In September 2011, Bruce Cohen and his production company, Bruce Cohen Productions, entered into an agreement (the “Cohen Agreement”) with SLP Films, Inc., a non-debtor special purpose entity formed by The Weinstein Company (“TWC”) to make Silver Linings Playbook (the “Picture”). The parties structured the Cohen Agreement as a “work-made-for-hire” contract, meaning Cohen owned none of the intellectual property in the Picture. In exchange, SLP Films agreed to pay Cohen $250,000 in fixed initial compensation, as well as contingent future compensation equal to roughly 5% of the Picture’s net profits (“Contingent Compensation”).

The Picture was successfully released in November 2012 and resulted in an Academy Award for Best Actress for Jennifer Lawrence.  The Bankruptcy Court subsequently found that TWC owned all the rights pertaining to the Picture, including the Cohen Agreement.

In 2017, TWC’s business floundered following many credible sexual misconduct allegations against its co-founder, Harvey Weinstein. As a result, TWC tried to sell its business and ultimately found Spyglass Media Group, LLC (“Spyglass”) as the only interested buyer. In March 2018, TWC filed its Chapter 11 bankruptcy petition and asked the Bankruptcy Court to approve the sale to Spyglass under Section 363 of the Bankruptcy Code. The sale closed in July 2018, though the Purchase Agreement gave Spyglass until November 2018 to designate which of TWC’s executory contracts it wanted to assume as part of the sale.

Cohen asserted that the Cohen Agreement was an executory contract and the amount necessary to cure all defaults under the Cohen Agreement was approximately $400,000. But Spyglass believed that the Cohen Agreement was not executory and in October 2018, it filed a declaratory judgment action against Cohen seeking a determination that the Cohen Agreement “is not executory and therefore was already [sold] to [Spyglass] pursuant to Bankruptcy Code section 363.”

The Court began its analysis by noting that, in the Third Circuit, the test for determining whether a contract is an executory contract is the Countryman Test—whether each counterparty to the contract has at least one material obligation to perform as determined by governing state law. 997 F.3d at 504.  The Court further found that

“the Countryman test attempts to foolproof the debtor’s choice to assume or reject contracts; thus, the debtor only has that flexibility for executory contracts—those contracts where there could be uncertainty about whether they are valuable or burdensome. A helpful perspective is to view executory contracts “as a combination of assets and liabilities to the bankruptcy estate; the performance the nonbankrupt owes the debtor constitutes an asset, and the performance the debtor owes the nonbankrupt is a liability.” Columbia Gas, 50 F.3d at 238 (citing Thomas H. Jackson, The Logic and Limits of Bankruptcy Law 106–07 (1986)). Under this framework, 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. See 3 Collier, supra ¶ 365.02[2](a). Treating it as an executory contract risks inadvertent rejection because the debtor would in effect be giving up an asset by rejecting it. Id. 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. Treating it as an executory contract risks inadvertent assumption, for the debtor would effectively be agreeing to pay the liability in full when the counterparty should instead pursue the claim against the estate like other (typically unsecured) creditors. It logically follows that where “the only remaining obligation is the [debtor’s] duty to pay”—the contract is not executory. See In re Teligent, Inc., 268 B.R. 723, 732 (Bankr. S.D.N.Y. 2001); see also Lubrizol Enter., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1046 (4th Cir. 1985). Thus, 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—do we invite the debtor’s business judgment on whether the contract should be assumed or rejected. See Mission Prod. Holdings, Inc. v. Tempnology, LLC, ––– U.S. ––––, 139 S. Ct. 1652, 1658, 203 L.Ed.2d 876 (2019); In re Penn Traffic Co., 524 F.3d 373, 382 (2d Cir. 2008). ”

Id. at 505.

The Court then applied this test to the Cohen Agreement and considered whether, under New York’s substantial performance test, each party had at least one remaining obligation under the Cohen Agreement that would constitute a material breach if not performed.  The Court found that TWC’s obligation to pay Cohen contingent compensation was clearly material because the amount of the Cohen’s contingent compensation greatly exceeded the fixed initial compensation. Id. at 507.

But the Court found that Cohen did not have any unperformed material obligations under the Cohen Agreement. The Court noted that “the essence of the Cohen Agreement was for Cohen to produce the Picture in exchange for money” and Cohen “contributed almost all his value when he produced the movie.” Id. The Court found that Cohen’s remaining obligations were “all ancillary after-thoughts in a production agreement.”  Id. The Court further found that (i) Cohen’s agreement to refrain from seeking injunctive relief about the exploitation of the Picture was redundant because Cohen had no intellectual property interest in the Picture, (ii) Cohen’s indemnification obligations were immaterial because the statute of limitations had likely run on any third party claims and (iii) the restrictions on Cohen’s ability to assign the agreement were ancillary boilerplate provisions.  Id.

The Court next considered Cohen’s argument that the parties had agreed in the Contingent Compensation provision of the Cohen Agreement that all of Cohen’s obligations were material. That provision provides that

[i]f the Picture is produced with [Cohen] as the producer thereof and [Cohen] fully perform[s] all required services and obligations hereunder and in relation to the Picture, and [is] not otherwise in breach or default hereof, [Cohen] shall be entitled to receive [Contingent Compensation].

The Court first noted that parties to an agreement can contract around a default rule such as the substantial performance rule—”that they can agree that what to the ordinary person is immaterial is nonetheless not so.” Id. The Court further found that “where the contract makes plain that certain unperformed obligations are material, we can conclude the contract is executory without further analysis.” Id. at 508 (citing In re General DataComm Industries, Inc., 407 F.3d 616, 623-24 (3d. Cir. 2005)). “Put another way, a breach can be considered material if ‘upon a reasonable interpretation of the contract, the parties considered the breach as vital to the existence of the contract.’” Id. (citing 23 Richard A. Lord, Williston on Contracts § 63:3 (4th ed. 2018)).

Turning to the Cohen Agreement, the Court rejected Cohen’s “forceful” argument because “the parties did not clearly and unambiguously avoid the substantial performance rule for evaluating executory contracts.”  The Court found that, in contrast to the cases upon which Cohen relied “where courts deferred to the parties’ agreement that all terms in the contract are material dealt with the remedies or termination section [of the agreement]”, the language Cohen relied on in the Cohen Agreement was “a nine-word phrase buried in a long covenant provision.^” Id. The Court further found that the distinction between a covenant and termination is meaningful.  Id. “When parties say that breach of a provision would result in termination or rescission of the contract, they make clear that the provision is material.” Id. “By contrast, covenants address the parties’ obligations (i.e., what they must and must not do) and typically are not a natural place to look when determining which of those obligations the parties consider to be material.”  Id. at 508-09.

The Court also found that the requirement that Cohen not be in default was better viewed as a condition to payment of the Contingent Compensation, not an obligation. “There is a distinction … between failure of a condition and a breach of a duty …. “[I]f the remaining obligations in the contract are mere conditions, not duties, then the contract cannot be executory for purposes of § 365.”  Id. at 509 (quoting In re Columbia Gas Sys. Inc., 50 F.3d 233, 241 (3d Cir. 1995)).

The Court then concluded as follows:

“To be clear, we recognize that parties can contract around a state’s default contract rule regarding substantial performance, and by doing so they can also override the Bankruptcy Code’s intended protections for the debtor. However, that result can only be accomplished clearly and unambiguously in the text of the agreement. For the reasons explained above, we do not believe the Cohen Agreement avoided New York’s substantial performance rule.”

Id. at 509. Accordingly, the Court held that the Cohen Agreement was not an executory contract because “Cohen’s remaining obligations were immaterial and ancillary to the purpose of the contract ….” Id.

In a February 10, 2015 letter opinion in the CWC Liquidation Inc. f/k/a Coldwater Creek Inc.) bankruptcy case, Chief Judge Shannon of the United States Bankruptcy Court for the District of Delaware held that a photographer did not hold a priority claim under Section 503(b)(9) of the Bankruptcy Code for the value of photographs provided to the debtors within the 20 days prior to the bankruptcy filing.  Pursuant to the applicable contract, the photographer was required to provide photographer services and work product to the debtors.  Judge Shannon held that the photographer provided services, not goods, because (i) the contract referred to services to be provided on numerous occasions and (ii) the relationship between the parties was that of a service provider.

Chief Judge Gross of the United States Bankruptcy Court for the District of Delaware recently issued an opinion further developing the contours of the preferential treatment afforded to commercial landlords under section 365(d)(3) of the Bankruptcy Code.  See WM Inland Adjacent LLC v. Mervyn’s LLC (In re Mervy­­­­­­­­n’s), Adv. Proc. 09-50920 (KG) (Del. Bankr., Jan. 8, 2013).  Section 365(d)(3) requires a debtor in possession to “timely perform all the obligations of the debtor … arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title.”

In the Mervyn’s adversary proceeding, a commercial landlord sought indemnification from the debtor pursuant to the terms of the lease related to the landlord’s post-rejection settlement of a foreclosure suit in California state court.  The lease provided that the debtor was required “to keep the premises free of mechanics’ liens, and pay [the landlord] as additional rent all amounts and charges due under the Lease, including attorneys’ fees.”  Id. at p. 2.

The foreclosure suit was instituted by a contractor who was owed money by the debtor for work done pre-petition on the property the landlord leased to the debtor.  Following the petition date, but prior to the rejection of the lease, the contractor filed mechanics’ liens against the landlord’s real property and filed the foreclosure suit.  The contractor and the landlord entered into a settlement of the foreclosure suit following rejection of the lease.

The landlord argued that its indemnification claim fell within the ambit of Section 365(d)(3) of the Bankruptcy Code.  The debtor argued that the indemnification obligation gave the landlord a pre-petition, unsecured claim either because (i) the obligation arose upon rejection of the lease under section 502(g) or (ii) it arose prior to the bankruptcy filing at the time that the contractor performed the work for the debtor.

Judge Gross readily rejected the debtor’s first argument, stating that “[t]he damages giving rise to the [the landlord’s indemnification claim] did not stem from the rejection of the Lease. Rather, the damages arose from the filing of mechanics’ liens against the Premises, a matter entirely separate from the rejection of the Lease.  Opinion at 11.

The Court also dismissed the debtor’s second argument.  Citing the Montgomery Ward decision, Judge Gross noted that “[t]he language of section 365(d)(3) refers to an ‘obligation,’ which is ‘something one is legally required to perform under the terms of the lease . . . and such an obligation arises when one becomes legally obligated to perform.’  Montgomery Ward, 268 F.3d at 209.  In the context of section 365(d)(3), the Court of Appeals for the Third Circuit noted the importance of post-petition, pre-rejection performance by debtor tenants ‘at the time required in the lease.’”  Id. at 11-12.  Following the Third Circuit’s directive that the terms of the lease dictate the time that an obligation arises, Judge Gross held that “once [the contractor] recorded the . . . Liens against the Premises . . . and [the landlord] was sued by [the contractor] . . ., the terms of the Lease dictate that Mervyn’s was obligated to indemnify [the landlord].”  Id.  Accordingly, Judge Gross held that the indemnification obligation arose post-petition despite the fact that the conduct and the debtor’s obligation to pay the contractor arose pre-petition.

In the alternative, the debtor argued that the indemnification obligation would not fall within the ambit of section 365(d)(3) of the Bankruptcy Code because the obligation arose when the foreclosure suit was settled after the lease was rejected, which was when the actual dollar amount of the obligation became known.  In addressing this issue, Judge Gross noted that “[i]n the context of section 365(d)(3), the relevant time is when an ‘obligation’ arises, which is different from when a ‘claim’ arises.  The Court of Appeals for the Third Circuit distinguished a ‘claim,’ which is an ‘unmatured right to payment,’ from an ‘obligation,’ which is ‘something one is legally required to perform under the lease.’”  Id. at 13.  Judge Gross then held that “[w]hile the Lease and conduct giving rise to the [indemnification claims] took place pre-petition, the actual “billing date,” or obligation, arose when [the contractor] filed its mechanics’ liens and it sued to foreclose upon them.  Therefore, the [indemnification claims] arose post-petition and pre-rejection under section 365(d)(3) as in Montgomery Ward.”  Id.

The debtor next argued that, even if Section 365(d)(3) was applicable, the landlord could not meet its burden of establishing its right to administrative expense treatment under Section 503(b)(1) of the Bankruptcy Code.  Relying on the language “notwithstanding section 503(b)(1) of this title” in Section 365(d)(3) and Judge Sontchi’s opinion in In re Goody’s Family Clothing, Inc., 401 B.R. 656 (D. Del. 2009) aff’d sub nom. In re Goody’s Family Clothing, Inc., 610 F.3d 812 (3d Cir. 2010), Judge Gross held that Section 503(b)(1) was inapplicable because the landlord’s indemnification claim stemmed from post-petition obligations under the lease pursuant to Section 365(d)(3).

Finally, the debtor raised two public policy arguments.  First the debtor argued that elevating the landlord’s indemnification claim to administrative priority status “’simply by conspiring with a third-party plaintiff’ would encourage a wait-and see hedging of bets regarding an anticipated bankruptcy.”  Opinion at 15.  Second, the debtor argued that granting the landlord administrative claim status would be inequitable.  Judge Gross dismissed both of these arguments because the indemnification obligation “arising from the Lease fits squarely into section 365(d)(3) and the Montgomery Ward rationale.”  Id.

The Mervyn’s opinion is likely correct under Montgomery Ward, which Judge Gross was constrained to follow, and the Montgomery Ward opinion was arguably correct based on a strict construction of Section 363(d)(3).  But the debtor’s public policy arguments raise legitimate questions regarding the application of Section 365(d)(3).  While the landlord and contractor in Mervyn’s may not have conspired to reach the result achieved, it is not hard to imagine a savvy landlord with experienced bankruptcy counsel making strategic decisions when a tenant’s bankruptcy is looming that could dramatically affect the landlord’s recovery.  For example, in Montgomery Ward where, pursuant to the terms of the lease, real property taxes were due upon receipt by the tenant, the landlord’s claim for property taxes for two full years in the amount of $426,729.87 was elevated to administrative expense priority status simply because the landlord sent three property tax bills to the debtor four days after the bankruptcy was filed despite the fact that the post-petition, pre-rejection period lasted approximately two months.  See Montgomery Ward, 268 F.3d at 207.  Judge Mansmann recognized both of these issues in her dissent in Montgomery Ward, stating “[i]n so holding, the majority elevates the accident or artifice of the billing date above the economic reality of the accrual, and thereby inappropriately burdens the administration of the bankrupt estate and unfairly favors landlords over similarly situated pre-petition creditors.”  Id. at 213.  Perhaps it is time for Congress to consider the policy implications of the Third Circuit’s interpretation of Section 365(d)(3).

VIEW OPINION

Section 363(m) of the Bankruptcy Code moots appeals of sale orders if a reversal of the order would “affect the validity of the sale.”  11 U.S.C. § 363(m).  The Third Circuit previously stated that this would include any appeal challenging a “central element” of the sale order subject to the appeal.  See Pittsburgh Food & Beverage v. Ranallo, 112 F.3d 645 (3d Cir. 1997).  In a recent case, the Third Circuit made explicit that a term in an asset purchase agreement transferring proceeds of estate causes of action to a trust in favor of the purchaser was a “central element” of the sale transaction and hold that an appeal seeking to eliminate the trust from the asset purchase agreement was barred as moot by Section 363(m).  Boeing Co. v. Alabama Aircraft Industries, Inc., Appeal No. 12-1290, December 12, 2012.