Following the minority line of cases in a notable split of authority among the circuits, the U.S. Bankruptcy Court for the District of New Mexico held that 11 U.S.C. Section 365(c)(1) does not prohibit assumption of an executory contract. In In re Aerobox Composite Structures, the bankruptcy court denied a licensor's motion to compel the debtor to reject a license agreement and/or for relief from the automatic stay to permit the licensor to cancel the agreement.
Facts and Background
Aerobox Composite Structures LLC (the debtor) filed a voluntary petition for relief under Chapter 11 of title 11 of the Bankruptcy Code on Jan. 23. Prior to the petition date, the debtor and Tubus Bauer GmbH entered into a patent and technology license agreement to which Tubus Bauer granted the debtor certain exclusive and non-exclusive licenses. The license agreement allowed for assignment of the subject licenses only after prior written approval by Tubus Bauer, such approval not to be unreasonably withheld. As of the petition date, the debtor had paid all monetary consideration to Tubus Bauer and had not at any time sought to assume or assign the license agreement.
Tubus Bauer asserted that the debtor was compelled to reject the license agreement, arguing that it was an executory contract that the debtor could not assume or assign under 11 U.S.C. Section 365(c)(1). In the alternative, Tubus Bauer argued that the court was required to lift the automatic stay to permit Tubus Bauer to reject the license agreement, since Section 365(c)(1) precluded the debtor from assuming or assigning it. The debtor, the unsecured creditors' committee and the debtor's postpetition financier opposed the motion.
As a preliminary matter, the court analyzed whether the license agreement was an executory contract. Although Tubus Bauer had been paid all monetary consideration, the court found that the license agreement was executory due to certain continuing material duties and obligations of both parties - namely, the debtor's duty not to sell certain materials and to maintain confidentiality, and Tubus Bauer's duty to defend its patent.
The court then turned to 11 U.S.C. Section 365(c)(1), which provides that:
"The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if: (1) (A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and (B) such party does not consent to such assumption or assignment."
Circuit Split
The court recognized a split in authority regarding the construction and application of Section 365(c)(1). Tubus Bauer urged the court to follow the majority of the circuit courts, which adhere to the "hypothetical test" articulated by the 9th U.S. Circuit Court of Appeals in Perlman v. Catapult Entm't (In re Catapult Entm't, Inc.). The Catapult court read Section 365(c)(1) to "[bar] a debtor in possession from assuming an executory contract without the nondebtor's consent where applicable law precludes assignment of the contract to a third party." That court found that to read otherwise, allowing a debtor in possession to assume any executory contract as long it did not contemplate assignment thereof, would effectively rewrite the statute to prohibit "assumption and assignment, rather than assumption or assignment." The Catapult court held that "where applicable nonbankruptcy law makes an executory contract nonassignable because the identity of the nondebtor party is material, a debtor in possession may not assume the contract absent consent of the nondebtor party."
In response, the unsecured creditors' committee urged the court to apply the "actual test" articulated by the 1st Circuit in Institut Pasteur v. Cambridge Biotech Corp. The "actual test" calls upon courts to make case-by-case inquiries to determine "whether the nondebtor party . . . actually was being forced to accept performance under its executory contract from someone other than the debtor party with whom it originally contracted."
The Cambridge Biotech court noted that Section 365(c)(1) is aimed at protecting non-debtor parties to personal service contracts from being forced to accept service from or render service to an entity other than the one with which it originally contracted. That court reasoned that since the debtor in possession is not materially distinct from the pre-bankruptcy entity that is party to the executory contract, it is appropriate to determine whether the nondebtor party is actually being forced to accept performance under its executory contract from an entity other than the debtor. The unsecured creditors' committee also argued that Tubus Bauer's categorical refusal to consent to assignment constituted a unilateral attempt by Tubus Bauer to alter the bargained-for terms of the license agreement, and an unreasonable withholding of consent, prohibited under the terms of the license agreement.
In the alternative, the unsecured creditors' committee encouraged the court to follow In re Footstar Inc. The Footstar court reasoned that the use of the term "trustee" in Section 365(c)(1) should not automatically be read to substitute the term "debtor in possession," finding that to do so "would render the provision a virtual oxymoron, since mere assumption [by the debtor in possession] (without assignment) would not compel the counterparty to accept performance from or render it to 'an entity other than' the debtor." Under Footstar, the debtor in possession would be precluded from assignment, since that would force the nondebtor party to the contract to accept performance from or render performance to an entity other than the debtor; but the debtor in possession would be entitled to assume an executory contract because it is "not 'an entity other than' itself."
The Court's Analysis
The court analyzed this issue under both the "hypothetical" and "actual" tests. Using the majority "hypothetical test," the court first had to determine whether applicable nonbankruptcy law would excuse Tubus Bauer from accepting performance from or rendering performance to a hypothetical third party. Because the license agreement involved use of a patent, the court reviewed federal patent law, which generally prohibits assignment of both exclusive and non-exclusive license agreements absent consent of the licensor. Tubus Bauer did not consent to such assignment, and as such, the court determined that under the "hypothetical test," the debtor would be prohibited from assuming or assigning the license agreement, regardless of whether it had attempted to assign same.
Using the minority "actual test," the court found that because the debtor had neither sought to assume nor reject the executory contract, Section 365(c)(1) would not prohibit assumption of the license agreement; thus, Tubus Bauer could not compel the debtor to reject it. The court ultimately found the minority line of cases to be better reasoned. The court ultimately followed this minority position, finding that the license agreement does not prohibit assignment. The court also found that by requiring Tubus Bauer not to unreasonably withhold its consent to assignment, the assignment term of the license agreement was less restrictive than the general federal common law prohibition against assignment of patents absent consent of the licensor - but because the court had already concluded that Section 365(c)(1) could not prevent the debtor from assuming the license agreement, it did not have to determine whether the assignment provision in the license agreement constituted "preconsent" by Tubus Bauer, which would render Section 365(c)(1) inapplicable.
Conclusion
The Aerobox court ruled in accordance with the minority of the circuits to consider this issue, finding that 11 U.S.C. Section 365(c)(1) does not prevent a debtor in possession from assuming an executory contract. This ruling constitutes the very revision of the statute against which the Catapult Entertainment court warned: the Aerobox court's adherence to the "actual test" resulted in a prohibition of assumption and assignment, rather than assumption or assignment, as the statute is written.
This split of authority leads to the question of whether Congress erred in its drafting of Section 365(c)(1) by using the word "or" rather than the word "and," because the policies of the Bankruptcy Code would certainly militate in favor of the minority interpretation of Section 365(c)(1). The split is a significant and substantive one, which may need to be resolved by our Supreme Court or even through a Congressional revision of Section 365.
Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.
Matthew E. Hoffman is an associate at the firm and practices in the area of business reorganization and financial restructuring. Admitted to practice in Pennsylvania and New Jersey, Hoffman is a member of the bankruptcy committee of the Philadelphia Bar Association and the American Bar Association. He also is a contributing editor for American Bankruptcy Institute's 3rd Circuit Update. Hoffman is a 2005 graduate of the Columbia University School of Law, where he was awarded the national Clinical Legal Education Association Outstanding Student Award, and a graduate of Brandeis University.
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