What happens to contracts?

Inasmuch as the appeal of American capitalism derives from the strength and predictability of its institutions, the sanctity of contracts forms one of its pillars.  In principle and generally in practice, parties cannot disavow contractual obligations based on caprice or changed circumstances . . . except in bankruptcy.

Article I, Section 8, Clause 4 of the United States Constitution authorizes Congress to enact “uniform Laws on the subject of Bankruptcies throughout the United States.”  Without going into all the history and detail, Congress assigned to federal District Courts, which then more or less delegated to the Bankruptcy Courts, the job of administering the Bankruptcy Code (title 11 of the United States Code).  Under the Bankruptcy Code, Congress expressly authorizes debtors to disavow (i.e., “reject”) executory contracts (i.e., contracts for which the parties have material outstanding obligations) under certain circumstances, subject to Bankruptcy Court approval.  In general, the non-bankrupt party treats rejection as a material breach of the contract as of the date of filing of the bankruptcy petition that excuses the non-bankrupt party from having to perform, with any resulting claim against the bankrupt party channeled through the bankruptcy claims process and paid pennies on the dollar.  Of course, exceptions and nuances exist, but this is the general rule.  No other judicial or administrative body in the United States has this power.  For this reason, and also because the Bankruptcy Code does not require insolvency as a prerequisite for filing a bankruptcy case, businesses that otherwise would not have filed for bankruptcy have filed for chapter 11 protection as a strategy for walking away from contracts or using the threat of walking away from contracts to compel renegotiations of contracts.

The foregoing presents a corporate restructuring lawyer’s perspective on how to deal with burdensome contracts.  Any litigator will attest, however, that it does not present the complete playbook.  Since the onset of COVID-19, corporate lawyers have had to refresh themselves on force majeure clauses and other defenses to enforcement of contracts, such as impossibility, impracticability, frustration of purpose, and mutual mistake.  Different standards apply for each, but all aspire to capture situations where performance of an executory or non-executory contract by one or more parties cannot or should not occur as a practical matter; it does not suffice that performance is merely inconvenient or commercially disadvantageous.  For obvious reasons, courts typically set a high bar and can be skeptical of commercially sophisticated parties invoking these defenses.  COVID-19 may change that.

It seems a safe bet that state and federal courts will see a surge of litigation seeking to excuse non-performance of contracts.  Much of this may play out in the Bankruptcy Courts.  Unlike many state and federal courts that have closed temporarily, most Bankruptcy Courts have remained open for new filings done electronically and also for telephonic or video hearings on a more limited basis.  Also, litigation in Bankruptcy Courts tends to proceed on a more expedited basis.  Companies already contemplating filing for chapter 11 protection, and even some not considering it, may decide bankruptcy provides a more efficient vehicle and more options for dealing with executory and non-executory contracts.  While technical (i.e., jurisdictional and constitutional) hurdles may arise to litigating contract claims in Bankruptcy Courts, procedural solutions are available, including District Courts overseeing adversary proceedings and other litigation relating to bankruptcy cases.

Certainly, it is not novel to counsel clients on their options for dealing with contracts.  That said we have had to expand our portfolio to encompass litigation options that until now we have not considered part of our core strategy.  At the same time, we have had to reacquaint ourselves with cases and other precedent we have not reviewed since the first year of law school.  Consequently, in connection with “first day” and other filings in chapter 11 cases, Bankruptcy Courts (and District Courts) should be prepared not only for motions to reject executory contracts but also for adversary proceedings and other litigation invoking force majeure and other defenses to excuse non-performance under contracts.

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