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27: Executory Ks – assignment, nondelegable Ks © Charles Tabb 2010.

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1 27: Executory Ks – assignment, nondelegable Ks © Charles Tabb 2010

2 Assignment outside of bankruptcy Most Ks can be assigned – a party can assign its rights, and delegate its duties ▫An exception would be if the K itself prohibits assignment, w/o the consent of the other party  i.e., anti-assignment clauses are presumptively valid outside of bankruptcy ▫Another exception –> ID of obligor = material By assignment, though, the assignor cannot relieve itself of its liability on the K

3 Bankruptcy default rule? (sort of) Much like the rules governing the rights of SPs in bankruptcy, in regard to the operative premise for non-dr parties to Ks, Congress has stated that: “ the courts will have to insure that the performance under the contract or lease gives the other contracting party the full benefit of his bargain.”

4 Changing some of the rules … Also as with SPs, the aspirational “full benefit of his bargain” language is not literally honored in bankruptcy ▫Especially true in the assignment context As with SPs, the “bargain” paradigm for protection is replaced with a norm of bankruptcy court oversight ▫Try to make sure non-dr is not hurt TOO bad, and try to benefit the rest of the crs

5 changes 1 st, anti-assignment clauses are invalidated, 365(f)(1) 2 nd, ipso facto clauses are invalidated, 365(e)(1) 3 rd, upon assignment, the estate and the debtor are relieved of any liability, 365(k)

6 Both debtor and estate off the hook After a bankruptcy assignment, the estate and the debtor are no longer potentially liable for future performance, 365(k) ▫Unlike non-bk rule wherein assignor remains liable ▫Non-dr may look only to the assignee for performance  And has NO SAY in approving the assignee – court does the okay for them Estate can capture ALL of the profit under a valuable K immediately, and bear none of the future performance risk

7 Adequate assurance required So what is the quid pro quo for the assignment for non-dr party, who ▫(i) cannot escape the clutches of bankruptcy via an ipso facto clause; ▫(ii) cannot prevent the assignment by insisting that it give consent (under anti-assignment clause); and ▫(iii) cannot look to debtor or estate for future performance obligation?

8 Adequate assurance Condition to assignment that supposedly provides the requisite protection for the non-dr is that the assignee must demonstrate “ adequate assurance of future performance” Not a defined term in Code Usually goes to whether the assignee can provide evidence of its prospective ability to perform the obligations of the K, financial or otherwise

9 Must “assume” 1 st One condition of assignment is that the estate must 1 st assume the K under 365(b) Ramifications: ▫1 st, any defaults must be cured ▫2 nd, assignment must be “cum onere” – the whole K, benefits and burdens alike ▫3 rd,some types of Ks cannot be assigned, b/c can’t be assumed (e.g., K to make a loan)

10 anti-assignment clauses invalid One of most significant provisions in bk treatment of Ks is that the non-dr cannot protect itself from bk by using anti-assignment clauses ▫Even though are perfectly valid and legal outside of bankruptcy ▫Serve at least 2 functions:  1 st, allow non-dr to capture profit in valuable K  2 nd, non-dr can protect itself from assignment risk True even if the scope of non-dr’s discretion under anti-assignment clause is limited – ▫e.g., that consent “not be withheld unreasonably”

11 The “valuable K” function hypo(p. 415): ▫3 year lease, rent of $8K/yr ▫After year 2, market rents increased to $13K/yr. ▫DR files bk, seeks to assign at market rent, capture the $5K profit (13-8) ▫If anti-assmt clause were valid, non-dr could block assmt., then (if estate did not want to assume lease), get premises back and relet at $13k market rate, and capture the $5K profit itself

12 Problem 8.7 Facts: ▫Debtor -> lease rent $20K/yr (retail space) ▫Assignment condition: Dr pay Lessor 75% of any amounts received from assignee above base rent ▫Debtor files chapter 11, and requests permission to assume and assign to Assignee for $28K/yr ▫Lessor objects  demands payment of $6K of the $8K increase, in accordance with 75% clause

13 Analysis 8.7 The “75% clause” is just an indirect form of anti- assignment clause, and is invalidated by 365(f)(1) Thus the estate is free to assign the K at the higher market rent of $28K, and thus will capture the entire $8K profit in the lease Non-dr gets its K rent of $20K, but no more

14 The “assignment risk” function Hypo: ▫Dr has 5-year supply K with Non-dr, in which Dr is obligated to supply all of Non-dr’s requirements for sulphur at posted market price ▫Dr as DIP seeks to assign the K to Smith, another sulphur supplier  Smith of course will pay Dr (and estate) $ ▫Non-dr legitimately has concerns about Smith’s reliability as a long-term supplier, based on various plausible business reasons

15 “assignment risk” cont. Outside of bankruptcy, if Non-dr had a clause entitling it to consent to any assignment, it could block the Dr’s attempted assignment to Smith ▫Only constraint would be that Non-dr likely would have to exercise “consent” in “good faith”  But would surely pass if had business reasons IN bankruptcy, however, Non-dr does not have power simply to withhold consent ▫Instead, must persuade the BK Court that its worries about Smith’s reliability are powerful enough to block an assignment that would bring estate many $

16 Policy, role of “adequate assurance” As noted earlier, the operative protection for non- drs in these sorts of cases is that the assignee (e.g., Smith in our hypo) can demonstrate “adequate assurance of future performance” to the bk ct All Non-dr can do in hypo is try to get bk ct to agree that its business concerns about Smith preclude finding “adequate assurance” ▫Legis history – “full benefit of bargain” policy  but of course NOT get “full benefit,” b/c non-dr is at bk ct’s oversight mercy – not control own fate

17 Shopping center rules As we’ll see in Martin Paint, the bk ct often ends up being a weak protector of non-dr, esp. when specter of $ for estate is looming The one scenario in which non-dr’s rights are in reality strongly protected in assignment is if is a lease in a shopping center ▫Then, under 365(b)(3), “adequate assurance” mandates very strict compliance with many of the terms of the lease

18 Use clauses? Could be de facto anti-assignment clause, if very narrowly tailored to describe dr’s business, and no other But also could be a legitimate part of the non- debtor’s K bargain And implicate the interests of 3 rd parties with whom the non-dr also has Ks The trick – which is it? legit part of deal, or disguised anti-assmt clause?

19 Use clause as anti-assignment Hypo: Dr lessee is restricted to using leased premises for combo hardware store & bike repair shop Dr wants to assign lease in bankruptcy Assignee must show “adequate assurance of future performance” (365(f)(2)(B)) ▫Which requires performance in compliance with lease terms, including the use clause Also must assume 1 st (365(f)(2)(A), and assumption must be “cum onere” ▫including use clause Literally, then, only possible assignees in the world would run a combo hardware/bike repair store

20 Martin Paint Stores Illustrates the tensions in analyzing the enforceability of a use clause in bankruptcy ▫How to protect the legitimate interests of:  The estate  The non-dr party to the K  Directly affected 3 rd parties

21 Martin Paint Facts: ▫Dr lease retail space from Feldco  Use clause: limit to selling paint & hardware ▫Feldco lease ↔ Persuasion (sells ladies clothes)  Exclusivity clause – Persuasion to have only store in building selling just ladies’ clothes ▫Dr’s ch 11 failed, auctioned off lease ▫High (only!) bidder = Pretty Girl  will pay $75K, net profit to bankruptcy estate = $40K  But runs ladies clothing store, not paint/hardware ▫Feldco & Persuasion both object  Argue violates use clause, exclusivity

22 Martin Paint Issue: has Pretty Girl (proposed assignee) demonstrated “adequate assurance of future performance” vis-à-vis the Feldco lease, notwithstanding fact that will not comply with the use clause, and notwithstanding fact will contravene the Feldco-Persuasion exclusivity clause?

23 Martin Paint Why did the debtor want to assign the lease? Why did the Creditors’ Committee support the debtor’s motion?  Simple – make $40 grand for the benefit of the estate!

24 Martin Paint puzzle If the non-dr (Feldco) is supposed to get the benefit of its bargain, and if the proposed assignee has no intention of complying with the use clause, by what authority can the court approve the assignment?

25 Authority to strike use clause 1 st  365(f)(1) – invalidates anti-assignment clauses … so in effect are asking if the use clause is tantamount to a disguised anti-assignment clause 2 nd, in construing “adequate assurance” under 365(f)(2)(B), for non-shopping center lease, draw negative inference from 365(b)(3)(C), which DOES require strict compliance with use clause in shopping center lease

26 Test? What test does the Martin Paint court invoke for assessing the enforceability of a use clause in “adequate assurance” context?  Actual and substantial detriment to the non-dr lessor (e.g., Feldco)  In short, the bankruptcy court substitutes ITS judgment as to whether the use clause has a legitimate business purpose necessary to protecting the interests of the non-dr

27 Martin Paint Could the Debtor assume the lease and start selling women’s clothes? ▫If not, seems dubious policy to let estate capture benefit of K by assigning instead Feldco would argue no, on “cum onere” theory – no basis for allowing estate as lessee to ignore provisions in lease ▫And no 365(f)(1) authority to strike as disguised anti-assignment clause

28 assume?, cont. Estate would counter: ▫1 st – use clause like a disguised ipso facto clause, and thus potentially invalid under 365(e)(1) ▫2 nd, -- again draw negative inference from shopping center lease, where to assume must, if lease in default, strictly comply with use clause  Answer not really clear

29 Martin Paint Why did Persuasion object? b/c assignment would violate its exclusivity clause with Feldco and expose it to more competition

30 Martin Paint What did the court do with Persuasion’s objection?  Said had no standing to object b/c neither a creditor nor an intended beneficiary of the use clause  And yet court’s holding did indisputably affect Persuasion’s interests

31 Martin Paint Why did Feldco object? Worried about its relationship with Persuasion ▫Would be in breach of exclusivity clause ▫And next time rent with Persuasion to be renewed, might not get as much rent Cares about “tenant mix” Worried that increased competition in women’s clothing might make ALL the affected tenants more of a business risk to pay rent

32 Martin Paint How did the court rule on Feldco’s objection, and why?  court held was NOT an “actual and substantial detriment” ▫Disagreed with assessment of business risk ▫Note not a “percentage lease” with either tenant  Might be different if so ▫Pretty Girl financials satisfactory

33 But what about the exclusivity breach? Fact that court believed that business projections showed that both Pretty Girl and Persuasion would be able to pay rent does not answer the legitimate concern that Feldco has that if use clause in lease is not honored, it then will be in breach of the exclusivity clause with Persuasion ▫And surely that qualifies as “actual and substantial detriment”

34 Martin Paint – “Catch-22” Why might it be argued that Martin Paint is the “Catch-22” of bankruptcy assignment cases?

35 Catch-22 Court held that Feldco was NOT in breach of the exclusivity clause with Persuasion, b/c the court’s own ruling on the assignment of the Martin Paint lease, which struck the use clause, made it legally impossible for Feldco to comply, which gives it a K excuse vis-à-vis Persuasion But had also held that Persuasion lacked standing! Yet court’s impossibility ruling stripped Persuasion of ability to enforce the exclusivity clause

36 What if shopping center lease? Would Martin Paint have come out differently if had been a shopping center lease? YES – b/c now “adequate assurance” requires strict compliance with a “use clause” under 365(b)(3)(C), and furthermore must respect “tenant mix” under 365(b)3)(D) In shopping center cases, give much more weight to the interests of affected 3 rd parties

37 Intro to nondelegable Ks K parlance: “assign rights, delegate duties” Issue in bankruptcy is whether the estate can either assume or assign the K when the duties under the K are nondelegable under non- bankruptcy law

38 Reasons for nondelegability Default rule: ARE delegable Exceptions: ▫1. K says no delegation ▫2. delectus personae, i.e., performance by THIS obligor is material ▫3. Limiting legislation  E.g., U.S. govt Ks (41 USC 15); patents

39 Easy case: ignore K clauses If the reason for the nondelegability is dependent on a K clause, the answer is clear – the clause is NOT ENFORCEABLE Hypo: yard-mowing K, anti-delegation clause Bankruptcy result  since unlikely that the ID of the yard mower is inherently material, in bk simply ignore the anti-delegation clause ▫K can be assumed or assigned

40 The “not easy” cases Bankruptcy treatment may become more problematic, however, if the reason for nondelegability under non-bankruptcy law is due either to: ▫1. non-dr has a material interest in performance by the debtor personally Or ▫2. limiting legislation restricts the debtor’s power to delegate duties under the K

41 Situations where nondelegability arises 1. Assumption by a trustee 2. Assumption by a DIP 3. Assignment to 3 rd party 4. enforcement of ipso facto clause

42 Relevant statutory provisions For assumption: 365(c)(1) For assignment: 365(f)(1), and also (c)(1) For ipso facto clauses: 365(e)(2) (essentially identical to 365(c)(1)

43 365(c)(1) (c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if ▫(1)(A) 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, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and ▫(B) such party does not consent to such assumption or assignment

44 365(f)(1) (f)(1) Except as provided in subsection (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection.

45 Another “easy” case Assumption by Chapter 7 trustee of personal service K, where non-dr has material interest in performance by the debtor as obligor personally (i.e., the delectus personae cases) Hypo: Lebron James K with Cavs, files ch. 7, his trustee seeks to “assume” the K Trustee can NOT assume here

46 Why trustee can’t assume Lebron’s K Matters to Cavs that LEBRON himself performs! ▫ NOT some bankruptcy trustee!

47 1 st really hard case: assumption by DIP What if, however, instead of filing chapter 7, Lebron filed chapter 11, and Lebron, in his capacity as the debtor in possession, sought to assume the K?

48 post-petition individual earnings issue? 541(a)(6) – postpetition earnings by an individual dr are excluded from bk estate ▫Possibly would be a logical basis to deny assumption on behalf of the estate – b/c all of the benefits from K (the wages) don’t got to estate anyway But in 2005 added 1115(a) –> captures post- petition earnings of individual Dr as property of the estate – so no longer a barrier to assumption

49 Do Cavaliers have legitimate gripe? So should the Cavs be able to block Lebron’s assumption of his playing K? NO -- He is still the guy stepping out onto the court as # 23 and scoring 30 a game ▫The Cavs are getting everything they bargained for ▫Should not matter a whit to them whether the $ they pay go to Lebron or his creditors

50 Hypothetical versus actual test Hypothetical: ▫Hypothetically, would the Non-dr party be entitled to block assignment by Dr to a 3 rd party? ▫If so (i.e., if Dr could not assign), then Dr as DIP cannot assume Actual: ▫Is the DIP actually trying to assign to a 3 rd party? ▫If not (i.e., if Dr as DIP is just trying to assume), then no problem – can assume

51 Catapult Entertainment Squarely raises the issue of the ability of a DIP to assume a K nondelegable under non-bk law Here, b/c of federal patent law

52 Catapult Entertainment Facts: ▫Catapult Entertainment in business of operating an online gaming network ▫Catapult was the licensee under several nonexclusive patent licenses with Perlman ▫Catapult filed chapter 11 ▫In its plan, Catapult proposed to assume the Perlman patent licenses ▫Perlman objected under 365(c)(1)

53 Catapult Entertainment

54 Competing arguments Perlman (Non-dr): Plain meaning ! ▫365(c)(1) sets up a hypothetical (you can’t assume if you couldn’t assign) test Catapult (Dr/DIP): that’s ridiculous, even Congress isn’t that stupid ▫And indeed we know Congress twice amended 365(c)(1) to try to change the hypo test

55 The statute’s inexorable command? (c) Catapult may not assume... the Perlman licenses,... if ▫(1)(A) federal patent law excuses Perlman from accepting performance from or rendering performance to an entity other than Catapult...; and ▫(B) Perlman does not consent to such assumption U.S.C. § 365(c) (substitutions in italics).

56 9 th circuit’s plain meaning application Federal patent law makes nonexclusive patent licenses personal and nondelegable – thus 365(c)(1)(A) is satisfied. Perlman withheld consent - thus 365(c)(1)(B) satisfied.  Accordingly, the plain language of § 365(c)(1) bars Catapult from assuming the Perlman licenses.

57 DIP’s attempts to escape “plain meaning” 1. Textual ▫A. Inconsistency between 365(c)(1) & 365(f)(1) – reference to “applicable law” in latter has little application if (c)(1) has broad hypo reading ▫B. “or debtor in possession” in (c)(1)(A) superfluous 2. Legislative history 3. Policy

58 Held – hypothetical test 9 th circuit did not buy Catapult’s attempts to escape plain meaning: ▫1 st, found plausible (albeit debatable!) meanings for textual language ▫2 nd, no need to look at legis history since statute plain, and anyway was a single committee report from 4 years earlier ▫3 rd, policy can’t trump what Congress said

59 Why didn’t attempted Congressional fix work? The killer is the “IF” in the introductory clause Changing verbiage after that (e.g., “other than the debtor or debtor in possession” in (c)(1)(A)) does nothing to change the hypothetical reading required by the construct “can’t assume IF can’t assign”

60 Practical impact? Gives non-dr (Perlman) more than he bargained for, and in effect gives him a powerful leverage to extract a payoff – can hold reorganization hostage

61 Assignment of non-assignable K The statute: 365(f)(1) Says: ▫1. can assign a K in bankruptcy, notwithstanding an anti-assignment provision  In the K  “or in applicable law” But ▫2. subject to 365(c)(1)

62 Full text of (f)(1) (f)(1) Except as provided in subsection (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection

63 Easy case, again Bar to assignment is dependent on a K anti- assignment clause Hypo: ▫yard-mowing K ▫K has anti-assignment clause ▫Dr (original mowing obligor) files chapter 7 ▫trustee wants to assign K to another mower  Trustee may assign

64 Magness Facts: ▫Magness & Redman filed ch 7 ▫Golfing members Dayton CC -> ▫Club rules:  Max 375 golfing members  No ability of current golfing member to assign or sell membership  Club fills golfing memberships by offering in order to people on the waiting list, already social members ▫Bk trustee wanted to sell golfing memberships unconstrained by club rules

65 Trustee’s motivation? Trustee’s reason for selling unconstrained by club rules is simple – make money for estate! For example, under club rules, must go in order of 70-person waiting list when a golfing membership becomes available Might take years for person # 70 to get to golf #70 might be willing to pay trustee big $ to jump to the head of line and get Magness’ golf spot

66 Magness Issue – interpretation of 365(f)(1) (in conjunction with 365(c)(1)) – is the prohibition in the club rules (enforced under Ohio state law) on a golfing member assigning his membership negated by 365(f)(1), thus allowing the trustee to sell (e.g., to rich and impatient #70!), or are those restrictions legitimate and enforceable under 365(c)(1), thus blocking the attempted sale?

67 Contradictions in 365(f)(1) Problem is that 365(f)(1) seems to speak out of both sides of its mouth (if a statute can do that): On the one hand (to use a different body metaphor) – (f)(1) nixes anti-assignment restrictions ▫In the K ▫OR “in applicable law” But on the other hand, (f)(1) is subject to (c)(1), and under (c)(1), anti-assignment rules “in applicable law” are enforced – unless dependent on a K clause

68 What does “or in applicable law” mean? The puzzle is what the reference to “or in applicable law” in (f)(1) can possibly add, since “applicable law” restrictions that are not dependent on a K clause are upheld under (c)(1)

69 Pioneer Ford harmonization Enforce anti-assignment rules effective independent of K anti-assignment clauses, but not enforce if “applicable law” simply validates K prohibitions on assignment Involved Rhode Island statute that prohibited assignment of car dealership without the manufacturer's consent, as long as consent not unreasonably withheld. First Circuit (Breyer, J.) concluded that the state statute must be enforced in bankruptcy - assignment prohibited ▫the court finding that the manufacturer’s consent was not unreasonably withheld, as required by the state statute

70 Pioneer Ford, cont. 365(c)(1) "refers to state laws that prohibit assignment 'whether or not' the contract is silent, while (f)(1) contains no such limitation." “Apparently (f)(1) includes state laws that prohibit assignment only when the contract is not silent; that is to say, state laws that enforce contract provisions prohibiting assignment”

71 criticized Many have criticized Pioneer Ford as engrafting a limitation onto statute that is not there In reality, the case involved not the anti-assmt rule, but the “adequate assurance of future performance” limit in 365(f)(2) – ▫Issue of whether manufacturer “unreasonably withheld” consent dovetails with adequate assurance question

72 Magness reconciliation 6 th Circuit in Magness comes up with a different harmonization of (f)(1) an d (c)(1): ▫(f)(1) contains the general rule (e.g., non-bk anti- assmt rules negated) ▫(c)(1) contains a narrow exception – if assignment by trustee will impact upon rights of a non-debtor third party, then “applicable law” protecting right of 3 rd party to refuse to accept performance from assignee will prohibit assignment by the trustee.

73 Harmonize? Solution depends on whether applicable non- bankruptcy law upholds right of non-debtor party to refuse performance from anyone other than debtor Emphasis on whether non-debtor party has an absolute right to block assignment, no matter what I.e. -- is the situation one where the only way that the K can be assigned is if the other party consents? Only if so will (c)(1)’s prohibition be triggered and bankruptcy assignment be precluded

74 How differ from Pioneer Ford? Focus in Magness is on whether non-dr has absolute right under non-bk law to refuse performance from someone other than Dr – no matter what! So in case like Pioneer, where state statute only allowed non-dr manufacturer to withhold consent to assignment if not “unreasonable,” the (f)(1) rule would control, not (c)(1) ▫And still protect manufacturer via “adequate assurance” test of 365(f)(2)

75 Limited “applicable law” There are very few situations in the law where the non-debtor party to K actually enjoys an absolute right to block assignment Unique personal service contracts, federal government contracts, and patent and copyright licenses are the most common examples

76 Application in Magness 6 th Circuit had to apply its rule to club membership case before it Concluded that personal association Ks, such as country clubs, are inherently non-assignable under state law ▫ID of specific person is material So “exception” of (c)(1) applies, K not assignable

77 Is this like Chicago Bd of Trade? 2 nd reason 6 th Circuit gave: the property right of the golfing member – and that of all the other prospective golfing members – are created and defined by the club rules As in Chicago Bd of Trade, those rules limit the power of current golfing member to assign, 363(e) – part of bundle of property rights And must honor and give effect to the property rights of 3 rd parties (e.g., the people on wait list)

78 can “property” analysis square with “K”? Query whether court’s “property” analysis, if taken literally, would swallow up the K rule in 365(f)(1) that overrides anti-assignment “laws” i.e., isn’t the whole point of 365(f)(1) to take away one of the sticks in the property bundle that the non-dr would have under state law??

79 Real reason can’t assign in Magness? What if the trustee were seeking to assign to the person who was (i) already an approved social member of Dayton Country Club – i.e., someone with whom other Dayton CC members were willing to associate with -- and (ii) was # 70 on waiting list for golf membership? In that situation, isn’t the club rule itself the only reason blocking assignment?

80 Is it “personal” or is it club rules? i.e., any “personal association” reason NOT to allow to assign to THIS guy? As opposed to THIS guy?

81 Reconcile Magness with Martin Paint? By way of hopeless frustrating review – can you reconcile the way the court in Magness DID accommodate the interests of 3 rd parties, to the detriment of the bankruptcy estate, as opposed to how the Martin Paint court largely IGNORED the rights of 3 rd parties, giving instead paramount consideration to estate’s interests? ▫That’s a rhetorical question!

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