Contract pre-petition, and has yet to cure the default. Id. at 657. Bankruptcy Code section 365(b)(4) permits the trustee or debtor-in-possession to compel a lessor to perform under a breached but unexpired lease if the debtor pays for the performance under the terms of the lease. 11 U.S.C. '365(b)(4). Although not discussed by the Lucre court, Bankruptcy Code section 365(d)(3) also requires the debtor to perform under a nonresidential lease prior to assumption or rejection of the lease. 11 U.S.C. '365(d)(3).

Even though the Lucre court viewed the contract from the debtor's point of view, the negative implication of the court's ruling is that the counterparty has grounds to argue that it is excused from performing until the debtor cures its own pre-petition breach under the terms of the Contract. Prior to the assumption and rejection decision, the counterparty's rights under the Contract remain unchanged, subject to the automatic stay and certain provisions in Bankruptcy Code section 365. In re Penn Traffic Co., 524 F.3d 373, 383 (2d Cir. 2008). Thus, a debtor that defaulted or breached a Contract pre-petition, and could not compel the counterparty to perform pre-petition, also cannot compel the counterparty to perform post-petition without curing the breach. Similarly, although the counterparty may be excused from performance by the debtor's pre-petition breach, cause likely does not exist for the counterparty to obtain relief from the stay to terminate the Contract or receive adequate protection unless the debtor has breached the Contract post-petition. See Lucre, 339 B.R at 663. See also 11 U.S.C. ' 362(d) (allowing relief from stay for “cause”).

While the Lucre opinion spans dozens of pages explaining the intricacies of executory contract law in bankruptcy, the moral of the opinion is simple. Parties to an executory contract in bankruptcy have the right to perform and right to refuse to perform based on the terms of the Contract. Absent a breach of a provision in the Contract, or a right granted in the Contract, aside from an ipso facto clause, a Contract counterparty has no right to lift the stay or to adequate protection based solely on the debtor entering bankruptcy. In Lucre, the debtor breached the Contract pre-petition, and thus the court permitted the counterparty to lift the stay and terminate injunctions compelling it to perform. In B & G, the debtor did not breach the Contract, and therefore, the court did not grant the counterparty relief.

Pre-Petition Protective Measures

While dealing with a debtor in bankruptcy may pose many business risks for Contract counterparties, careful drafting of a Contract can help to reduce risks after a bankruptcy is filed. If the Contract requires the counterparty to outlay significant capital upfront, before being paid by the debtor, the counterparty should attempt to include stricter default provisions in the Contract to give itself protection, should the debtor spiral into bankruptcy. With stricter default provisions, if the debtor defaults pre-petition, the counterparty has the ability to terminate the Contract pre-petition, avoiding the economic risks of performing under the Contract with a debtor in bankruptcy. Additionally, stricter default provisions increase the likelihood of a default by the debtor post-petition, giving the counterparty additional grounds to cease performance, seek modification of the stay, or seek adequate protection.

Counterparties to these Contracts may also want to consider including provisions in their Contracts that entitle them to monitor the financial health of the debtor and declare a default if certain financial benchmarks are not met. Finally, counterparties can limit their potential liability, if at all possible, by entering into Contracts that do not require considerable upfront capital expenditures, securing the payments under the Contract through a letter of credit, proceeds of which are not property of the estate, and requiring advanced payments before services are rendered by the counterparty. See In re Oakwood Homes Corp., 342 B.R. 59, 67 (Bankr. D. Del. 2006). (holding proceeds from letters of credit are not property of the estate).

Post-Petition Protective Measures

Counterparties dealing with a debtor in bankruptcy that has yet to default on a Contract should consider seeking a consensual resolution with the debtor in order to protect itself from the risks of post-petition performance. As stated above, the court is unlikely to grant any relief from the automatic stay or adequate protection based solely on business risk. One option for counterparties is to set up a monitoring system with the debtor, which allows the counterparty to take action should certain events occur.

For example, the counterparty could agree with the debtor that the counterparty will receive periodic financial statements and updates from the debtor. Under the agreement, if counterparty feels insecure with the debtor's position, the counterparty has the right to schedule a hearing on shortened notice to resolve the issue. The counterparty should also have the right to schedule a hearing on shortened notice if the debtor misses a payment under the Contract. Finally, the counterparty should attempt to include in the agreement a provision providing for grounds to lift the automatic stay should the debtor default. Thus, if a payment is missed, the debtor would likely be in default, an emergency hearing would scheduled, and, per the terms of the agreement, the judge would likely lift or modify the automatic stay for the counterparty.

Another option for counterparties is to move the court to set a deadline for assumption or rejection of the Contract. Bankruptcy Code section 365(d)(2) permits the court to set a deadline for the debtor-in-possession to assume or reject of Contract. 11 U.S.C. ' 365(d)(2). Although this option may not completely eliminate the economic risks inherent in the Contract, especially if administrative claims are not paid in full, it limits the amount of economic risk moving forward.

By taking preventative measures such as these, the counterparty can limit the risks associated with dealing with a debtor in bankruptcy, and the potential liability associated with that risk. The ability to monitor the debtor and act proactively before damage can be caused to the counterparty rather than reactively after losses have been incurred, allows the counterparty to protect itself from the hazards of dealing with debtors in bankruptcy, without seeking extraordinary relief from the court.

Conclusion

Unfortunately, Bankruptcy Code section 365 puts counterparties to executory contracts and unexpired leases at considerable risk. Although counterparties can attempt to obtain relief from dealing with a debtor in bankruptcy through lifting of the automatic stay or by obtaining adequate protection, courts are reluctant to grant such relief if the sole reason for the relief is exposure to economic or business risks from dealing with a debtor in bankruptcy. Rather, courts will only grant relief if a default exists and the Contract itself provides a remedy. Counterparties can, however, take preventative steps pre-petition, as well as post-petition, to protect themselves from liability stemming from the risks associated with dealing with debtors in bankruptcy.

Adam L. Rosen is a partner and Christopher J. Rubino is a law clerk awaiting admission at SilvermanAcampora LLP in Jericho, NY. Mr. Rosen is a member of this newsletter's Board of Editors.