Not So Fast: An Option to Purchase Real Estate May Not Always Be Rejected by the Debtor in Bankruptcy

Background
Bankruptcy Code section 365 allows a debtor to “reject” so-called “executory contracts.” Since 1978, much ink has been spilled by judges, practitioners and academics trying to define the term executory contract because that term is not defined in the statute. The generally applied definition (and that used by the Yang Court) requires ongoing material performance obligations under the agreement by the debtor and non-debtor. Subject to detailed exceptions, rejection constitutes the debtor’s repudiation (a breach and not termination) of the contract, stripping the non-debtor of specific performance rights, and rendering it a pre-bankruptcy creditor. One exception provides that despite debtor’s rejection of a contract for the sale of real property, the non-debtor purchaser may retain its specific performance rights if it is in possession of the property at the time of the bankruptcy filing. See Section 365(i).

In Yang the debtor owned two parcels of real estate. Before bankruptcy he signed agreements with a potential purchaser (Unison) whereby the latter paid a fee in exchange for the option to later purchase for additional cash consideration a percentage interest in the real estate. The option holder recorded mortgages to secure its claims under the option agreements. The debtor sought to reject the options as executory contracts in separate motions, and the purchaser opposed. Distinguishing an option for a purchase agreement, the Yang Court ruled on the debtor’s objection to one of the option agreements and adopted the reasoning that “if the option is not exercised, nothing happens and neither party commits a breach” to hold that it “was not persuaded by Debtor’s argument that Unison has a remaining obligation.” The Yang Court thus concluded that the option could not be rejected as an executory contract.

Observations
Yang renews the debate and raises implications regarding the ability of a debtor to use bankruptcy and rejection to untether debtor-owned real property from a purchaser, to presumably then attempt to sell to someone else at a materially higher price, thus recovering more for the bankruptcy estate and its creditors. Our observations follow.

First, as indicated, had the option been instead a full-blown agreement to purchase the subject property, Yang could have rejected it, unless the purchaser was in possession (which appears to have not been the case). Similarly, had the purchaser exercised the option before Yang’s bankruptcy, the agreement could have been rejected (again, so long as it was not in possession). The Yang decision implies that by exercising the option after the bankruptcy filing the holder may have greater specific enforcement rights than those of a buyer subject to section 365(i). However, from a policy perspective it seems difficult to reconcile the preferred or different treatment for a non-possessory option holder compared to a non-possessory purchaser under a sale agreement.

Second, while no two option agreements are identical, it appears that most courts considering whether options are executory find that they are. 3 Collier on Bankruptcy, ¶ 365.02 (16th ed. 2023); In re RoomStore, Inc., 473 B.R. 107, 113 (Bankr. E. D. Va. 2012) (collecting cases on majority rule). Therefore, the Yang decision seems to be in the minority. As observed in several of our alerts, where there is lack of uniformity in the application of the Bankruptcy Code, there is opportunity for forum shopping.

Third, potential workarounds almost always exist. A seller anticipating the possibility that it might one day want out of an option could include as many performance obligations as possible for each party to fit within the generally accepted definition of an executory contract, though it is not clear from the case law what additional terms might be considered material in a particular case. The seller might also simply repudiate (i.e., breach by anticipatorily refusing to perform) the option prior to bankruptcy and assess whether the bankruptcy judge nevertheless enforces non-bankruptcy law specific performance rights.

Fourth, debtor sellers are wise to undertake a cost-benefit analysis before rejecting real estate sale and related agreements. Even if the buyer is unable to secure specific performance, absent a limit on damages in the agreement, it will enjoy a claim that is often measured by the difference between the contract price and the presumptively higher value (or contemplated sale price) of the property. In that case, the value of selling to an alternative buyer may not ultimately benefit the debtor. Indeed, the buyer in Yang likely considered the risk of rejection in a later bankruptcy case when it secured the seller’s obligations under the options with mortgages. Presumably, if the rejection motion had been granted, the buyer would have held a secured claim for damages comprising (a) the amount initially paid to acquire the option and (b) the difference between the price to acquire the interests in the properties and some judicially determined value of such interest.

Conclusion
Options are common in real estate and other commercial transactions. Yang teaches that regardless of majority/minority treatment of options, and the broader underlying policies that support giving debtors the ability to reject executory contracts, some courts continue to stringently apply the mutual-material-obligation standard. Consequently, some contracts will not be susceptible to rejection in bankruptcy despite the potential economic benefits to the estate. It also means there will likely continue to be both workaround efforts by those seeking to preserve and effectuate rejection and the associated benefits and those seeking to obstruct rejection of option agreements, as well as a basis to select one forum for filing chapter 11 relief over another.

(This is another in our series of client alerts related to the intersection of bankruptcy and real estate, including several alerts on executory contract topics).