In the April 2003 edition of the Business Restructuring Review (vol. 2, no. 4), we reviewed a decision handed down by a Maryland district court interpreting a provision in the Bankruptcy Code that deals with restrictions on the ability of a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to assume and/or assign certain kinds of unexpired contracts. In RCC Technology Corp. v. Sunterra Corp., the court ruled that section 365(c) of the Bankruptcy Code did not preclude a DIP from assuming a software license agreement that could not be assigned under federal copyright law. In doing so, the district court took a side on a controversial issue that has perpetuated a rift in the judiciary. On one side of the divide stand the Circuit Courts of Appeal for the Third, Ninth and Eleventh Circuits. These courts have held that the statute should be strictly interpreted to prohibit the assumption of any unassignable contract, whether or not the DIP or trustee intends to assign it. Arrayed against these courts is the First Circuit, which ruled that unassignable contracts can be assumed if the DIP intends to continue performing under them. The Fourth Circuit had not issued any binding precedent on this question at the time that the Maryland district court rendered its decision in RCC Technology. It has now done so. In RCI Technology Corp. v. Sunterra Corp., the Court of Appeals reversed the Maryland district court's decision and allied itself with the majority of circuits that have addressed this issue.
Assumption, Rejection and Assignment of Executory Contracts
Section 365(a) of the Bankruptcy Code allows a DIP or bankruptcy trustee to "assume" (reaffirm) or "reject" (terminate) most kinds of contracts or agreements that are in force - referred to as "executory" - as of the bankruptcy filing date. In a chapter 11 case, the DIP or trustee may make this decision at any time prior to confirmation of a plan of reorganization, unless the court orders otherwise upon request of the non-debtor contracting party. This latitude affords the DIP an opportunity to determine which of its executory contracts should be assumed because they are beneficial to the estate and which should be rejected.
The advantages of having the ability to assume or reject contracts extend beyond relief from onerous obligations that may be instrumental to the success of a reorganization. This is so because the Bankruptcy Code allows a DIP or trustee to extract value from favorable contracts and leases by first assuming them and then assigning them to third parties for consideration. Under section 365(f)(1), assignment is generally permitted "notwithstanding a provision in an executory contract . . . or in applicable law, that prohibits, restricts or conditions the assignment of such contract or lease."
Despite the broad powers granted to a DIP or trustee in this respect, certain non-debtor parties that contract with a debtor are granted a measure of protection by the Bankruptcy Code. Section 365(c) of the Bankruptcy Code provides that a DIP or trustee may not "assume or assign" an executory contract or unexpired lease if "applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession" and such party does not consent to assumption or assignment.
Accordingly, whenever "applicable law" (generally construed to mean state law or federal non-bankruptcy law) would prevent assignment of a contract or lease without consent, a debtor is required to obtain that consent from the non-debtor party. Courts have applied this provision to a wide variety of contracts. Among these are personal service contracts, including employment agreements, contracts with the United States government, which cannot be freely assigned under federal law, certain kinds of franchise agreements, and licenses of intellectual property, which cannot be assigned without consent under federal intellectual property law. Thus, many debtors (especially those in the technology industry) find that their rights with respect to certain executory contracts are significantly curtailed.
The Statutory Muddle
Few (if any) courts quarrel with the proposition that section 365(c) prevents a debtor from assigning a contract without the non-debtor's consent if the contract could not be assigned outside of bankruptcy without such consent. The language of section 365(c), however, would seem to mean that the debtor cannot even assume the contract itself and agree to perform thereunder, even if it has no intention of assigning the contract to a third party.
The cause of the confusion stems from the statute's use of the phrase "may not assume or assign" instead of "assume and assign." Many courts hold that this phrase means that the statute applies to a debtor who seeks to either assume the agreement and perform itself as well as to a debtor who seeks to assume the agreement and assign it to a third party. Under this literal interpretation, the court posits a hypothetical question: could the debtor assign the contract to a third party under applicable non-bankruptcy law? If the answer is no, then the debtor not only cannot assign the contract, it cannot assume the contract either. This approach is commonly referred to as the "hypothetical" test. In In re West Electronics, Inc., the Third Circuit applied this approach in ruling that the debtor could not assume a contract with the federal government calling for production of military equipment because federal law prohibited assignment of the contract without the government's consent.
Other courts find that, despite the language of the statute, the phrase "may not assume or assign" should be interpreted to mean "may not assume and assign" and apply it only when the debtor is seeking to assign the contract or lease at issue to a third party. Under this approach, the court inquires whether the debtor is actually trying to assign the contract to a third party. If not, the court will not prevent assumption. This approach is commonly referred to as the "actual" test because the court looks to what the debtor's actual intentions are. Prominent among adherents to this view is the Court of Appeals for the First Circuit, which ruled in Institut Pasteur v. Cambridge Biotech Corp. that federal common law and contractual restrictions against assignment of patents did not preclude assumption of a patent by a chapter 11 debtor.
Courts adopting the "hypothetical" test have generally done so because they feel constrained by the plain, unambiguous language of the statute. To these courts, no reason is sufficient to permit them to disregard this plain language. Courts adopting the "actual" test, however, cite a variety of problems with the competing view. Such courts note the conflict of the "hypothetical" test approach with "the general goals of Chapter 11 [in allowing] . . . licensees to benefit from the protections of the bankruptcy law while encouraging the maximization of the economic value of the debtor's estate." Further, such courts suggest that the odd result required by the "hypothetical" test, where a non-debtor party obtains the ability to free itself from some kinds of contracts simply because of its bankruptcy filing, could not be supported by any bankruptcy policy. Finally, "actual" test courts often state that the language appears to be a result of a simple drafting error: Congress meant "and" but said "or." The debate over these two approaches, neither of which is wholly satisfying, took center stage in the RCI Technology case.
The legislative history of section 365(c) does little to resolve the controversy because there really isn't any. Added to the Bankruptcy Code in 1984, the statute as it now reads is widely perceived to have had its genesis in a 1980 House amendment to an earlier Senate technical corrections bill. That amendment was accompanied by a relatively obscure committee report, which states in relevant part that "[t]his amendment makes it clear that the prohibition against a trustee's power to assume an executory contract does not apply where it is the debtor that is in possession and the performance to be given or received under a personal service contract will be the same as if no petition had been filed because of the personal nature of the contract." The First Circuit relied on the 1980 report in its adoption of the actual test, but other courts find it unpersuasive in divining what Congress intended in section 365(c).
RCI Technology
Chapter 11 debtor Sunterra Corporation was one of the world's largest resort management businesses. Part of its business involved managing a timeshare club, through which club members were allowed to trade their timeshare rights at Sunterra resorts for similar rights at other resorts. Sunterra needed to acquire an integrated computer system to enable it to manage the timeshare club. It accomplished this goal by acquiring specialized software from RCI Technology Corporation (formerly known as Resort Computer Corporation or RCC) pursuant to a software license agreement. After Sunterra filed for bankruptcy, RCI sought a ruling from the bankruptcy court that the agreement at issue could not be assumed under federal copyright law. The bankruptcy court denied the motion and RCC appealed to the Maryland district court.
On appeal, the district court found that the agreement was the type of contract that could not be assigned under federal copyright law. It accordingly ruled that section 365(c) did in fact apply to the contract, finding clear error in the bankruptcy court’s determination below that the license was not an executory contract capable of being assumed or rejected in the first place. Observing that courts disagree about the meaning of the statute, the court concluded that it found "the actual test to be far more harmonious with the statutory scheme." RCI appealed again.
This time it prevailed. At the outset, the Fourth Circuit rejected the argument that the hypothetical test leads to an absurd result because it pits section 365(c) against section 365(f)(1) and is internally inconsistent. Section 365(f)(1) allows assignment of a contract notwithstanding any provision under "applicable law" that conditions, prohibits or restricts assignment, while section 365(c) bars assignment when "applicable law" does the same. The Fourth Circuit reconciled these two provisions, however, by reasoning that the applicable law referenced in each was distinct. According to the court, whereas "applicable law" under section 365(f)(1) refers to a law that, as a general matter, prohibits or restricts the assignment of a contract, applicable law under section 365(c) refers to a law that does not merely recite a general ban on assignment, but instead more specifically excuses a party from accepting performance from an entity other than the original contracting party.
Next, the Court of Appeals addressed the apparent inconsistency in section 365(c)'s reference to "the debtor or the debtor in possession" in defining those entities to or from whom performance need not be rendered or accepted under applicable law. According to Sunterra, "if the directive of Section 365(c)(1) is to prohibit assumption whenever applicable law excuses performance relative to any entity other than the debtor, why add the words 'or debtor in possession'? The [hypothetical test] renders this phrase surplusage." The Fourth Circuit found, however, that the term "debtor in possession" refers "neatly" to the assignment portion of the phrase "assume or assign" in section 365(c).
It reasoned that assumption and assignment are "two conceptually distinct events." As a result, the court explained, before a debtor assigns a contract that is not otherwise assignable under applicable law, it must undergo a two-step process and obtain two separate consents from the non-debtor party: one upon assumption and one at assignment. According to the Fourth Circuit, the term "debtor in possession" comes into play during the latter step - section 365(c) forbids assignment, absent consent, where applicable law excuses the non-debtor party from rendering performance to or accepting performance from an entity other than the debtor-in-possession.
The Fourth Circuit dismissed the argument that literal interpretation of section 365(c) is inconsistent with the general bankruptcy policies of "fostering a successful reorganization and maximizing the value of the debtor's assets." It agreed with RCI's contention that Congress did not sacrifice every right of a non-debtor party to the reorganization process. In similar fashion, the Court of Appeals dismissed the argument that Congress intended that the disjunctive "or" in "assume or assign" be interpreted as the conjunctive "and." While recognizing that such a reading would probably lead to a preferable policy outcome, the Fourth Circuit found that it was within Congress' discretion to reach such a result, not the courts.
Conclusion
RCI Technology Corp. v. Sunterra Corp. highlights the need for clarification of the meaning of the statute by either Congress or the Supreme Court. Neither has acted so far to resolve a conflict that has been smoldering for 15 years. As such, debtors and non-debtors alike can have no degree of certainty regarding the effect of a bankruptcy filing on contracts and leases that cannot be assumed without the non-debtor's consent under applicable non-bankruptcy law. The issue isn't likely to be settled any time soon. The Supreme Court has yet to agree to hear a case on whether the "hypothetical" or the "actual" test is the proper one. Lawmakers have not been moved to solve the problem either. Sweeping bankruptcy reform legislation that has been mired in Capitol Hill trenches for over six years is devoid of any attempt to clarify a provision that has and will continue to bedevil courts.
With no resolution of this matter on the horizon, the practical challenges confronting parties to these kinds of contracts can only be accurately assessed on a case-by-case basis by reference to the particular court presiding over the debtor's bankruptcy case. To date, the Third, Fourth, Ninth and Eleventh Circuits have adopted or expressed approval of the "hypothetical" approach, while the First Circuit has rejected it in favor of the "actual" test. Lower courts line up on both sides of a rift that does not show any promise of being resolved in the foreseeable future.
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RCI Technology Corp. v. Sunterra Corp., 361 F.3d 257 (4th Cir. 2004).
RCC Technology Corp. v. Sunterra Corp., 287 B.R. 864 (D. Md. 2003), rev’d, 361 F.3d 257 (4th Cir. 2004).
In re West Electronics Inc., 852 F.2d 79 (3d Cir. 1988).
Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1997).
Perlman v. Catapult Entm't, Inc. (In re Catapult Entm't, Inc.), 165 F.3d 747 (9th Cir. 1999).
City of Jamestown v. James Cable Partners, L.P. (In re James Cable Partners, L.P.), 27 F.3d 534 (11th Cir. 1994).
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