Do You Have a Contract with a Debtor in Bankruptcy?

March 5, 2013

by: Robert F. Higgins

Section 365 of the Bankruptcy Code allows a debtor in bankruptcy (with the permission of the bankruptcy court) to either assume or reject a partially performed contract or lease to which it is a party at the time of the bankruptcy filing.  This provision effectively allows the debtor to receive the benefits of contracts and leases that are favorable to the debtor, and to terminate those that are not favorable to the debtor.  If the debtor chooses to reject the contract, then the other party to the contract is limited to filing a proof of claim in the bankruptcy and receiving payment as allowed under the Bankruptcy Code, which generally means that the damages will be discharged with payment of only a few cents on the dollar.  If the debtor chooses to assume the contract, then the debtor will be required to cure any existing defaults and perform the remaining obligations under the contract.

A problem that often arises is that the debtor does not immediately seek bankruptcy court permission to assume or reject the contract, but simply continues after the filing of the bankruptcy to receive the benefits of the contract, while at the same time reserving the right to reject the contract later in the bankruptcy, and therefore to avoid the need to perform its own obligations under the contract.  In that event, the other party to the contract is confronted with the question of whether it must continue to perform even though the debtor has not assumed the contract.

A number of bankruptcy courts have held that the other party to the contract can be required to perform under the contract even though the contract has not yet been assumed by the debtor, and even though the debtor may be in default under the contract.  Those rulings put the nondebtor party to the contract at risk that it will end up holding the bag for the debtor’s nonperformance under the contract.  One way to reduce that risk is to have your bankruptcy attorney early in the case ask the bankruptcy court to require the debtor to perform its own obligations under the contract, or to provide “adequate assurance” that it will perform.  The bankruptcy court has the power to enter such orders, but generally does not do so without being asked to do so by one of the parties involved in the matter. 

Before continuing to do business with a bankrupt entity, it is critical to protect your rights.  Being pro-active will help to ensure that you are paid under your contract.