Balancing Equity in Executory Contract Disputes: A Comparative Analysis of Debtor and Non-Debtor Rights
ZIYAN WU* ∙ April 2, 2024 ∙ ARTICLE
Throughout history, tracing back to the courts in England, the concept of equity has been rooted in judicial decisions.[1] The consideration of fairness has multiple appearances in the Bankruptcy Code, anticipating the balance of societal interests, creditor interests, and debtor interests.[2] Chapter 11 of the Bankruptcy Code deals with corporate reorganization. Its purpose is to solve the incomplete contracting problem induced by the financial distress via facilitating a structured renegotiation that allows parties to preserve value in the face of hold-up threats.[3] To prompt the success of the corporate reorganization without unduly delaying creditors, the Bankruptcy Code grants the debtor several privileges.[4]
One of the debtor’s privileges is the discretion accorded with respect to executory contracts. Section 365(a) permits the debtor’s estate to take the benefit of pre-petition contracts for the estate by assuming them.[5] The debtor is granted great leeway to decide how to handle the pre-petition contract signed with non-debtor parties. The debtor’s bankruptcy estate can seek the court’s approval to assume a contract when the benefits of performing the contract outweigh the burdens.[6] If the burdens exceed the benefits, the debtor is able to seek the court’s approval to reject the contract.[7] However, the discretion afforded to the debtor may result in unfairness towards the non-debtor parties.
This article will delve into the established case law and current statutes in different jurisdictions to explore the feasibility of an ideal approach for resolving disputes of executory contracts, with an emphasis on balancing equity between the debtor and non-debtor parties. It will be structured into three sections. First, it will briefly explain the definition of executory contract under the U.S. Bankruptcy Code. Second, it will focus on the position of debtors and non-debtor parties in executory contract disputes. Finally, this article will compare the bankruptcy systems in different jurisdictions, aiming to conclude whether there is a better approach to balance the interests between the debtors and the non-debtor parties in executory contract disputes.
1.1 What Is an Executory Contract?
In accordance with section 365(a) of the Bankruptcy Code, the debtor, subject to the court’s approval, “may assume or reject any executory contract or unexpired lease signed by the debtors.”[8] Basically, the debtor is entitled to decide upon two categories of contracts: firstly, an unexpired lease between a debtor-tenant and a non-debtor-landlord; and secondly, an executory contract. There is no further statutory definition of “executory contract” in the Bankruptcy Code. However, bankruptcy case law has progressively shaped this definition. In Gouveia v. Tazbir, the Seventh Circuit Court of Appeals elucidated that the term of executory contract, in the context of bankruptcy, is “a contract under which the bankrupt and the other party both are obligated, that such obligation remains unperformed by either party, and that failure of either to complete performance would constitute a material breach excusing the other of performance.”[9] This interpretation has gained widespread acceptance and is broadly applied across various federal courts.[10]
The definition of executory contract contains two elements. First, at the time of filing the bankruptcy petition, neither the debtor nor the non-debtor party has fulfilled contractual obligations as stipulated in the contract or has obtained benefits from the performance of the other party.[11] Second, the definition requires that a future failure to perform these pending obligations by either party would result in a material breach of the contract.[12]
1.2 The Position of the Debtor and the Non-debtor Party Under Section 365
In the context of executory contracts, the Bankruptcy Code applies a general rule, entitling the debtor to assume or reject them at any time prior to the confirmation date of the reorganization plan.[13] The time for determining whether there are unperformed obligations such that the failure of performance would constitute a material breach of contract is the time when the bankruptcy petition is filed.[14] The standard of whether a breach of contract is material is contingent upon the state law governing the contract.[15]
The debtor may “assume” an unexpired lease or an executory contract, so long as it can cure defaults and provide sufficient assurance that the contractual obligation would be performed in the future.[16] Assumption of the unexpired lease or executory contract allows the debtor to retain the ongoing benefits and commit to future obligations stipulated under the lease or contract.[17] The “assumed” contract or lease would continue to exist as “a combination of assets and liabilities to the bankruptcy estate,” allowing them to continue to operate as-is.[18]
The court grants the debtor several privileges in an attempt to ensure the debtor’s discretion to assume the unperformed contract. One typical example of these privileges is the prohibition on “ipso facto” clauses. An “ipso facto” clause is a contractual term that one party may modify or terminate the other party’s right under the contract when the other party is facing an insolvency condition or financial difficulties.[19] Section 365(e)(1) precludes the non-debtor party from enforcing those clauses.[20] The purpose of such prohibition is to “deter the race of diligence of creditors to dismember the debtor before bankruptcy and promote equality of distribution.”[21] Sections 363(l) and 541(c) serve to diminish the effect of “ipso facto” clauses and strengthen the rights of the debtor along with its bankruptcy estate in utilizing the benefits and property interests under an assumed contract.[22] There is no statute that obliges debtors to cure breaches of such clauses or to provide adequate assurance in order to assume an executory contract.[23] The “ipso facto” clauses lose the enforceability at this stage as their enforceability ends upon filing the bankruptcy petition.[24]
Moreover, the interim before the assumption of an executory contract exacerbates the inequitable position of non-debtor parties. The bankruptcy court held that the non-debtor party is bound by the contractual terms pending the debtor’s assumption or rejection of the executory contract.[25] The non-debtor party is not “free to ignore” the terms of the contract and thus is obligated to continue to perform the contract.[26] The court further concluded that the non-debtor party’s non-performance of contract during the interim constitutes a breach of the contract, where the debtor has a claim for remedy.[27]
Conversely, although the non-debtor party is required to perform the executory contract while waiting for the decision of the debtor, the debtor may fail to perform its contractual obligations (for example, pay the pre-petition performance of the non-debtor party) during this period due to its financial inability. In NLRB v. Bildisco & Bildisco, the U.S. Supreme Court established a protective rule for the non-debtor party, claiming that if the debtor “elects to continue to receive benefits” from the non-debtor party under an executory contract “pending a decision to reject or assume it,” the debtor is obligated to pay such benefits at a “reasonable value.”[28]
Although later Congress overturned part of the judgment of Bildisco, allowing the trustee to “make unilateral changes in the terms or conditions of a collective bargaining agreement during reorganization,” the discussion of enforceability of general executory contracts under Chapter 11 was left intact deferentially.[29] In practice, nevertheless, this rule is a certain amount of comfort with a limited effect. The Court in Bildisco failed to address how to enforce the payment incurred during the interim by merely reiterating that the expenses and liabilities may be treated as administrative expenses with “the highest priority on the debtor's estate” should the debtor assume the contract.[30] Meanwhile, the Court did not identify either the time at which the debtor shall pay the “reasonable value” or the factors that may be considered in determining such “reasonable value,” which increased the difficulty for the non-debtor party to secure repayment.[31]
1.3 Better Approach: Compare the Rules of Executory Contracts Under Different Jurisdictions
For a long time, the U.S. Supreme Court adhered to the rejection-as-rescission approach, entitling the debtor to avoid the executory contract that the burdens of performance outweigh the benefits.[32] After Tempnology, the Court made a shift to treat the rejection as a breach of contract, empowering the non-debtor party to decide whether to terminate the contract or to request performance of vested property interests.[33] Despite such progress, the Tempnology approach does not fully solve the inequity with which the non-debtor party is confronted. The non-debtor party is generally prevented from seeking specific performance or other equitable remedies for the debtor’s unfulfilled future obligations.[34] This section aims to explore approaches in other jurisdictions to determine whether fairer methods of dispute resolution exist between the debtor and the non-debtor party.
1.3(a) The Australian Approach
The Australian bankruptcy system adopts an approach that enhances the bargaining power of non-debtor parties in executory contract disputes during the process of bankruptcy petition. The occurrence of a company’s liquidation does not automatically entitle the debtor to terminate or repudiate an executory contract.[35] Meanwhile, different from the U.S. approach, with particular exceptions, the Australian law, in general, permits the “ipso facto” clauses to remain effective even after the debtor has filed for bankruptcy, allowing the non-debtor party to terminate or modify the contract with the debtor.[36] As a result, the non-debtor party retains more initiatives in potential executory contract disputes, as the debtor has to negotiate the continuation of executory contract with an “ipso facto” clause with the non-debtor party, “if the company relies upon the contract for its ongoing business, so as to facilitate a sale as going concern.”[37]
However, in terms of the executory contract without an “ipso facto” clause, the Australian law takes a similar approach to the U.S. law. The non-debtor party cannot request the enforcement of such contracts during the liquidation process and the liquidator is empowered to dispose such contracts as a part of the liquidating corporation’s property.[38]
1.3(b) The Japanese Approach
The civil law countries appear to also adopt a debtor-oriented approach in dealing with the executory contract disputes. In Japan, the administrator (i.e. the debtor’s bankruptcy estate) possesses the authority to decide whether to assume or reject an executory contract.[39] Similar to the U.S. Bankruptcy Code, upon assuming the contract, the administrator is obligated to fully perform the contract obligation as an administrative expense.[40] However, Japan’s approach is different from the U.S. bankruptcy law in that the effect of rejecting an executory contract is rescission of such contract. Once the contract is rescinded, the contract would be treated as having never been established. As a result, the administrator shall return any property or monetary damages equal to the value of services that the non-debtor party has provided.[41] Simultaneously, the non-debtor party is not allowed to insist upon the performance of vested property interests under the contract.[42]
Moreover, Japan places a distinct emphasis on the public utility in the context of bankruptcy proceedings.[43] Under the Japanese jurisdiction, a contracting party that owes the debtor an obligation to supply continuous performance cannot refuse to perform its obligation on the sole basis of the claim that has accrued prior to the filing of the petition.[44] Such statute makes significant impacts on the public utility corporations, such as electricity supplying corporations, telephone-telegram corporations, gas supply corporations, and water suppliers.[45] These entities are entitled to assert their claim and seek satisfaction notwithstanding the automatic stay provision.[46]
The Japanese approach makes the scales incline to the debtor’s interest. It empowers the debtor to avoid contractual obligations upon rejection of a contract, treating such rejection as rescission rather than a breach. Under the Japanese approach, different from the Tempnology rule, the non-debtor party would be even not entitled to retain the vested property interest under a rejected contract (for example, the trademark license contract).[47] Furthermore, the non-debtor party contracting with public utility corporations are facing further restrictions, which prohibit them from stopping continuous performance even if their claim has accrued prior to the filing of the reorganization petition.[48]
1.3(c) The German Approach
The German bankruptcy law aims to achieve different objectives compared to the jurisdictions previously mentioned. Instead of facilitating the reorganization plan, the primary purpose of the German insolvency procedure is to maximize the returns to creditors.[49] The insolvency procedure only favors the continuance of a business if it is in the best interest of the creditors.[50] Its other primary aim is to “remove from the market businesses that are financially and economically unviable to avoid spillover effects on other market participants and their business operations.”[51] In 2021, theAct on the Further Development of Restructuring and Insolvency Law (SanInsFoG) came into force, providing a tool for financial liabilities of reorganization and reorganization plan.[52]
In terms of the executory contracts, the insolvency procedure accords the debtor considerable discretion in deciding whether to assume or reject such contracts.[53] The rationale of this flexibility is that the mandatory enforcement of an unprofitable executory contract would impair the interests of financial creditors, potentially compelling them to accept a significantly lower quota.[54] According to the Insolvency Code (InsO), the debtor has an exceptional privilege to choose whether or not to perform an executory contract. If the administrator refuses to perform the executory contract, the non-debtor party is entitled to its claims for non-performance only as an insolvency creditor. The non-debtor party may request the administrator to opt for performance or non-performance, and the administrator is obligated to state its intention without negligent delay.[55] However, if the administrator refuses to state its intention, the non-debtor party cannot sue for continuance of performance under such contract.[56] The German court has adopted the “ride-through” doctrine, similar to that of the U.S., which stipulates that the enforcement of a contract is suspended until the administrator decides whether or not to perform it.[57]
Meanwhile, under the InsO, the vulnerable groups of non-debtor parties are afforded a more favorable position.[58] Different from the U.S. bankruptcy system typically treating an unperformed employment agreement as a general executory contract, whose fate is contingent upon the debtor’s decision, the InsO does not grant such great leeway for the debtor to terminate an employment executory contract.[59] The administrator is required to present a valid reason for the termination of an employment contract, as if in non-insolvency circumstances.[60] Usually, the administrator has to prove that the termination of such employment is necessary for the success of reorganization (betriebsbedingte Kündigung).[61]
Basically, the InsO adopts a framework similar to that of the U.S. Bankruptcy Code and the Japanese bankruptcy procedures, granting the debtor more privileges in performance of the executory contract.[62] However, the German and Japanese bankruptcy systems differ from the U.S. law in that they take the public interest into specific consideration.[63] The Japanese approach is inclined to consider the macro-perspective of social welfare, enacting a mandatory statute to ensure the stability of the public utility supply.[64] In contrast, the German approach reflects a micro-perspective concern in social benefits, which provides certain statutory protections on the vulnerable non-debtor parties like employees.[65] The civil law countries appear to incorporate a regulatory function into the reorganization procedures of private entities and focus more on the fairness between parties in the process of legislation.[66]
In conclusion, comparing the insolvency procedures across different jurisdictions, a common framework emerges where the debtor is accorded the discretion to assume or reject an executory contract in the process of bankruptcy. There are slight differences among different jurisdictions in their approaches to deal with such contractual disputes, depending upon the objective of legislation. The civil law countries like Japan and Germany tend to emphasize achieving the regulatory function through bankruptcy law, providing additional protections on specific groups and industries related to public interests.[67] Instead, the common law countries focus more on the success of business reorganization, intending to facilitate business success without causing harms to creditor’s interests.[68]
The Australian approach may provide some referential value for the U.S. Bankruptcy Code. The validation of the “ipso facto” clause can minimize the potential loss for the non-debtor party, increasing their bargaining power during negotiations with the debtor.[69] Meanwhile, the German approach also offers potential insights for the future development of the Bankruptcy Code, considering Germany’s reputation for strong social security mechanisms and worker protections.[70] Employees are recognized as a particularly vulnerable group with less bargaining power compared to their debtor-employer, which places them in a more disadvantaged position than a general non-debtor party. This situation highlights the need for U.S. legislation to provide enhanced protections for certain groups.
*JD Candidate at Notre Dame Law School, 2025
[1] Jay Lawrence Westbrook, Equity in Bankruptcy Courts: Public Priorities, 94 Am. Bankr. L.J. 203 (2020).
[2] Id.
[3] Anthony J. Casey, Chapter 11's Renegotiation Framework and the Purpose of Corporate Bankruptcy, 120 Colum. L. Rev. 1709 (2020).
[4] In re Newark Airport/Hotel Ltd. Partnership, 156 B.R. 444, 451 (Bankr. D.N.J. 1993) (citing In re Pine Run Trust, Inc., 67 Bankr. 432, 434 (Bankr. E.D. Pa. 1986)).
[5] 11 U.S.C. § 365(a).
[6] In re Columbia Gas System Inc., 50 F.3d 233, 238 (3d Cir. 1995).
[7] Id.
[8] 11 U.S.C. § 365(a).
[9] Gouveia v. Tazbir, 37 F.3d 295, 298 (7th Cir. 1994).
[10] In re Knutson, 563 F.2d 916, 917 (8th Cir. 1977). See also In re Weinstein Co., 997 F.3d 497 (3d Cir. 2021). The court held that executory contracts are contracts where the debtor and the nonbankrupt counterparty each has material obligations left to perform as of the bankruptcy filing.
[11] In re Knutson, 563 F.2d at 917-8.
[12] Id.
[13] 11 U.S.C. § 365(d)(2).
[14] In re Weinstein, 997 F.3d at 504.
[15] Id.
[16] 11 U.S.C. § 365(b); See also Placid Oil, LLC v. Avalon Farm, Inc., 2022 Bankr. LEXIS 1565 (N.D. Tex. 2023).
[17] In re Godwin Bevers Co., Inc., 575 F.2d 805, 807 (10th Cir. 1978).
[18] In re Weinstein, 997 F.3d at 504.
[19] 11 U.S.C. § 365(e)(1).
[20] Id.
[21] Merit Mgmt. Grp., LP v. FTI Consulting, Inc., 138 S. Ct. 883, 888 (2018) (quoting Union Bank v. Wolas, 502 U. S. 151, 162 (1991)).
[22] 11 U.S.C. § 363(l); 11 U.S.C. § 541(c). Section 363(l) further bans on “ipso facto” clauses by entitling the bankruptcy trustee to take actions like using, selling, and leasing using the property belonging to the bankruptcy estate, notwithstanding any provision in a contract or a lease that is conditioned on the insolvency condition of the debtor or the commencement of a bankruptcy case. Meanwhile, section 541(c) provides that a debtor’s interest would become the property of the bankruptcy estate, regardless of any provision to terminate or modify the interest based upon the future insolvency condition of commencement of a bankruptcy case.
[23] 11 U.S.C. § 365(b)(2).
[24] Id.
[25] In re El Paso Refinery, L.P., 196 B.R. 58, 71 (Bankr. W.D. Tex. 1996).
[26] Id. at 72.
[27] Id.
[28] Nat'l Labor Relations Bd. v. Bildisco & Bildisco, 465 U.S. 513, 531 (1984).
[29] In re FBI Distrib. Corp., 330 F.3d 36, 44 (1st Cir. 2003).
[30] Bildisco, 465 U.S. at 532.
[31] Id.
[32] Mission Prod. Holdings v. Tempnology, LLC, 139 S. Ct. 1652, 1662 (2019).
[33] Id.
[34] See In re Avianca SA, et al., 618 B.R. 684, 707 (Bankr. S.D.N.Y. 2020). The court held that the non-debtor parties are generally not entitled to request debtors’ specific performance of future obligations in an executory contract dispute.
[35] Elizabeth Streten, Executory contracts in insolvency: The Australian perspective, in Executory Contracts in Insolvency Law 30, 38 (Jason Chuah & Eugenio Vaccari ed., 2023).
[36] Corporations Act 2001, § 434J, § 451E (Austl.).
[37] Streten, supra note 35, at 38.
[38] Corporations Act 2001, s § 471B, § 477, § 500 (Austl.).
[39] Koichi Shimojima, Executory Contracts and Leases in Bankruptcy - Japan, 10 Int’l Bus. L.AW. 305, 305 (1982).
[40] Id.
[41] Id. at 306.
[42] Id. at 305
[43] Id. at 306.
[44] Corporation Reorganization Act, Art. 62(1) (2002) (Japan).
[45] Shimojima, supra note 39, at 307.
[46] Id.
[47] Corporation Reorganization Act, Art. 61 (2002) (Japan).
[48] Shimojima, supra note 39, at 307.
[49] David Christoph Ehmke & Annika Wolf, Executory contracts in insolvency: The German perspective, in Executory Contracts in Insolvency Law 329, 330 (Jason Chuah & Eugenio Vaccari ed., 2023).
[50] Id.
[51] Id.
[52] Act on the Further Development of Restructuring and Insolvency Law (2021) (Ger.).
[53] Insolvency Code, § 103 (2021) (Ger.).
[54] Ehmake & Wolf, supra note 49, at 340.
[55] Insolvency Code, § 103 para 2 (Ger.).
[56] Insolvency Code, § 103 (Ger.).
[57] Bundesgerichtshof [BGH] [Federal Court of Justice] Apr. 24, 2002, IX ZR 313/99 (Ger.). The Federal Court of Justice overruled the “expiration theory,” which indicated that the contract would expire with the beginning of the insolvency procedure and only be revived on a decision by the insolvency administrator or debtor to perform it. Under this case, the court supported the “suspension theory,” treating the contract as being suspended unless the administrator made a decision of whether to perform the contract or not.
[58] See Insolvency Code, § 108, § 113 (Ger.).
[59] See 11 U.S.C. § 365, § 502; See also Insolvency Code, § 108 (2021) (Ger.).
[60] Ehmake & Wolf, supra note 49, at 344.
[61] Id.
[62] See 11 U.S.C. § 365; See also Insolvency Code, § 103 (Ger.).
[63] See Shimojima, supra note 39, at 307. The Japanese legislation provides extra protections on public utility industry. See also Insolvency Code, § 108 (Ger.). The employees are accorded special protections during the process of insolvency.
[64] Id.
[65] Id.
[66] See Ehmake & Wolf, supra note 49, at 330. The German legislation attempts to regulate the market through the enactment of the Insolvency Code. See also Chun Jin & Stacey Steele, supra note 47, at 391. Most commentators consider that the general objective of Japanese bankruptcy law is fairness between parties.
[67] Id.
[68] See Australian Securities & Investments Commission, Voluntary Administration: A guide
for creditor, Australian Securities & Investments Commission (June 2023), https://asic.gov.au/regulatory-resources/insolvency/insolvency-for-creditors/voluntary-administration-a-guide-for-creditors/#the-purpose-of-voluntary-administration. See also In re Newark Airport, supra note 4, at 451.
[69] Streten, supra note 35, at 38.
[70] Federico M. Mucciarelli, Employee Insolvency Priorities and Employment Protection in France, Germany, and the United Kingdom, 44 J. L. & Soc’y 255, 269 (2017).