Thoughts From the BAP on How to (re)Define an “Executory Contract”
Making a quiet entrance into the public realm during the final week of last year, a new opinion from the United States Bankruptcy Appellate Panel of the Ninth Circuit (the “BAP”) suggests that it is time to revisit the definition of an “executory contract” as has been applied for years by the United States Court of Appeals for the Ninth Circuit. The opinion, Carruth v. Eutsler (In re Eutsler), B.A.P. 9th Cir. December 27, 2017, is careful to follow the Ninth Circuit’s holding in Unsecured Creditors’ Comm. v. Southmark Corp. (In re Robert L. Helms Constr. & Dev. Co.), in deciding an appeal which turned on whether or not a shareholders’ agreement that contained a buy-out mechanism was executory or not. But the new BAP opinion lingers on a discussion of how and why that long-relied-on authority should be revisited.
It is tempting to dismiss the BAP’s provocative musings on executory contracts as nothing more than intellectual day-dreaming. But practitioners have for many years been reading, analyzing, debating, drafting around, and counseling clients about Helms and the “Countryman” definition of executory contracts adopted by Helms. A change to the rule in Helms would be a seismic event—a contract provision that most thought would be interpreted in one manner would suddenly be thrown into question and potential challenge. Millions of dollars riding not only on options but also on franchise agreements, licensing arrangements, film development, and distribution deals, and countless other transactions would have to be re-analyzed. Thus, although the BAP did not actually change the rule—it has no power to do so and to its credit, the panel acknowledged as much—even the potential for such a change is a significant event.
The underlying case: Carruth v. Eutsler
In Eutsler, the founder and then 25.5% owner of a company filed a chapter 13 case. The shares held by Eutsler were subject to a “Stock Restriction/Buy-Sell Agreement” allowing either the company or the 49% minority shareholders to buy the shares in certain circumstances, including the bankruptcy of shareholder/debtor Eutsler. The company, still controlled by Eutsler and/or the other seemingly friendly (the opinion does not say so but it seems likely) 25.5% shareholder, received notice of Eutsler’s bankruptcy case but never exercised the buy-out provision. Later (at least as they claim) the minority shareholders learned of the bankruptcy case and wanted to try to buy Eutsler’s shares under the formula. The Bankruptcy Court found for Eutsler and the minority shareholders appealed to the BAP.
The BAP explained that the provision in the shareholders’ agreement provided that, “upon the occurrence of certain ‘terminating events,’ one of which was ‘the filing of any proceedings for bankruptcy . . . by a Shareholder,’ that shareholder was required to give written notice to the corporation and other shareholders. The corporation then had the option, but not the obligation, to purchase the shareholder’s stock at a price-based formula. If the corporation did not timely exercise the option, the other shareholders had the same option.” Eutsler, pp. 2-3.
The Bankruptcy Court ruled that the shareholders’ agreement was not an “executory contract” and that therefore the minority shareholders’ rights under the agreement to trigger the buy-sell mechanism were lost after the filing of the bankruptcy case. The BAP affirmed that ruling, characterizing the shareholder agreement as an option agreement and finding under Helms that it was not an executory contract. The BAP agreed with the Bankruptcy Court’s analysis about whether or not the shareholders’ agreement was executory, writing:
The bankruptcy court correctly held that the Ninth Circuit has adopted Professor Countryman’s definition of an executory contract: “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 the performance of the other.” Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973); see In re Helms Constr., 139 F.3d at 705 (“An executory contract is one ‘on which performance remains due to some extent on both sides.’”).
Executory contracts: the BAP criticizes the “Countryman” decision
This result, although adding to the case law in the area and worthy of scrutiny by those dealing with similar contracts and facts, is not particularly noteworthy. What is noteworthy is that the BAP went out of its way to criticize the “Countryman” definition used to identify executory contracts in the first place in the Ninth Circuit (and many other circuits), a test which has literally been used for decades by courts and practitioners.
The BAP had previewed in a footnote that as far as it was concerned there were issues with the reasoning of Helms:
We explain in footnotes why we think the court of appeals should revisit some of those issues, including the definition of “executory contract” in general and specifically whether an option contract such as the Buy-Sell Agreement is an executory contract.
The BAP felt that a “new” test proposed in an article co-authored by the prominent law professor Jay Westbrook would be a better idea. It stated:
Most courts follow the Countryman definition, but some decisions adopt a more flexible approach. See, e.g., Chattanooga Mem’l Park v. Still (In re Jolly), 574 F.2d 349, 351 (6th Cir. 1978) (“[D]efinitions [such as Countryman’s] are helpful, but do not resolve this problem. The key, it seems, to deciphering the meaning of the executory contract rejection provisions, is to work backward, proceeding from an examination of the purposes rejection is expected to accomplish. If those objectives have already been accomplished, or if they can’t be accomplished through rejection, then the contract is not executory within the meaning of the Bankruptcy Act.”). A very recent law review article makes a powerful argument in favor of a “modern contract approach” to executory contracts. Under that approach, all contracts with any unperformed obligation on either side, material or not, are “executory contracts” under § 365. Jay Lawrence Westbrook & Kelsi Stayart White, The Demystification of Contracts in Bankruptcy, 91 Am. Bankr. L.J. 481 (2017). The alternative approaches have much to recommend them; the Countryman definition turns on factors that have little if anything to do with the underlying policies of bankruptcy law and produce anomalous results in some cases. But neither party to this appeal challenges Helms Construction, and we could not disregard or overrule it even if they asked us to do so.
Still walking through the Helms analysis to affirm the Bankruptcy Court, the BAP noted in yet another footnote that the new proposed test would make every limited liability company operating agreement an executory contract:
The advocates of the modern contract approach would treat LLC operating agreements (which are similar in many respects to the Buy-Sell Agreement in this case) and options in general as executory contracts. Westbrook & White, supra n.6, at 503-06, 511-13. This approach has substantial appeal, but we are not writing on a blank slate. Instead, we must follow Helms Construction, which holds otherwise.
At least this author does not find a rule that would turn every single LLC operating agreement (and there are millions of them) into an “executory contract”—meaning that the entities could file bankruptcy and reject their own charters—something that has “substantial appeal.” It also would be in conflict with the way LLC operating agreements and the economic agreements they embody have been treated over the last 20 years by bankruptcy courts, although that is a topic for another day.
For the moment, the “Countryman” definition remains the law in the Ninth Circuit. Those with executory contract questions in 2018 can only wonder how whatever advice they give (or receive) might be viewed years in the future when disputes arise and a court must render a decision.