The debtor was a redeveloper of one of the Port Authority of New York and New Jersey’s bus stations. The debtor and the Port Authority entered into a ground lease under which the debtor would manage and oversee the redevelopment of the project in exchange for a lease to operate and maintain a mall to be constructed on the site. Pursuant to the ground lease, the debtor could hire contractors and subcontractors, subject to the Port Authority’s approval, and the debtor was responsible for paying them.
Nearly two years after entering into the ground lease, the debtor hired Tutor Perini Building Corp. to act as the general contractor for the redevelopment project pursuant to a separate construction contract. The contractual relationship soured, and the debtor and Tutor Perini landed in arbitration proceedings, where Tutor Perini established that it was owed approximately $113 million under the construction contract.
A few years later, the debtor filed for chapter 11, seeking to sell substantially all of its assets, including its rights under the ground lease. While the debtor and the Port Authority settled the Port Authority’s cure claim against the debtor under the ground lease, Tutor Perini objected to the sale of the ground lease. Tutor Perini argued that its $113 million claim under its rejected construction contract effectively was a default under the ground lease, entitling it to a “cure claim” that needed to be remedied as a condition to the debtor’s assumption of the ground lease. If successful, Tutor Perini’s objection would have prevented the sale of assets until the debtor paid Tutor Perini in full, allowing it to skip ahead of other unsecured creditors (and receive a greater recovery), without the debtor assuming the construction contract.
The Bankruptcy Court and District Court Decisions
The bankruptcy court characterized Tutor Perini’s argument that it held a cure claim under the ground lease as reframing the nature of the debtor’s failure to pay cure costs. In doing so, the bankruptcy court rejected Tutor Perini’s arguments that section 365(b)(1)(A) contained no textual limitation on who may assert a cure claim, and its alternative argument that it was a beneficiary under the ground lease.
Affirming the bankruptcy court, the district court first held that Tutor Perini could not be a third-party beneficiary under New York law because it was not specifically named as a beneficiary in the ground lease. The district court also held that allowing a party with only an economic interest, short of an actual contractual right, to assert a cure claim would “turn the Bankruptcy Code’s priority scheme on its head.” In Tutor Perini’s case, it had no contractual rights under the ground lease against the debtor (or otherwise) and therefore could not assert a cure claim.
The Second Circuit’s Decision
In affirming the decisions below, the Second Circuit began by analyzing section 365 at its most fundamental level. Section 365(a) allows a debtor to assume beneficial contracts and leases and reject those that are burdensome. Because assumption forces the non-debtor counterparty to continue doing business with the debtor, section 365(b) requires that the debtor satisfy certain conditions to make the non-debtor party whole, including curing any defaults. As a result, the non-debtor counterparty is afforded administrative priority and paid in full rather than the lower priority given to general unsecured creditors whose contracts are rejected and are infrequently paid in full.
The Second Circuit held that, to receive priority under section 365(b)(1)(A), a creditor asserting a cure claim must have some right to pursue a breach of contract claim against the debtor under the assumed contract or lease. In reaching its decision, the Second Circuit explored the congressional intent and language of section 365.
First, assumption under section 365(a) compels a non-debtor counterparty to continue performing. In return, section 365(b) ensures that the non-debtor counterparty receives the full benefit of its bargain. As a result, section 365(b) cannot be read to grant administrative priority to “someone whose claims against the debtor do not arise from a contract assumed under section 365(a).” Otherwise, that non-party would receive a windfall without making any bargains with or owing any further performance to the debtor, effectively allowing the non-party to “cut the line and stand in front of even secured creditors in exchange for nothing.”
Second, the text of section 365 indicates that priority is provided to those who hold claims under assumed contracts and leases. Subsections 365(b)(1)(B) and 365(g) both indicate that “Congress clearly contemplated the rules of priority for creditors with claims actually arising under contracts, and not just for any party who claims some tangential interest in a contract short of a legal right to sue under it.” Further, section 365(g) affords low-priority treatment to those holding claims stemming from breaches of rejected contracts and leases. Allowing a non-party like Tutor Perini whose own contract was rejected to enjoy payment priority by asserting a cure claim would warp the priority scheme and render it nonsensical. As a result, section 365’s textual constraints do not leave room for an expansive reading of section 365(b)(1)(A).
Like the lower courts, the Second Circuit rejected Tutor Perini’s attempt to assert third-party beneficiary rights in the ground lease under New York law. Under New York law, an intended beneficiary may sue on a contract made for its benefit, while an incidental beneficiary has no right to enforce a contract. A further wrinkle in this analysis stemmed from New York construction contract law: Construction contracts generally must state that the contracting parties intended to benefit a third party to grant that party a right to sue, and contracts providing that a third party will be retained to assist in the performance by the promisee do not make the third party an intended beneficiary. Given these principles, the Second Circuit had no trouble finding that the ground lease merely allocated payment responsibilities between the debtor and the Port Authority and was not a promise to perform obligations for the benefit of any contractor. Notably, the ground lease specifically named third-party beneficiaries, none of which were Tutor Perini. While the Court did not decide whether an intended beneficiary of an assumed contract or lease may seek priority under section 365(b), the Court suggested in dicta that intended beneficiaries hold a right to performance, such that the protections afforded to non-debtor counterparties could reasonably be extended to intended beneficiaries.
The Second Circuit’s decision highlights the potential importance of being a named beneficiary to a contract to which the creditor is not a party, and more importantly, the need for the creditor to have alternative remedies for defaults. Parties similarly situated to Tutor Perini can protect themselves by requesting credit support and securing rights against ultimate beneficiaries (in Tutor Perini’s case, the Port Authority) such as by obtaining a letter of credit, guarantee or indemnity.
An important takeaway for debtors is to carefully evaluate their contracts’ intended beneficiaries because intended beneficiaries may be able to assert cure claims, which may increase the administrative expenses the debtor may have to pay to assume contracts and ultimately exit chapter 11.
(This is another in our series of client alerts related to the intersection of bankruptcy and real estate.)