Debtor's Power to Reject Executory Contract Trumps Counter-Party Debtor's Power to Assume Same Agreement

The only contracts the statute applies to are executory contracts. The Bankruptcy Code contains no definition for what constitutes an “executory” contract; however, one very commonly accepted definition of such an agreement is one under which substantial performance remains to be completed by both the debtor and the non-debtor party at the time of the filing of the bankruptcy. This is known as the “Countryman” definition, named after the professor who devised it.

Another, lesser used, definition of an executory contract is one under which the bankruptcy estate would derive a benefit from the assumption or rejection of the contract. This standard is known as the “functional” definition.

Assumption and Rejection Under the Code

Generally speaking, and with certain limited exceptions, Bankruptcy Code section 365 allows a debtor to keep or “assume” favorable executory contracts, as well as to compel the counterparty to the agreement to continue to perform in accordance with its terms. 11 U.S.C. ' 365. Similarly, section 365 also enables a debtor to discard or “reject” burdensome or otherwise unfavorable agreements and avoid future performance obligations under the contract ' amounting, in essence, to a statutorily authorized breach of contract.

While the decision to assume or reject an executory contract can be difficult, there are many instances in which the decision is relatively simple. For example, a debtor will naturally elect to assume a long-term supply agreement under which the counter-party is required to sell the debtor materials or supplies on terms very favorable to the debtor ' i.e., at below market prices ' where the debtor would be forced to pay significantly more for the same materials were it not for the existence of the supply contract. Conversely, a debtor would likely choose to reject a long-term supply agreement under which the debtor is required to purchase materials over time at a price that is well above current market prices.

Regardless of the circumstances ' whether a debtor elects to assume or reject an agreement ' the debtor's decision, while subject to court approval, is reviewed by the court under the deferential “business judgment” standard. In re MF Global Holdings Ltd., 466 B.R. 239, 242 (Bankr. S.D.N.Y. 2012). Under this standard, a debtor's decision to assume or reject an agreement will be approved absent a showing of abuse of discretion or bad faith on the part of the debtor. In re G Survivor Corp., 171 B.R. 755, 757 (Bankr. S.D.N.Y. 1994

In short, debtors in bankruptcy have considerable discretion to assume or reject executory contracts, so long as their decision to do so amounts to an exercise of rational business judgment.

So what happens when these two competing forces meet? In other words, what is the result when a debtor in one Chapter 11 bankruptcy seeks to reject the very same contract a debtor in another Chapter 11 case seeks to assume?

That was the situation recently faced by the court in the bankruptcy of Noranda Aluminum, Inc. and its affiliated debtors. In re Noranda Aluminum, Inc., 2016 Bankr. LEXIS 1118 (Bankr. E.D. Mo. Apr. 7, 2016).

The Noranda Bankruptcy

Noranda Aluminum filed its voluntary Chapter 11 bankruptcy petition on Feb. 8, 2016. That same day, it filed a motion seeking authority to reject a long-term bauxite sales agreement (the Sale Agreement) between Noranda Bauxite Ltd. (Noranda) and Sherwin Alumina Co., LLC (Sherwin).

The Sale Agreement, entered into in 2012, was set to run through the end of 2018. Under the contract, Noranda sold bauxite from its Jamaican mines to Sherwin for use in its aluminum processing and manufacturing operations. Almost all bauxite sold by Noranda to third parties was sold pursuant to the Sale Agreement.

Meanwhile, Sherwin had previously (on Jan. 11, 2016) filed its own voluntary bankruptcy proceeding in the United States Bankruptcy Court for the Southern District of Texas. Through one of Sherwin's “first-day” motions, it sought authority to assume the very same Sale Agreement.

The assumption/rejection stakes were high for both Noranda and Sherwin, each of which faced the real prospect of liquidation according to the court. As the court observed: “What makes this otherwise ordinary ' 365 Rejection Motion extraordinary are the parties, timing and stakes involved. The parties to the [Sale Agreement] are each Chapter 11 debtors in possession ' [Noranda] asserts that it will lose approximately $16.5 million under the contract in 2016 alone. Sherwin disputes that [Noranda] loses money on the contract and argues that if rejection is granted, it may be forced out of business, causing 575 workers to be unemployed.” Noranda Aluminum, 2016 Bankr. LEXIS 1118 at *2.

Even though, as acknowledged by the court, the stakes were high and the factual circumstances were exceptional, the legal standard was fairly straightforward. At its core, the question before the court was whether Noranda's decision to reject the Sale Agreement met the business judgment test. However, before applying the business judgment standard, the court first considered Sherwin's argument that a different test should apply due to the unique circumstances of the case.

The Balancing of The Equities Test

Before turning to the business judgment test, the Noranda court addressed Sherwin's contention that the court should instead utilize a “balancing of the equities test” because both parties to the Sale Agreement were debtors in bankruptcy. Sherwin cited case law arguably supporting a balancing of the equities under such circumstances. See, e.g., In re Midwest Polychem, Ltd., 61 B.R. 559, 562 (Bankr. N.D. Ill. 1986) (“The balancing of the equities is especially neessary where ' one Chapter 11 debtor formally requests rejection of an executory contract and another Chapter 11 debtor effectively seeks assumption.”)

However, the Noranda court was not persuaded by Sherwin's arguments. For one thing, the cases in support of a balancing test were dated. For another, they were not binding on the Noranda court, and they ran counter to the test used by the majority of courts. Finally, and quite directly, the Noranda court stated, “To the extent [such cases] require a consideration of the interests of counterparties in the application of the business judgment rule, I disagree with them.” Noranda Aluminum, 2016 Bankr. LEXIS 1118 at *7.

The court explained there is no Bankruptcy Code provision providing “special treatment” for rejection of a contract just because the other party seeks to assume the same agreement in its own bankruptcy case. Id. at *8-*9 (citing, among others, In re Pilgrim's Pride Corp., 403 B.R. 413, 425 (Bankr. N.D. Tex. 2009) (“If the bankruptcy court must second-guess every choice by a trustee or debtor in possession that may economically harm any given locale, the business judgment rule applicable to contract rejection ' will be swallowed by a public policy exception.”)).

Thus, while expressing sympathy to the predicament faced by Sherwin, the court decided not to deviate from the business judgment rule.

The Business Judgment Test

As the court explained, in the Eighth Circuit and elswhere, the business judgment test is used to review a debtor's decision to assume or reject an executory contract. The test involves a determination as to whether the transaction is in the best interest of the estate. Noranda Aluminum, 2016 Bankr. LEXIS 1118 at *4. As the court noted, this is not an onerous burden to meet, and it “does not require the bankruptcy court to put itself in the position of the trustee or debtor-in-possession.” Id.

As further explained by the court, the test involves two steps. The first question is whether the decision to assume or reject is an exercise of sound business judgment with a resulting benefit to the estate. If the answer to that question is yes, then the court should not interfere with the debtor's exercise of business judgment, unless there is a showing of bad faith or abuse of discretion. Id. at *5. Accordingly, unless the debtor's decision is manifestly unreasonable or made in bad faith, the court should approve the decision as long as the proposed action appears to enhance the estate. Id.

The court found that Noranda clearly satisfied the business judgment test. Noranda presented evidence satisfactory to the court that it would lose millions of dollars under the Sale Agreement in 2016 absent rejection of the agreement. While it was true that Noranda would continue to lose money with its bauxite shipping even after rejection, such losses would be substantially less. In fact, the evidence was such that Noranda would be better off without the Sale Agreement, even if it was unable to replace it with an agreement with another customer.

Simply put, Noranda suffered significant cash losses under the Sale Agreement, and the costs of performance were substantially greater than the benefits Noranda derived under the contract. Thus, Noranda would be in a better position after rejection than it would have been without rejection. Moreover, rejection would place Noranda in a better position to potentially attract new customers. Indeed, the evidence showed that rejection of the Sale Agreement was necessary to enable Noranda to achieve a restructuring. For that simple reason, the decision to reject the agreement was a sound exercise of Noranda's business judgment, regardless of the outcome for Sherwin. Noranda Aluminum, 2016 Bankr. LEXIS 1118 at *20.

In examining the second part of the business judgment test, the court found that Noranda's decision to reject the Sale Agreement was not motivated by bad faith, nor did it amount to an abuse of Noranda's business discretion. In this regard, Sherwin asserted that Noranda was improperly using the prospect of rejection as a means to renegotiate pricing under the contract. But the court was unpersuaded, finding no bad faith or gross abuse of business discretion as a result of any efforts to obtain more favorable pricing for bauxite supplies. To the contrary, Noranda's decision to reject the Sale Agreement was based on the fact that it was unprofitable and burdensome to the estate, regardless of whether Noranda would be able to secure an alternate agreement. Given these circumstances, there was no credible argument or evidence showing bad faith or abuse of discretion. Id. at *10-*12.

Likewise, the bankruptcy court disregarded Sherwin's other argument that Noranda had failed to take account of Sherwin's sizeable claim for rejection damages. The court disregarded this as a relevant factor for consideration, and found that even if the size of the claim was relevant, the support in favor of rejection by the Official Committee of Unsecured Creditors was persuasive. Id. at *18.

As the Noranda case demonstrates, a debtor's ability to reject a burdensome contract is a fundamentally important component of bankruptcy law. Noranda Aluminum , 2016 Bankr. LEXIS 1118 at *3-*4. This authority is vital to the Chapter 11 process, because rejection can relieve a debtor's estate of burdensome obligations that would otherwise impede the debtor's ability to successfully reorganize. Id. (citing In re Old Carco LLC (f/k/a Chrysler LLC), 406 B.R. 180, 187 (Bankr. S.D. N.Y. 2009)).

Conclusion

The Noranda court's decision underscores the importance of a debtor's ability to assume or reject an executory contract, and the deference a court will give to a debtor's decision. Even though Sherwin was a debtor in a separate bankruptcy case and had sought to assume the Sale Contract in that proceeding, the Noranda bankruptcy court emphasized that the relevant inquiry under the business judgment test does not take into account the interests of the counterparty to the contract sought to be rejected. Rather, it focuses on the benefit to the estate of rejecting the burdensome contract. Noranda Aluminum, 2016 Bankr. LEXIS 1118 at *19.

Observing that “[t]here is no specific statutory provision providing special treatment for rejection of a contract simply because the counterparty seeks to assume the same contract in his own bankruptcy case and will suffer if it is not able to do so[,]” the court declined the invitation to add a “ special provision” to the Bankruptcy Code that would impose a heightened standard for rejection where none is warranted. Id. at *9, *20.

Postscript

Shortly after the decision, Sherwin appealed the bankruptcy court's rejection order. However, since the time of the appeal, Noranda and Sherwin have agreed to interim measures designed to ensure the continued supply of bauxite to Sherwin on pricing terms more palatable to Noranda. Pursuant to the interim agreement, the two parties have also implemented a litigation moratorium, which includes dismissal of the appeal by Sherwin. The agreement also provides for a commitment by the parties to use their best efforts to achieve a longer-term arrangement for the supply of bauxite.

Andrew L. Turscak, Jr. is a partner and James J. Henderson is an associate in the Business Restructuring, Creditors' Rights & Bankruptcy Group at Thompson Hine LLP in Cleveland. They can be reached at [email protected] and [email protected].