Chapter 13 Failure Is an Option: Bankruptcy Risks and
V. Treatment of Executory Contracts and Unexpired Leases
A project finance transaction is governed by a patchwork of interrelated contractual undertakings that allocate risk, establish relative rights of recovery, and provide for the creation and operation of the project itself. In addition to the loan and security docu- ments, the typical project finance transaction features a host of engineering, procure- ment and construction contracts, operating agreements, maintenance agreements, management agreements, supply agreements, offtake and power purchase agreements, and hedging contracts. It is important to consider how these contracts can be treated in bankruptcy.
Under Bankruptcy Code § 365, a trustee or debtor-in-possession is generally autho- rized to assume, assign, or reject the debtor’s executory contracts and unexpired leases. 32 The purpose behind Bankruptcy Code § 365 is to “allow a debtor to reject executory contracts in order to relieve the estate of the burdensome obligations while at the same respect to certain types of hedging contracts; i.e. , “swap agreements” (as defi ned under 11 U.S.C. § 101(53B)) and “forward contracts” (as defi ned under 11 U.S.C. § 101(25)). Under those safe harbor provisions, a hedge provider may be entitled to exercise its contractual rights of acceleration, liquidation, termination, and setoff notwithstanding the automatic stay and other provisions of the Bankruptcy Code that would otherwise interfere with such remedies.
See, e.g. , 11 U.S.C. §§ 362(b)(6), 362(b)(17), 362(o), 560 and 556.
28 See Nantucket Investors II v. California Fed. Bank ( In re Indian Palms Assocs .), 61 F.3d 197, 207 (3d Cir. 1995) (“[I]n determining whether a secured creditor’s interest is adequately pro- tected, most courts engage in an analysis of the property’s ‘equity cushion’ — the value of the property after deducting the claim of the creditor seeking relief from the automatic stay and all senior claims.”).
29 See Landry v. Chevy Chase Fed. Sav. Bank ( In re Landry ), 1994 U.S. App. LEXIS 1559 (9th Cir. Cal. Jan. 20, 1994) (stating that “cause” for purposes of § 362(d) “includes a debtor’s lack of equity in a property, debtor’s failure to make post-petition mortgage payments, and inadequate protection of a creditor’s interest in the property.”).
30 See In re Holly’s, Inc ., 140 B.R. 643 (Bankr. W.D. Mich. 1992) (“A foreseeable contingent possibility of jeopardy to a secured creditor’s property rights is suffi cient cause to warrant relief from stay — current on-going diminution of collateral value is not an absolute prerequi- site to obtaining relief.”).
31 See Pegasus Agency v. Grammatikakis ( In re Pegasus Agency ), 101 F.3d 882, 886 (2d Cir. N.Y.
1996) (“Without a credible reorganization plan in prospect, [the debtor] is not entitled to the continuation of the automatic stay under Section 362(d)(2)(B).”).
32 See 11 U.S.C. § 365(a).
time providing ‘a means by which a debtor can force others to continue to do business with it when the bankruptcy filing might otherwise make them reluctant to do so.’” 33 The Bankruptcy Code does not define the term “executory contract.” With that said, however, most courts have adopted the definition endorsed by Professor Vern Countryman; i.e., “a contract under which the obligation of both the bankrupt and the other party to the contract is so far clearly unperformed that failure of either to com- plete performance would constitute a material breach excusing the performance of the other.” 34
In most instances, the debtor’s decision to assume or reject an executory contract or unexpired lease is governed by the business judgment standard. 35 That is, a bankruptcy court will not disturb a trustee or debtor-in-possession’s decision to assume or reject an executory contract or unexpired lease except where “the decision is so unreasonable that it could not be based on sound business judgment, but only on bad faith or whim.” 36 Generally speaking, a trustee or debtor-in-possession can be expected to reject con- tracts and leases that are unprofitable or burdensome and assume contracts and leases that are profitable to the estate (sometimes referred to colloquially as “cherry-picking”).
The rejection of an executory contract or unexpired lease is generally deemed to be a breach of the contract or lease as of the date immediately preceding the filing of the bankruptcy petition, 37 and may be accomplished by motion or through a Chapter 11 plan of reorganization. 38 Prior to assumption or rejection in a Chapter 11 case, an executory contract is not enforceable against the debtor but generally remains enforce- able against the nondebtor counterparty. 39
To assume or assign an executory contract or unexpired lease, a trustee or debtor-in- possession must (1) cure the existing defaults under the contract or lease, and (2) provide adequate assurance that the contract or lease will continue to be performed in the future. 40 The Bankruptcy Code generally allows a trustee or debtor-in-possession to assume an executory contract or unexpired lease even where the contract, on its face, purports to terminate upon bankruptcy. 41 In most instances, such ipso facto clauses are deemed unenforceable in bankruptcy. 42 Likewise, a trustee or debtor-in-possession is
33 In re Chatequgay Corp. , 10 F.3d 944, 954 (2d Cir. 1985) ( quoting Richmond Leasing Co. v.
Capital Bank , N.A. , 762 F.2d 1303, 1310 (5th Cir. 1985)).
34 Countryman, Executory Contracts in Bankruptcy: Part I , 57 MINN. L. REV. 439, 469 (1973).
See, e.g. , Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc. , 756 F2d 1043 (4th Cir.
1985), cert. denied, 475 U.S. 1057 (1986).
35 See, e.g. , In re Orion Pictures Corp. , 4 F.3d 1095, 1099 (2d Cir. 1993).
36 In re Balco Equities Ltd., Inc ., 323 B.R. 85 (Bankr. S.D.N.Y. 2005) (quotations omitted).
37 11 U.S.C. § 365(g)(1).
38 See 11 U.S.C. § 1123(b)(2).
39 See NLRB v. Bildisco & Bildisco , 465 U.S. 513, 532 (1984); In re Feyline Presents, Inc ., 81 B.R. 623, 626 (Bankr. D. Colo. 1988) (stating that “an executory contract under Chapter 11 is not enforceable against the debtor party, but is enforceable against the nondebtor party prior to the debtor’s assumption or rejection of the contract.”).
40 11 U.S.C. § 365(b)(1).
41 11 U.S.C. § 365(e)(1).
42 See Id. The term “ipso facto” means “by the fact itself” or “by the mere effect of an act or fact.”
BLACK’S LAW DICTIONARY 828 (6th ed. 1990). “Ipso facto clauses are provisions in executory
TREATMENT OF EXECUTORY CONTRACTS AND UNEXPIRED LEASES
generally permitted to assign an executory contract even where the contract contains express language purporting to prohibit its assignment. 43 If a trustee or debtor-in- possession elects to reject an executory contract, the nondebtor counterparty can assert a claim for rejection damages, which is treated as a prebankruptcy claim. 44 In the case of a rejected real property lease, the nondebtor’s claim for rejection damages is subject to a statutory cap. 45
The powers conferred by Bankruptcy Code § 365 could have a number of implica- tions for project-related bankruptcy cases. For example, in a project company bank- ruptcy, the project company debtor can use its authority to reject an above-market supply agreement. The project company debtor could, likewise, reject a below-market offtake agreement, including perhaps a power purchase agreement, or reject an out-of- the-money hedging contract. As a corollary, in a project supplier bankruptcy, the sup- plier debtor can reject a below-market supply agreement. In a project offtake purchaser bankruptcy, the purchaser debtor can reject an above-market offtake agreement. Given the interrelatedness of the various supply, output, and hedging contracts in a project financing transaction, and the risk allocation and revenue streams that flow from them, the rejection of any one undertaking could disrupt the entire project through cross- defaults and other means.
In addressing Bankruptcy Code § 365, the law is unsettled over the treatment of executory contracts subject to a filed rate with the Federal Energy Regulatory Commission (FERC). The issue of potentially conflicting jurisdiction between the bankruptcy courts and FERC has been addressed in a number of bankruptcy cases, with inconsistent results. In the case of Mirant Corp. v. Potomac Electric Power Co.
( In re Mirant ), 46 for example, the Fifth Circuit Court of Appeals held that the Federal Power Act (FPA) does not preclude a debtor from rejecting a FERC-jurisdictional contract pursuant to Bankruptcy Code § 365 without first obtaining approval from FERC, even though such rejection can indirectly impact filed rates. In reaching this conclusion, the Fifth Circuit reasoned that the rejection of a contract under Bankruptcy Code § 365 constitutes a breach that gives rise to damages, and that the FPA does not give FERC exclusive jurisdiction over breach of contract claims where the alleged breaches are unrelated to an approved rate. The Fifth Circuit did not grant carte blanche to the bankruptcy court. Instead, the Fifth Circuit noted that the standard typically used for contract rejection under Bankruptcy Code § 365 (i.e., business judgment) perhaps should be supplanted with a more “rigorous” standard given the public interest implicated by such contracts under the FPA. 47
contracts and unexpired leases which result in a breach solely due to the fi nancial condition or bankruptcy fi ling of a party.” In re Lee West Enterprises, Inc. , 179 B.R. 204, 209 (Bankr. C.D.
Ca. 1995).
43 11 U.S.C. § 365(f)(1).
44 See g enerally 11 U.S.C. § 502(g).
45 See 11 U.S.C. § 502(b)(6).
46 378 F.3d 511 (5th Cir. 2004).
47 Id . at 525 (stating that the “[u]se of the business judgment standard would be inappropriate because it would not account for the public interest inherent in the transmission and sale of electricity . . .”).
The Fifth Circuit’s Mirant decision stands in contrast to a more recent decision by the District Court for the Southern District of New York in the case of Calif. Dep’t of Water Res. v. Calpine Corp. ( In re Calpine Corp. ). 48 In Calpine , the district court ruled
“the Bankruptcy Code does not expressly limit FERC’s jurisdiction.” 49 The court also ruled the debtor’s attempt to reject FERC-jurisdictional wholesale power agreements would interfere with FERC’s exclusive jurisdiction and regulatory authority over such agreements, and constitutes an improper “collateral attack” on the filed rate. The Calpine court found the Bankruptcy Code does not limit or abrogate FERC’s regula- tory authority, noting that “what FERC giveth, only FERC may taketh away.” 50 The court reasoned that, because the discontinuance of service that rejection entails involves a change in service, only FERC could authorize it.
Given the current conflict among reported case law authorities, participants in proj- ect finance transactions involving FERC-jurisdictional contracts face some uncertainty regarding the treatment of such contracts in bankruptcy.