Whether a Contract is Divisible for Purposes of Section 365 of the Bankruptcy Code
Christopher Bolz, J.D. Candidate 2015
Cite as: Whether a Contract is Divisible for Purposes of Section 365 of the Bankruptcy Code, 6 ST.
JOHN’S BANKR. RESEARCH LIBR. NO. 4 (2014).
Introduction
Section 365 of the Bankruptcy Code governs the assumption, rejection, and assignment
of executory contracts and unexpired leases in bankruptcy cases.
1
Although the definition of an
executory contract has not been codified, it is considered to be a contract that has not been fully
performed. The assumption or rejection of an executory contract is achieved through court
approval, except in certain instances concerning Chapter 7 bankruptcy.
2
Rejection leads to a
non-administrative unsecured claim for damages.
3
Following rejection, neither the estate nor the
other party owes performance to one another.
4
The trustee or debtor in possession must assume or reject an executory contract in its
entirety.
5
However, when a “contract” is actually several different contracts, the “contract” may
be divisible.
6
State law governs divisibility.
7
This makes it difficult to pinpoint exactly what
conditions make a contract divisible. However, case law tends to cite the intent of the parties as
1
See 2 Norton Bankr. L. & Prac. 3d § 46:4.
2
See id. § 46:12.
3
See id. § 46:24.
4
See id.
5
See id. § 46:1.
6
See id. § 46:4.
7
See id. § 46:5.
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the most important factor governing divisibility.
8
But, if a court finds that two or more
“contracts” are part of an integrated transaction, the contract must be assumed or rejected in its
entirety.
9
This Article will focus on the rules of divisibility in Kansas, New Jersey, Texas, and
Illinois. Kansas focuses on the intent of the parties.
10
New Jersey looks to intent and the
noninterrelatedness of the obligations of the parties to the agreement.
11
Texas looks at the intent
of the parties, the subject matter of the agreement, and the conduct of the parties.
12
Finally,
Illinois looks at whether the parties would be willing to exchange part performance irrespective
of subsequent events or whether the divisions made are simply for the purpose of requiring
periodic payments.
13
Part I of this Article examine the rejection of executory contracts generally.
Part II will examine how the rules of divisibility are applied in Kansas, New Jersey, Texas, and
Illinois. Finally, Part III will highlight the practical implications of divisibility in regards to the
two parties to the contract.
I. Rejection of Executory Contracts
Only executory contracts and unexpired leases may be assumed or rejected under section
365.
14
Neither the Bankruptcy Code nor the Bankruptcy Act provides a statutory definition of an
executory contract.
15
However, the House and Senate Committee Reports define executory
8
See id. § 46:11.
9
See id.
10
See In re: Hawker Beechcraft, Inc., et al., Reorganized Debtors, No. 12–11873, 2013 WL
2663193, at *3 (Bankr. S.D.N.Y. Jun. 13, 2103).
11
See In re T & H Diner, Inc., 108 B.R. 448, 455 at *450(D.N.J. 1989).
12
See In re Wolflin Oil, L.L.C., 318 B.R. 392, 398 (Bankr. N.D.T. 2004).
13
See Fid. & Deposit Co. v. Rotec Indus., 392 F.3d 944, 947 (7
th
Cir. 2004).
14
See 2 Norton Bankr. L. & Prac. 3d § 46:1.
15
See 2 Norton Bankr. L. & Prac. 3d § 46:5.
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contracts as, “contracts on which performance remains due to some extent on both sides.”
16
Rejection of an executory contract can occur in two ways. Firstly, the executory contract can be
deemed rejected in a Chapter 7 case if the trustee does not act quickly in assuming the contract.
17
Secondly, and more common, a court must approve the rejection of an executory contract.
18
Rejection lies solely with the trustee, subject to court approval.
19
When an unassumed executory contract is rejected after the commencement of a case, the
rejection leads to a nonadministrative unsecured claim for damages.
20
Rejection constitutes a
breach that is deemed to have occurred immediately before the filing of the petition.
21
Following
rejection, the trustee loses the benefit of performance by the other party and avoids future
performance by the state.
22
Rejection leaves the other party with a prepetition claim for
damages.
23
The damages are determined by state law to the extent that they do not conflict with
the Code.
24
Because the claim is considered a prepetition obligation, the debtor usually pays
pennies on the dollar. If the breach is considered a post-petition obligation, the breach will give
rise to an administrative expense, which the debtor will have to pay in full.
II. Divisibility of Executory Contracts
A trustee or debtor in possession must assume or reject an executory contract in its
entirety.
25
He may not choose favorable provisions to assume and unfavorable provisions to
16
See id.
17
See 2 Norton Bankr. L. & Prac. 3d § 46:12.
18
See id.
19
See id.
20
See 2 Norton Bankr. L. & Prac. 3d § 46:24.
21
See id.
22
See id.
23
See id.
24
See id.
25
See 2 Norton Bankr. L. & Prac. 3d § 46:1.
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reject. The contract must be assumed cum onere.
26
However, not every document denoted as a
contract must be treated as a single, indivisible whole. A “contract” may be a term applied to a
document that is actually several different contracts put together.
27
The contract may be
considered severable if this is the case.
State law typically governs whether a contract is divisible.
28
Intent seems to be a factor
that is looked at by most states and is the most important aspect a court looks at when
determining the severability of a contract.
29
Federal courts often apply a three-factor test when
judging intent. The factors are (1) the differing nature and purpose of parts of the agreement, (2)
the separate and distinct consideration which may be attributed to different parts of the
agreement, and (3) the noninterrelatedness of obligations of the parties to the agreement.
30
There
is an exception to these guidelines set out by these courts. If a court finds that two or more
“contracts” are part of an integrated transaction, the trustee or debtor in possession must assume
or reject the contracts in their entirety.
31
Since it is difficult to state a concrete rule about the
divisibility of executory contracts, the remainder of this section will focus on how federal courts
apply different state laws to the issue.
A. Divisibility Under Kansas Law
In In re Hawker Beechcraft, Inc., the United States Bankruptcy Court for the Southern
District of New York applied Kansas state law to determine the divisibility of a contract.
32
There, the debtor and supplier entered into purchase order agreements and two master
26
See id.
27
See id.
28
See 2 Norton Bankr. L. & Prac. 3d § 46:11.
29
See id.
30
See id.
31
See id.
32
See In re: Hawker Beechcraft, Inc., et al., Reorganized Debtors, No. 12–11873, 2013 WL
2663193, at *3 (Bankr. S.D.N.Y. Jun. 13, 2103).
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agreements. After filing, the debtor wanted to assume some purchase orders while rejecting
other purchase orders. The supplier objected, arguing that the master agreements and purchase
orders constituted a single, indivisible contract.
33
Under Kansas law, courts examine the intent of the parties to determine if a contract is
divisible. In another Kansas case, Blakesley v. Johnson, the court stated, “[w]hether or not a
contract is entire or divisible is a question of construction to be determined by the court
according to the intention of the contracting parties as ascertained from the contract itself and
upon a consideration of all the circumstances surrounding the making of it.”
34
In In re Hawker Beechcraft, Inc., several factors demonstrated that the master agreement
and purchase orders were intended to be independent contracts. The integration clause in the
master agreement omitted any reference to the purchase orders, demonstrating that the two
agreements were not to be looked at as a whole.
35
The court also looked to the performance,
termination, and assignment provisions in the master agreement, which showed further evidence
that the purchase orders were to be treated as separate contracts. For example, “If the [m]aster
[p]lastics [a]greement was terminated, any outstanding release which is partially or totally
unfilled on the date of termination shall continue to be subject to all the terms and conditions
hereof.”
36
B. Divisibility Under New Jersey
Under New Jersey law, courts also focuses on the intent of the parties as a guiding factor
in determining whether a contract is divisible. For example, in In re T & H Diner, Inc., The
United States District Court for the District of New Jersey found that a contract was not
33
See id.
34
See id. at *8.
35
See id.
36
See id. at *20.
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divisible, providing a nice contrast to the ruling seen in In Re Hawker Beechcraft, Inc.
37
In T &
H Diner, the debtor executed a purchase agreement with its landlord for a restaurant facility.
The parties also executed a lease agreement. Nine years later, the debtor filed for bankruptcy.
They moved to assume the lease agreement while rejecting the purchase agreement, citing
divisibility.
38
The In Re T & H Diner, Inc. court, focused on the third factor of the three-factor
test mentioned above: the noninterrelatedness of obligations of the parties to the agreement. The
Court stated, “In this matter the lease and purchase agreements are inextricably intertwined.”
39
Evidence backing this up includes the fact that, “the sub-lease specifically states that a default
under the notes will be a default under the sub-lease.”
40
The court also tied this fact into the
concept of the intent between the parties. The court stated, “Since the sub-lease says what it says
in that regard, absent evidence to the contrary or modification or other [parol] evidence, that
provision that the defaults under the notes would be part of the defaults under the sub-lease, was
the intention of the parties at the time they signed the sub-lease.”
41
C. Divisibility Under Texas Law
In, In re Wolflin Oil, L.L.C., the United States Bankruptcy Court for the Northern District
of Texas determined that a master agreement was divisible under Texas law, which applies its
own three-factor test to determine severability. Under Texas law, the court will consider the
following three factors in determining whether a contract is divisible: “(1) the intent of the
37
See In re T & H Diner, Inc., 108 B.R. 448, 455 (D.N.J. 1989).
38
See id. at *450.
39
See id.
40
See id.
41
See id.
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parties; (2) the subject matter of the agreement; and (3) the conduct of the parties.”
42
The intent
of the parties is given the most weight of the three factors.
43
In In re Wolflin Oil, L.L.C., the debtor was an operator of six quick lube service centers.
They were leased from the landlord under six leases. Each lease provided that a default would
occur upon the failure to pay rent. The debtor wanted to assume four of the leases while
rejecting the other two. The landlord claimed that the leases were part of one integrated
contract.
44
The court defined a severable contract as a contract that includes, “two or more
promises which can be acted on separately such that the failure to perform one promise does not
necessarily put the promisor in breach of the entire agreement.”
45
The In re Wolflin Oil, L.L.C. court first looked to the second factor of the test and found
that the subject matter weighed in favor of divisibility.
46
There was nothing in the lease
agreement that said each store could not be operated independently from each other.
47
This
means that it is unlikely that the contracts were part of an integrated transaction. The court then
looked to the third factor of the test and found that the conduct of the parties favored
divisibility.
48
This was due to the fact that the debtor made payments on the stores individually
as opposed to one master payment.
49
“A severable contract may exist when the performance by
one party consists of several distinct and separate items and the price paid by the other party is
apportioned to each item.”
50
The court then turned its focus to the final factor—intent. The
42
See In re Wolflin Oil, L.L.C., 318 B.R. 392, 397 (Bankr. N.D.T. 2004).
43
See id.
44
See id. at *395.
45
See id. at *397.
46
See id.
47
See id.
48
See id. at *398
49
See id.
50
See id.
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language of the contract provides the best evidence of intent.
51
Each lease contained a different
rent calculation. Also, the leases made no references to the other leases.
52
The court held that it
was the intent of the parties to have these contracts be divisible.
D. Divisibility Under Illinois Law
Applying Illinois law, in Fid. & Deposit Co. v. Rotec Indus., the United States Court of
Appeals for the Seventh Circuit did not focus on the parties’ intent as much as the courts in the
previously mentioned cases. Instead, on the issue of divisibility, the court looked to whether the
parties had divided up their performance into installments in such a way that each prior
performance by one party was compensation for a corresponding performance by the other
party.
53
The test was whether the parties would be willing to exchange part performance
irrespective of subsequent events or whether the divisions made were simply for the purpose of
requiring periodic payments.
54
There, the plaintiff was a company that had acquired the debtor’s contract rights. The
debtor had rejected an executory contract with a construction company regarding the
construction of a dam. The plaintiff claimed that the contract was divisible and looked to
enforce other aspects of the contract. The court held that the contract was not divisible because
the debtor had agreed to assist in preparing a bid for a construction project, to allow the bid to be
submitted under its name, and to provide services once the bid was accepted.
55
Performance was
not divisible and separate from the other aspects of the contract.
56
The debtor was expected to
51
See id.
52
See id.
53
See Fid. & Deposit Co. v. Rotec Indus., 392 F.3d 944, 947 (7
th
Cir. 2004).
54
See id.
55
See id. at 948.
56
See id.
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participate throughout the project.
III. Implications
The ability to assume or reject executory contracts, as well as the divisibility of executory
contracts, is crucial to litigants in bankruptcy cases. A party that is in bankruptcy will tend to
want a contract to be divisible. It gives them flexibility in their reorganization. They can reject
contracts that will be detrimental to them, while accepting contracts that will benefit them.
57
Conversely, creditors will tend to prefer a contract to not be divisible. When the contract is
deemed to be divisible, creditors lose control over which obligations they must fulfill.
58
This can
be an economic burden on a creditor. The parties should make sure to address the potential
conflict over divisibility during the drafting of contracts. They should clearly state their intent
regarding the divisibility of the contract. They should also be wary of how the laws of their state
deal with divisibility. However, the problem is that when parties enter into a contract, they may
not anticipate a party going into bankruptcy at a later date. Therefore, the problem regarding
divisibility often goes unaddressed.
Conclusion
Executory contracts can play a major role in bankruptcy proceedings. The ability to
reject them, while paying pre-petition damages, allows for a smoother transition for the debtor.
The divisibility of certain executory contracts further allows a debtor to tailor his bankruptcy
towards his needs. These benefits often depend on the state that the debtor contracts in. State
law governs whether or not an executory contract is divisible. Even though the courts apply
57
See Elizabeth Lea Black, What are "Administrative Expenses" Under § 503 (b) of Bankruptcy
Code (11 U.S.C.A. § 503(b)) Granted First Priority for Payment Pursuant to § 507 (a)(1) of
Code (11 U.S.C.A. § 507(a)(1)), 140 A.L.R. Fed. 1 (2014).
58
See id.
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different standards depending on the state, intent seems to be the most important factor that the
courts look at.
