Alert
Alert
02.10.23
A recent bankruptcy court ruling answers the question of whether a garden-variety discounted payment agreement to release a large debt contingent on prior full payment of an agreed smaller sum is an “executory contract” that may be assumed and assigned under section 365 of the Bankruptcy Code over a creditor’s objection. In In re Svenhard's Swedish Bakery, Nos. 19-15277-C-11, DT-61, 62, 2022 WL 17824403 (Bankr. E.D. Cal. Dec. 19, 2022), the U.S. Bankruptcy Court for the Eastern District of California concluded that such an agreement was not assumable either because it was not executory for lack of mutuality or because contracts to extend financial accommodations are excluded from assumption under the Bankruptcy Code. The bankruptcy court therefore denied the debtor’s motion to assume the pre-petition discounted payment agreement and the related settlement between the debtor and its successor-in-interest.
Background
In a series of transactions, US Bakery acquired Svenhard’s Swedish Bakery’s business and caused Svenhard’s operations to move locations. This move triggered termination of a collective bargaining agreement with the union representing Svenhard’s workers and that termination caused Svenhard’s to become obligated for certain pension contributions that the court categorized as the “withdrawal liability.”
Several years later, Svenhard’s and the pension fund agreed to settle the $43 million withdrawal liability for a payment of $3 million, payable in monthly installments over 20 years. The agreement provided for releases to Svenhard’s upon full payment of the discounted amount.
Svenhard’s made the first six payments due under the discounted payment agreement, then defaulted because US Bakery took control of Svenhard’s operations and facilities such that Svenhard’s abruptly lacked the revenue to make the required payments to the pension fund. The pension fund gave notice of default and five business days in which to cure the default. Svenhard’s filed its chapter 11 case on December 19, 2019, one day before the cure period expired.
Several years into Svenhard’s chapter 11 case, and after a mediation between Svenhard’s and US Bakery (the pension fund was excluded from the mediation), Svenhard’s and US Bakery agreed, among other things, that (1) Svenhard’s would assume the defaulted discounted payment agreement with the pension fund, and (2) the agreement would be assigned to US Bakery and US Bakery would make the payments. Thus, Svenhard’s filed a motion to assume the agreement under section 365 of the Bankruptcy Code, and a related motion under Federal Rule of Bankruptcy Procedure 9019 to approve its settlement with US Bakery.
Notably, when Svenhard’s filed these motions, the pension fund already had a successor liability action against US Bakery pending. The agreement assumption strategy embodied in the Svenhard’s/US Bakery settlement was designed in part as an effort by US Bakery to cut off those claims, which strategy may have played a role in or otherwise impacted the court’s decision. The pension fund opposed Svenhard’s motion to assume the discounted payment agreement, believing its successor claims against US Bakery had real merit and that it could collect the full amount of the withdrawal liability from US Bakery as a successor-in-interest to Svenhard’s business.
Executory Contracts
Section 365(a) of the Bankruptcy Code provides that a trustee or debtor in possession, subject to the court’s approval, may assume or reject any executory contract. The Bankruptcy Code, however, does not define the term “executory contract” and over time, two general approaches to the definition have emerged: (1) the traditional Countryman test, which describes an executory contract as “[a] contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other,” and (2) the more result-oriented “functional” test, which focuses on whether the bankruptcy estate will benefit from the assumption or rejection of a contract.
The Svenhard’s bankruptcy court noted that the Ninth Circuit follows the Countryman test and focuses on mutuality of obligation. In concluding that the discounted payment agreement was not executory, the court reasoned that (1) as of the date of the bankruptcy filing, both sides had “nominal” obligations remaining, (2) the pension fund’s obligation was contingent on prior full performance by Svenhard’s and therefore the pension fund had no obligation to perform and “needed to do nothing to avoid being in breach,” and (3) under the Restatement (Second) of Contracts, “performance of a duty subject to a condition cannot come due unless the condition occurs or is excused.” For these reasons, the court determined as a matter of fact that the discounted payment agreement was not an executory contract and could not be assumed and assigned pursuant to section 365 of the Bankruptcy Code.
Financial Accommodations
To the extent the discounted payment agreement was executory, the court also analyzed the issue of whether it was nevertheless not assumable under section 365(c) of the Bankruptcy Code. As relevant here, that provision limits a trustee or debtor in possession’s right to assume a contract to make a financial accommodation, to or for the benefit of the debtor.
The bankruptcy court described “financial accommodations” as “extensions of money or credit for the benefit of the debtor” and noted prior cases holding that a pre-petition workout agreement may constitute a “financial accommodation” for purposes of section 365(c)(2). Analyzing this issue, the court held that because the discounted payment agreement allowed Svenhard’s to pay a sum of money over time that was a fraction of its total liability, the agreement benefited Svenhard’s by allowing it to discharge a much larger liability and was, therefore, a financial accommodation and not assumable.
Conclusion
This decision demonstrates that a lender or other creditor may not be forced to perform under a discounted or deferred settlement (or similar agreement) where the other party defaults and subsequently files for bankruptcy protection. Indeed, where collateral value (or the debtor’s business generally) has improved, or where, as in this case, a non-debtor may be liable, a lender or creditor may understandably not want to give up that potential additional value. The bankruptcy court’s decision in Svenhard’s provides a path forward for those potentially increased creditor recoveries.
Conversely, an objection to assumption may not make economic sense and the debtor (with the creditor’s support) may want to assume the agreement and pay the discounted amount in full. Under this court’s analysis, however, the parties may not be able to guarantee themselves the benefit of a pre-petition workout agreement. In such cases, all hope is not lost. A lender or other creditor could potentially protect their interests by filing a claim in the bankruptcy case or by entering into the same agreement post-petition and submitting that agreement to the court for approval under Bankruptcy Rule 9019, although this path has the same risks as any other settlement that could be challenged.