Section 365 of the US Bankruptcy Code: Analyzing Executory Contracts & Unexpired Leases
Under the United States Bankruptcy Code, a debtor undergoing a chapter 11 reorganization has the unique opportunity to reject any unfavorable executory contracts or unexpired leases. The claims by counterparties in these situations will generally become general unsecured claims impacting the totality of recoveries for unsecured creditors, but the value gained by rejecting these liabilities can have a meaningful effect on a debtor’s post-emergence financial and operational outlook.
The work involved to compile, review and analyze a debtor’s entire list of executory contracts and unexpired leases can be cumbersome and tedious, as many debtors lack a centrally organized contract database. In these cases, a well-detailed work plan overseen and executed by an experienced restructuring professional is necessary to ensure a debtor has effectively cleansed itself of unfavorable contracts. In distressed matters, there are times when a financial advisor is engaged in the context of disarray and chaos. Recently terminated management, rogue employees, a disjointed board, excessive leverage, angry creditors, failing service lines, unhappy customers, lawsuits and sometimes even pending legal charges are all the norm. Adding insult to injury, there is often only enough cash to fund a short runway to a bankruptcy filing. In these cases, triage is usually the first step to ensure that sufficient funding is in place to weather the short-term and to get all requisite documents necessary for a filing in place. Once the situation has stabilized and a debtor is under the automatic stay and other protection provided by chapter 11, attention can be turned to the business of compiling and analyzing leases and contracts.
Step one in this process is to identify the key personnel who will be able to provide the necessary information, which includes operations (all business segments and locations), accounting, IT, back-office, procurement and sales to assist in compiling the key terms of the executory contracts and unexpired leases. These folks should also take the first pass at identifying any contracts or leases that are deemed to be off-market or non-core to the debtor’s reorganized business and, thus, making them a candidate for rejection. As contracts and data roll in, a financial advisor needs to not only examine contract terms, but also perform a risk analysis on the likelihood of unfavorable contracts and leases that exist and that are not being provided. An ongoing dialogue with the debtor’s management and staff focused on identifying areas of weakness or areas where outstanding contracts could be missed needs to be opened. Experience has indicated that organizations have an easy time identifying contracts that affect day-to-day operations, but often fail to identify one-off or non-operational contracts. Importantly, these missed contracts are potentially the most burdensome and valuable to reject during a bankruptcy. If, after performing an initial contract review, it is clear there is a high risk of failing to identify material, unfavorable contracts, an alternative strategy of rejecting all contracts not explicitly accepted should be discussed and potentially implemented to ensure no stone goes unturned.
The normal course operating procedure for accepting or rejecting contracts during a bankruptcy is to accept all executory contracts and leases not explicitly rejected in a bankruptcy court filing. This strategy is relatively clean and prevents a debtor from inadvertently rejecting a contract vital to day-to-day operations. On the other hand, there are times when the inverse is the best path forward, which is to say, rejecting all contracts not explicitly accepted. While this alternative strategy can be risky in that a debtor may inadvertently reject a necessary contract, it should always be considered to minimize the risk that a debtor gets stuck with burdensome and unwanted contracts post-emergence. Under this alternative strategy, a debtor files an exhibit detailing all executory contracts and unexpired leases it accepts and will continue operating under post-emergence. All executory contracts and unexpired leases not listed are deemed rejected and any damages will fall into the general unsecured claims pool. Post-emergence, the reorganized debtor can then focus on establishing a profitable business operating under the contracts it has explicitly accepted without the fear of contingencies or obligations arising under out-of-market contracts. In this case, the debtor has effectively used the Bankruptcy Code to cleanse itself of potential unknown liability.
As is often the case in bankruptcy, the path forward is often not immediately clear. Contract and lease rejections are no exception, so any contract and lease rejection exercise must be managed by an experienced restructuring professional to ensure that debtors take full advantage of the rights and remedies afforded to them under the bankruptcy code and best position themselves for success upon emergence.