The bankruptcy court found that because the debtor was already subject to a state court-specific performance order compelling it to take the ancillary steps necessary to close the sale, the contract was no longer executory and could not be rejected.

Introduction

In In re Brick House Properties, Bk. No. 20-26250, (Bankr. D. Utah June 11, 2021), the U.S. States Bankruptcy Court for the District of Utah denied a debtor’s motion to reject its prepetition contract for the sale of real property under Section 365 of the Bankruptcy Code. The bankruptcy court found that because the debtor was already subject to a state court-specific performance order compelling it to take the ancillary steps necessary to close the sale, the contract was no longer executory and could not be rejected.

Background

The debtor in this case, Brick House Properties, LLC, owned real property and improvements in Riverton, Utah worth approximately $1.59 million as of December 2020. Included among the real property were about 1.4 acres of pastureland. On Aug. 3, 2016, Brick House entered into a real estate purchase contract to sell 1.005 acres of the pastureland to Vesna Capital, LLC for $250,000. The pastureland was located in a desirable suburb of Salt Lake City, and Vesna intended to subdivide the land into two residential building lots. The parties’ contract provided that the deadline to close the sale “shall be 10 days after receiving Riverton City approval of the subdivision and recordation of the subdivided property.”

Upon execution of the contract, Vesna immediately moved forward with the necessary applications for Riverton City’s approval of its proposed subdivision, but disputes arose between Vesna and Brick House. Ultimately, Vesna commenced a state court action against Brick House asserting claims for, among other things, breach of contract. Vesna filed a motion for summary judgment, and Brick House responded with a motion for judgment on the pleadings. Brick House also moved to amend its answer to assert that the contract was void because it violated Riverton City’s building code. The state court entered an order finding that the contract was valid, that Vesna had substantially performed its obligations under the contract, and that Brick House had breached the contract by interfering with Vesna’s ability to obtain approval of its subdivision application. The state court denied Brick House’s request to void the contract, finding that any violation of Riverton City’s code could be resolved through the issuance of a variance. Accordingly, the state court ordered specific performance requiring Brick House to obtain a variance from Riverton City or, in the alternative, giving Vesna power of attorney to obtain the variance required for approval of the subdivision.

Following the state court’s order, the parties eventually resolved the variance issue in early 2020, just in time for the onset of the COVID-19 pandemic. Vesna continued to move forward with obtaining the approvals needed for the subdivision plat, and secured all but one of the required signatures before Brick House filed for bankruptcy protection on Oct. 21, 2020 in the U.S. Bankruptcy Court for the District of Utah.

Brick House’s owner and sole member, Emily Aune, ran a Montessori school on the property with her husband, and the school paid rent to Brick House. Due to the COVID-19 pandemic, the Montessori school experienced a 50-60% decline in enrollment that negatively impacted cash flow. Although Brick House was current on its mortgage payments as of the petition date, it was in technical default of the mortgage in that its EBITDA had fallen below the level it was required to maintain. There were approximately $287,000 in filed and scheduled unsecured claims against Brick House’s estate. However, 94% of those claims were insider claims of Aune and her husband. Excluding those insider claims, the pool of secured and unsecured claims in Brick House’s bankruptcy case consisted of: nonpriority unsecured claims totaling $17,310.32, property taxes of $17,320.83, and a mortgage in the amount of $784,098.76.

About a week after filing its bankruptcy petition, Brick House filed a motion under section 365 of the Bankruptcy Code to reject the real estate purchase contract. The practical effect of Brick House’s motion, if that motion were granted by the bankruptcy court, would be to relieve Brick House of its performance obligations under the parties’ contract, subject to the requirement that Brick House pay any “cure amounts” necessary to excuse its performance. Vesna filed an objection to the motion to reject, and Brick House filed a sur-reply. After ordering additional briefing on the motion, the bankruptcy court held an evidentiary hearing on April 23. At the conclusion of the evidentiary hearing, the court authorized the parties to submit supplemental briefing on the issue of whether the contract constituted an executory contract in light of the prior rulings of the state court.

Discussion

Brick House argued that the contract was executory and could be rejected under Section 365 and the “Countryman” definition of executory contracts: in general terms, that definition is expansive and would provide that a contract is “executory” where substantive performance is due from both parties to the contract. Vesna contended that the state court order of specific performance rendered the contract nonexecutory, notwithstanding that the order was limited to the issue of resolving the variance issue. The bankruptcy court agreed with Vesna, and held that the contract was non-executory and could not be rejected.

The bankruptcy court first noted that courts generally agree that the term “executory contract” cannot be applied to a judicial order, because “once a judgment for specific performance is entered, the parties’ remaining unperformed obligations become nonmaterial, or ‘ministerial’ acts through which the parties merely carry out the court’s directive.” In the dispute at bar, the court found that Vesna had obtained an order of specific performance from the state court following Brick House’s refusal to resolve the variance issue with Riverton City. The state court had rejected Brick House’s attempt to void the contract, finding that any violation of the building code could be resolved by a variance, and entered an order of specific performance compelling Brick House to obtain the variance or, alternatively, enabling Vesna to do so. The bankruptcy court found that, while most specific performance orders on real estate contracts order the seller to convey title, the state court’s specific performance order had “the obvious intent of facilitating Vesna’s efforts to record the subdivision plat and close the sale.” Consequently, the bankruptcy court held that the intent of the state court’s order was to remove Brick House’s discretion as to performance under the contract and to require the debtor to halt all efforts to avoid the sale and to take all steps necessary to close the sale. As such, Brick House’s performance under the contract was no longer deemed “executory,” but was merely a ministerial act necessary to carry out the state court’s directive.

The bankruptcy court further held that even had the state court’s order not rendered the contract non-executory, the contract was nevertheless non-executory because it did not satisfy the “Countryman” definition of an executory contract. As noted above, under that standard—as adopted by courts within the Tenth Circuit—a contract is executory where “significant unperformed obligations” remain on both sides of the transaction. Because Brick House’s only remaining obligation was to convey legal title upon Vesna’s tender of the purchase price, the bankruptcy court found that no “significant” obligations remained unperformed.

Conclusion

Following Brick House, potential debtors should not assume that they can use the bankruptcy process to avoid their obligations under all contracts to which they may be party. The bankruptcy court found, among other things, that Brick House had filed its bankruptcy petition for the express purpose of dissolving its contract with Vesna after getting cold feet in the sale. Further, the bankruptcy court noted that rejection was an abuse of Brick House’s business judgment and did not reflect rational financial analysis: it reasoned that, had Brick House allowed the sale to close, the purchase price paid by Vesna would have been more than sufficient to pay in full all noninsider claims and ameliorate the cash-flow issues of the Montessori school owned by Brick House’s principal and her husband. In other words, but for its unreasonable refusal to let the sale close, Brick House did not need to be in bankruptcy.

In short, potential debtors should not assume that a bankruptcy filing will necessarily be their “cure-all.” Instead, they should be mindful of the fact that even the expansive “Countryman” definition of an “executory contract” will not necessarily save them in the event that they present to the bankruptcy court already burdened with a state court order of specific performance.

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.

Malcolm Bates, an associate with the firm, practices in the area of business reorganization and financial restructuring.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.