Fifth Circuit Holds Asset Purchaser Unable to Acquire Rejected License Agreement

A year after the bankruptcy court approved the asset sale and related agreements, T sued the debtors, alleging that they had failed to comply with their obligations under the Licensing Agreement "to provide quarterly reports and pay licensing fees …." Id. As the asserted owner of the License, R "intervened and removed the proceeding to the bankruptcy court, arguing that the … debtor estates had assigned or otherwise transferred the License to [it]." Id.

The Lower Courts

The bankruptcy court held that R had no "rights under the License Agreement" because it "had not purchased the License under any of the" sale orders and, in any event, "the License Agreement was an executory contract that was rejected by operation of law [sixty days after the Chapter 7 order for relief,] prior to any alleged transfer." Id., at 2. The district court affirmed.

The Fifth Circuit

License Agreement an Executory Contract

Under Fifth Circuit precedent, a contract is executory if "performance remains due to some extent on both sides" and if "at the time of the bankruptcy filing, the failure of either party to complete performance would constitute a material breach of the contract, thereby excusing the performance of the other party." In re Murexco Petroleum, 15 360, 62 (5th Cir. 1994). The issue in Provider Meds, said the court, was whether "both sides … owed additional performance under the License Agreement, and whether any party's failure to perform would constitute a material breach excusing the other side's performance." 2018 WL 5317445, at 3.

The Fifth Circuit rejected R's argument that T's settlement obligation to refrain from suing the debtors was "illusory." Id., at 4. Despite the earlier stipulated dismissal of T's patent infringement suit, "principles of claim preclusion … would not have barred" T from suing the debtors. Id., at 6. Therefore, T "had an ongoing material obligation under the License Agreement to refrain from suing the debtors." Id., at 6. Similarly, the debtors "also had corresponding material obligations under the License Agreement" requiring them "to take certain ongoing actions, such as filing quarterly reports and not discussing the settled lawsuit." Id.

The court further rejected R's unsupported argument "that a license [which] is only 'perpetual' and not 'perpetual and irrevocable,' is irrevocable in the face of material breach …." Id., at 7. The License here was "perpetual," and thus "not revocable at will." Id. "[B]oth sides [thus] had ongoing material obligations under the … License Agreement, making it an executory contract." Id.

Agreement Rejected by Operation of Law

Code section "365(d)(1) imposes a sixty-day deadline for a bankruptcy trustee to assume an executory contract, starting here with the cases' conversion from Chapter 11 to Chapter 7. After that deadline passes, the contract will be deemed rejected by operation of law." Id. Because the License Agreement here was executory, "it was deemed rejected when each of the bankruptcy estates failed to assume it prior to the expiration of the sixty-day period." Id. This statutory deadline applies only in Chapter 7 liquidation cases, for, as the court noted, a trustee or a Chapter 11 debtor-in-possession "may assume or reject an executory contract at any point before the plan is confirmed." Id., at 3, citing Code §365(d)(2) and In re O'Connor, 258 F.3d 392, 400 (5th Cir. 2001). See, NLRB v. Bildisco & Bildisco, 465 U.S. 513, 529 (1984) (reorganizing debtor needs more time to decide on rejection).

No Notice Requirement

The court rejected R's argument for avoiding the Code's sixty-day deadline in Chapter 7 cases because the debtors had failed to schedule the License Agreement and because the trustees were "unaware of the contract within the sixty-day period." 2018 WL 5317445, at 7. "Like most circuits," the Fifth Circuit had not addressed this issue "directly," but stressed that the License Agreement "was a matter of public record" in the 2010 district court patent litigation. Id., at 8. Nor was there any evidence of "intentional concealment" by the Chapter 7 debtors. Id. Because Code §365(d)(1) imposes no "actual or constructive notice requirement for when the sixty-day deadline applies," the Fifth Circuit refused to "read such a requirement into the statute when doing so is not supported by the statutory text." Id.

The Effect of Rejection

The court also dismissed R's argument that the trustees could still sell the License Agreement even when it had been rejected. "The rejection of an executory contract places that contract outside of the bankruptcy estate … [and] cannot be sold under a provision that authorizes a trustee to sell 'property of the estate.'" Id. For a contract to be sold under Code §363, it must be "assumed and assigned under section 365." Id.

In sum, "the License Agreement was deemed rejected by operation of law when each Chapter 7 trustee failed to assume it within the sixty-day period." Moreover, "the statutory presumption of rejection after sixty days is conclusive where there is no suggestion that the Debtor intentionally concealed a contract from the estate's trustee." Id.

Analysis

Provider Meds shows inadequate pre-acquisition diligence by a prospective buyer. A little digging would have disclosed the rejection of the License Agreement before the bankruptcy court entered the sale order. Within the past year, a Chapter 11 debtor-in-possession lender made a similar mistake. Banco Panamericano, Inc. v. City of Peoria, Inc., 880 F.3d 329 (7th Cir. 2018) (lender with lien on all of chapter 11 debtor's assets failed to discover that lease, thought to be its collateral, had been terminated prior to financing).

In addition, aside from the previously noted Tempnology and Sunbeam circuit splits to be resolved by the U.S. Supreme Court in the next year, the Connecticut Supreme Court defined the effect of bankruptcy on contracts last year: Bankruptcy "does not constitute a per se breach of contract and does not excuse performance by the other party in the absence of some further indication that the [debtor] either cannot, or does not, intend to perform," held the Connecticut court in a lengthy opinion on Nov. 21, 2017. CCT Communications, Inc. v. Zone Telecom, Inc., 2017 WL 54777540, 13 (Ct. Nov. 21, 2017) (en banc), superseding 324 Conn. 654, 153 A.3d 1249 (2017).

The Supreme Court rejected the trial courts' erroneous finding that the plaintiff debtor's bankruptcy petition "constituted a breach of [contract, permitting] the defendant to terminate that agreement." Id. at 2. Because the trial court never found that the debtor (CCT) "either could not or did not intend to perform its obligations as a result of its bankruptcy filing", it had not "breached the … agreement by filing for bankruptcy protection." Id. at 13. Nothing in the contract itself supported the trial court's "conclusion that filing the [bankruptcy] petition constituted a breach by [CCT]." Id.

Equally important, the Connecticut court rejected the lower court's enforcement of an "ipso-facto" bankruptcy termination clause, reasoning that the specific contractual language in this case "only" gave the nondebtor defendant "the option to terminate." Id. at 12. Nor, on the facts of the case, could the nondebtor rely on the pre-Code "judicially made … ride-through" doctrine to evade the Code's invalidation of ipso-facto termination clauses (§365(e)(1)). Under that doctrine, when a contract is neither assumed nor rejected during a reorganization, it passes through unaffected and remains an obligation of the reorganized debtor. Because the nondebtor had failed to pursue its available remedies (e.g., stay modification), during the reorganization, it was unfair to allow it to terminate the agreement later. See, Michael L. Cook "Connecticut Supreme Court Defines Bankruptcy Effect on Contracts," 35 Bankr. Strategist No. 3 (Jan. 2018) (http://bit.ly/2FoqMzV).

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Michael L. Cook is of counsel, at Schulte Roth & Zabel LLP in New York and a member of this newsletter's Board of Editors.