Third Circuit Clarifies What Makes a Contract “Executory” Under the Bankruptcy Code

On May 21, 2021, the Third Circuit issued an opinion in the high-profile bankruptcy of The Weinstein Company, LLC (TWC) clarifying precisely what ingredients are needed to make a contract “executory” under § 365 of the Bankruptcy Code.

Section 365 is the provision of the Bankruptcy Code which allows a debtor-in-possession to assume or reject executory contracts and unexpired leases. In order for an executory contract to be assumed (meaning, to be retained by the debtor; as opposed to being tossed out by virtue of “rejection”), the debtor must cure or provide adequate assurance that it will cure any defaults under that executory contract. See 11 U.S.C. 365(b)(1). An executory contract that has been assumed may be subsequently assigned by the debtor to another entity, the purchaser of property from Debtors’ bankruptcy estate pursuant to a § 363 sale. The § 365 cure provision does not, however, apply to non-executory contracts. In this enlightening opinion penned by Judge Ambro, the Third Circuit makes clear precisely which contracts are “executory.”

As a matter of background, TWC and its debtor affiliates (collectively, the Debtors) filed for relief under Chapter 11 of the Bankruptcy Code in March 2018 amidst numerous sexual misconduct allegations brought against co-founder Harvey Weinstein. Prior to the petition date, TWC sought to sell its business; but, perhaps because of its crumbling reputation, there was only one prospective buyer: the predecessor-in-interest of Spyglass Media Group, LLC (Spyglass). The overriding goal of TWC’s bankruptcy was to get court approval on an asset purchase agreement with Spyglass, pursuant to § 363 of the Bankruptcy Code. Among the assets in Debtors’ bankruptcy estate was a contract with Bruce Cohen, who produced the critically-acclaimed Silver Linings Playbook, released in November 2012. Among other things, TWC’s contract with Bruce Cohen (the Cohen Agreement) includes a provision that assures that Cohen will receive certain future compensation equal to roughly 5% of the net profits of Silver Linings Playbooks. Debtors sold the Cohen Agreement, among myriad other assets, to Spyglass in a § 363 sale (the Sale). At the time of the Sale, TWC owed Cohen approximately $400,000 in unpaid contingent compensation.

At issue before the Third Circuit was whether the Cohen Agreement was “executory” at the time of the Sale. If so, then Cohen is entitled to the cure amount of approximately $400,000; if not, then Cohen is owed nothing for the unpaid contingent compensation (but will remain entitled to future contingent compensation). Ultimately, the Third Circuit found the Cohen Agreement to be non-executory, thereby affirming the District Court’s decision, which itself affirmed the Bankruptcy Court’s decision.

As a general matter, the Third Circuit follows the so-called Countryman test for determining whether a contract is executory or non-executory.  Under the Countryman test, an executory contract is defined as “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 performance of the other.” Spyglass Media Group, LLC v. Cohen (In re Weinstein Company Holdings, LLC), Nos. 20-1750 and 20-1751, slip op., pages 10–11 (3d Cir. May 21, 2021) (quoting Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973)). A contract is also not executory under § 365 “unless both parties have unperformed obligations that would constitute material breach if not performed” and such obligations are owed “when the bankruptcy petition is filed.” Id., at page 11 (quoting In re Columbia Gas Sys. Inc., 50 F.3d 233, 239–40 (3d Cir. 1995)). What makes a breach “material” is a question of state law. See id. In reliance on the above principles, the Third Circuit succinctly enunciated the test for executory contracts: “[T]he test for an executory contract is whether, under the relevant state law governing the contract, each side has at least one material unperformed obligation as of the bankruptcy petition date.” Id. (emphasis added).

To further clarify this caveat to the Countryman rule, the Third Circuit analogized the need to perform material obligations to assets and liabilities of the bankruptcy estate. “[T]he performance the nonbankrupt owes the debtor constitutes an asset, and the performance the debtor owes the nonbankrupt is a liability.” Id. In reliance on the above framework, the Court explained that “a contract where the debtor fully performed all material obligations, but the nonbankrupt counterparty has not, cannot be executory; that contract can be viewed as just an asset of the estate with no liability.” Id., at pages 11–12. “On the other extreme, where the counterparty performed but the debtor has not, the contract is also not executory because it is only a liability for the estate.” Id., at page 12. Rephrased, the Court explained that “only where a contract has at least one material unperformed obligation on each side—that is, where there can be uncertainty if the contract is a net asset or liability for the debtor—[does the Court] invite the debtor’s business judgment on whether the contract should be assumed or rejected.” Id.

As explained above, in the context of a § 363 sale, in order for an executory contract to be assumed and subsequently assigned to the buyer of a debtor’s assets, the debtor must first cure or provide adequate assurance that it will cure any defaults to such executory contract. If, however, the contract being purchased by the buyer in a § 363 sale is not executory, the debtor has no obligation to cure. Put plainly, “if the contract is not executory, it can be sold to a § 363 buyer like any other liability or asset.” Id., at page 13. “In the case of a non-executory contract where only the debtor has material obligations left to perform, the contract is a liability of the estate, and if the buyer wants to buy it, the buyer is voluntarily assuming that liability.” Id. This results in the buyer being burdened only by a go-forward need to “fulfill obligations under the contract it bought after the sale closes, just as it would with any other asset or liability.” Id., at page 14.

Applying this test, the Third Circuit concluded that the Cohen Agreement was non-executory because, although failure to pay contingent compensation to Cohen would result in a material breach, Cohen as counterparty does not maintain any outstanding obligations the non-performance of which would result in material breach under New York law (the applicable state law) or by the terms of the Cohen Agreement. See id., at page 25. Such is the case because, as the Third Circuit indicated, Cohen’s remaining obligations (i.e., to refrain from pursuing injunctive relief over intellectual property he does not own) were ancillary and immaterial. Id., at page 22. Importantly, the Court elaborated that parties could contract around a state’s default contract rule regarding substantial performance (which is key in defining what sorts of breaches are material), and that, by crafting provisions that take the contract outside of such state rules, parties can “override the Bankruptcy Code’s intended protections for the debtor.” Id. However, the Court cautioned that contracting around a state’s default substantial performance rule “can only be accomplished clearly and unambiguously in the text of the agreement.” Id. In this instance, the Third Circuit concluded that ”[n]o provision in the contract clearly and unambiguously overrode New York’s default substantial performance rule that obligations are immaterial if they do not go to the root and purpose of the transaction,” and that, therefore, the Cohen Agreement was subject to New York’s substantial performance rule and commensurate definition for material breach. Id., at page 25.

Despite Cohen not being entitled to any cure amount under § 365, the Court did indicate that the amount owed to Cohen before closing of the Sale can still be asserted as an unsecured claim to be paid on a pro rata basis with other unsecured creditors, provided such claim is timely. Id. The Third Circuit also made clear that, although Spyglass does not owe Cohen the unpaid pre-Sale amount, Spyglass nonetheless assumed the responsibility to pay Cohen’s contingent compensation on a go-forward basis. Id., at pages 7–8.