Executory Contracts: Sometimes Debtors Can Be Choosers!
The Bankruptcy Code affords debtors a broad right to assume, assign, or reject their executory contracts. Debtors may pick and choose among their executory contracts — assuming those contracts that they favor and rejecting the others — the choice is theirs. There is, however, one catch. Regardless of whether a debtor decides to assume, assign, or reject the executory contract, its decision applies to the entire contract; the debtor cannot cherry pick among the terms of a contract. For this reason, a debtor will generally be incentivized to view a bundle of related agreements as separate independent contracts so as to retain the right to assume only those contracts that are beneficial to its postpetition operations, whereas the counterparty to such related agreements will generally prefer to view the related agreements as one integrated contract which the debtor must assume as a whole so as to retain the benefit of its bargain.
These diverging interests were front and center in In re Physiotherapy Holdings, Inc., a recent decision from the United States Bankruptcy Court for the District of Delaware. Prepetition, the debtors, who operated an outpatient physical therapy clinic, hired a consulting firm to assist in improving their revenue cycle. At that time, the debtors entered into a number of agreements with the consulting firm, including a master agreement and a software license agreement that granted the debtor the right to use the consulting firm’s accounting software. About two years later, the debtors filed petitions under chapter 11 accompanied by a prepackaged plan that sought to assume the software license agreement, while at the same time reject the remaining agreements, including the master agreement. The reason for the selective assumption was no secret: the debtors required the continued use of the licensed accounting software for a period of time post-emergence because the software was critical to the operation of their business. In addition, the debtors had already paid for the use of the accounting software, and, therefore, the cost of assuming was negligible. The debtors sought to reject the master agreement because it contained a broad provision that required the debtors to indemnify the consulting firm for any liability, loss, and expense related to claims by third parties arising out of the consulting firm’s service to the debtors. The debtors could not afford to take on this indemnification risk especially in light of the lawsuit that the prepackaged plan’s litigation trust had commenced against the consulting firm for alleged problems relating to the software. Unsurprisingly, the consulting firm objected to the proposed assumption and rejection and argued that the three agreements were integrated and should be treated as one. The court confirmed the prepackaged plan but reserved judgment on the issue.
In rendering its decision, the court only briefly addressed whether the debtor could assume the license agreement under section 365(c) of the Bankruptcy Code. Section 365(c) prohibits a debtor from assuming or assigning an executory contract, without the consent of the nondebtor party, if applicable nonbankruptcy law would excuse the nondebtor party from accepting or rendering performance from a party other than the original contracting party. In the Third Circuit, courts have applied a strict interpretation of section 365(c), holding that a debtor cannot assume an executory contract where such applicable nonbankruptcy law would prevent assignment to a third party absent consent of the nondebtor party. In certain circumstances, nonbankruptcy law will restrict the assignability of intellectual property. Accordingly, in chapter 11 cases involving the assumption or assignment of intellectual property, section 365(c) often proves to be the most contested point. Here, however, the court concluded that the express terms of the license agreement and the master agreement permitted the assignment of the debtor’s rights under the agreement and, therefore, the explicit terms of the agreements overrode any potential prohibition on the assumption or assignment of the software license.
Having summarily dismissed the 365(c) argument, the court focused its decision almost entirely on whether the three agreements could each be independently assumed, assigned, or rejected or, whether they comprised a single integrated agreement that could only be assumed, assigned, or rejected as one. In support of its objection, the consulting firm directed the court to integration clauses that appeared in both the license and master agreements. In the master agreement, for example, the integration clause provided that the terms of the master agreement “shall be incorporated” into the license agreement. In reply, the debtors’ argued that if the agreements were, in fact, intended to be read as a single agreement, there would be no need for the narrower indemnity provision that appeared in the license agreement because such language would effectively have been moot in light of the broader indemnity clause in the master agreement. Further, the debtors pointed to language in the license agreement stating that the license agreement “supersedes conflicting portions” of the master agreement.
Ultimately, the court concluded that the agreements did not constitute an integrated agreement. For one, the agreements were signed at different times. Two, in the event of a contradiction in the terms between the license agreement and the master agreement, the master agreement “took the back seat.” Three, the court held that the integration clause in the master agreement did not reduce the separate license agreement to a mere component of the master agreement, but instead served to indicate that the intention of the parties were reflected in the agreements as written. Finally, the court distinguished the agreements from multi-part agreements that cannot be severed, such as a master lease that incorporates multiple separate leases by observing that, unlike such multi-part agreements, the agreements at issue could each stand alone as separate and complete agreements. As a result, the debtors were allowed to simultaneously assume the license agreement and reject the master agreement.
This outcome was particularly favorable for the debtors. Had the court found that the agreements were a single integrated agreement that either had to be assumed or rejected as a whole, the debtors would have been faced with the difficult decision of either rejecting the agreements wholesale and losing access to the critical accounting software program or assuming all of the agreements and taking on the unknown cost of indemnifying the consulting firm. When negotiating the terms of prepetition contracts, the implications of the Bankruptcy Code are often given short shrift. Yet, the risk of being in this undesirable bind might just be enough to encourage contracting parties to consider whether their related agreements are, in fact, a single agreement or whether such agreements are separate stand-alone agreements, and to explicitly negotiate terms to reflect such considerations.