Fifth Circuit: Bad Faith Does Not Overcome Deferential Business Judgment Standard Applied to Assumption or Rejection of Contracts in Bankruptcy

The ability of a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to assume, assume and assign, or reject executory contracts and unexpired leases is an important tool designed to promote a "fresh start" for debtors and to maximize the value of the bankruptcy estate for the benefit of all stakeholders. Bankruptcy courts generally apply a deferential "business judgment" standard to the decision of a trustee or DIP to assume or reject an executory contract or an unexpired lease.

In In re J.C. Penney Direct Marketing Services, L.L.C., 50 F.4th 532 (5th Cir. 2022), the U.S. Court of Appeals for the Fifth Circuit affirmed lower court rulings approving a DIP's decision, at the behest of the purchaser of its assets, to reject a commercial ground lease, even though an agent retained by the DIP to market its shopping center leases acted in bad faith in negotiations with a sublessee intent upon acquiring the ground lessor's interest. In so ruling, the Fifth Circuit rejected the sublessee's argument that the DIP's decision to reject the lease should not receive deference under the business judgment standard due to the agent's bad faith. According to the Fifth Circuit, in the absence of evidence that the decision to reject did not enhance the bankruptcy estate or was "clearly erroneous, too speculative, or contrary to the Bankruptcy Code," the presumption created by the business judgment rule could not be overcome. Nor, the court noted, did the sublessee demonstrate that the DIP's decision was "so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice."  

Assumption and Rejection of Executory Contracts and Unexpired Leases in Bankruptcy

Section 365(a) of the Bankruptcy Code provides that, with certain exceptions delineated elsewhere in the statute, "the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor." The trustee's power to assume or reject contracts and leases (among other powers) is conferred upon a DIP under section 1107(a) of the Bankruptcy Code. Rejection results in a court-authorized breach of the contract, with any claim for damages treated as a prepetition claim against the estate on a par with the claims of other general unsecured creditors (unless the debtor has posted security). 11 U.S.C. § 365(g). Assumption of a contract requires, among other things, that the trustee or DIP "cure" all existing monetary defaults and provide "adequate assurance of future performance." 11 U.S.C. § 365(b). The cure obligations set forth in section 365(b)(1) do not apply to defaults triggered by the debtor's financial condition (including its bankruptcy filing) and certain other breaches. See 11 U.S.C. § 365(b)(2).

The Bankruptcy Code does not define the term "executory." Many courts have adopted the test for executoriness articulated by Professor Vern Countryman, who in 1973 defined an "executory" contract as "[a] contract under which the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other." See V. Countryman, "Executory Contracts in Bankruptcy: Part I," 57 Minn. L. Rev. 439, 460 (1973); see also V. Countryman, "Executory Contracts in Bankruptcy: Part II," 57 Minn. L. Rev. 479 (1974); see generally Collier ¶ 365.02 (16th ed. 2022) (citing cases). If a contract or lease is not executory, it may be neither assumed nor rejected. Instead, the contract may give rise to either an estate asset or a liability—in the latter case, a claim that may be asserted against the estate by the non-debtor party.

The trustee or DIP may not assume or assign any executory contract or unexpired lease, whether or not such contract or lease prohibits or restricts an assignment of rights or delegation of duties, if: (i) applicable law excuses the non-debtor party from accepting performance from or rendering performance to an entity other than the debtor or the DIP, and the non-debtor party does not consent to assumption or assignment; (ii) the contract is one "to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor"; or (iii) the lease is a nonresidential real property lease that was terminated under applicable non-bankruptcy law prior to entry of the order for relief. 11 U.S.C. § 365(c).

Bankruptcy courts generally will approve a proposed assumption or rejection of a contract or lease if presented with evidence that either course of action is a good business decision. See Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652, 1658 (2019) ("The bankruptcy court will generally approve [the] choice [to assume or reject], under the deferential 'business judgment' rule."); Richmond Leasing Co. v. Cap. Bank, N.A., 762 F.2d 1303, 1309 (5th Cir. 1985) ("as long as assumption of a lease appears to enhance a debtor's estate," a bankruptcy court should withhold approval only when "the debtor's judgment is clearly erroneous, too speculative, or contrary to the provisions of the Bankruptcy Code"); see generally Collier at ¶ 365.03[2] (citing cases and noting that "[u]nder the Code, most courts have applied a 'business judgment' test to trustees' decisions to assume or reject contracts or leases").

Some courts have concluded that a bankruptcy court should summarily affirm a DIP or trustee's decision to assume or reject a contract or lease unless it is "so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim, or caprice." Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1047 (4th Cir. 1985); accord In re Mallinckrodt PLC, 2022 WL 906458, *6 (D. Del. Mar. 28, 2022); In re Fin. Oversight & Mgmt. Bd. for Puerto Rico, 631 B.R. 559, 569 (D.P.R. 2021); In re Trans World Airlines, Inc., 261 B.R. 103, 121 (Bankr. D. Del. 2001); In re Wheeling-Pittsburgh Steel Corp., 72 B.R. 845, 850 (Bankr. W.D. Pa. 1987). 

Upon assumption, most kinds of executory contracts also may be assigned by the trustee or DIP to third parties under the circumstances specified in sections 365(c) and 365(f). Pending the decision to assume or reject, the trustee or DIP generally is obligated to keep current on most obligations that become due under the contract postpetition. 11 U.S.C. §§ 365(d)(3) and (d)(5).

J.C. Penney

In 1971, J.C. Penney Properties, Inc. ("JCP") leased commercial real estate in Illinois at below-market rent from a ground lessor for 30 years with an option to extend the lease for an additional 70 years. In 1981, JCP subleased the shopping center property, which was then unprofitable, to a bank trustee, thereby rendering JCP a pass-through entity because the ground lease and the ground sublease provided for identical rental payments. Thereafter, JCP had no ongoing operations associated with the property. In a separate agreement, the bank trustee purchased the existing improvements on the parcel from JCP for approximately $4 million. The bank then assigned its interest in the ground sublease to Klairmont Korners, L.L.C. ("Klairmont"). In later years, Klairmont unsuccessfully attempted to obtain a non-disturbance agreement from the ground lessor and to purchase both the property and JCP's interest in the ground lease.

In 2020, JCP filed for chapter 11 protection in the Southern District of Texas for the purpose of selling substantially all of its assets as a going concern under a chapter 11 plan. JCP ultimately negotiated a multibillion-dollar transaction to sell its business under an asset purchase agreement (the "APA") with Copper Retail JV LLC and an affiliate (collectively, "OpCo") that would be the cornerstone of a chapter 11 plan. The court confirmed that plan in December 2020, after which JCP began to liquidate its remaining assets. Under the plan, rejected leases would be terminated and the non-debtor parties thereto would have an unsecured claim for any damages, and assumed leases would be sold or assigned to OpCo. The final decision whether to assume or reject leases (the "designation rights") would be made by OpCo pursuant to the terms of the APA.

The court authorized JCP to retain a real estate agent to market JCP's 800 unexpired leases. The agent repeatedly provided false information to Klairmont for the purpose of starting what became a messy bidding war for the ground lease. During those negotiations, Klairmont made several offers (ranging from $1.25 million to $3 million) to induce JCP to assume the ground lease and to assign it to Klairmont. Meanwhile, the ground lessor engaged in negotiations to extract itself from this below-market lease. Aided by the agent's disclosure of confidential information, the ground lessor and an investor first offered $1.5 million to induce JCP to reject the ground lease and then raised the offer to $1.7 million.

Even though the consideration offered by Klairmont was greater, JCP and OpCo decided that the ground lessor's offer was preferrable, largely due to litigation costs associated with the Klairmont offer arising from an anticipated dispute over the amount of adequate assurance payments required to assume and assign the ground lease. In March 2021, JCP, at OpCo's direction, sought court authority to reject both the ground lease and ground sublease, but subsequently withdrew its motion to reject the ground sublease.

The bankruptcy court expressed dismay regarding the events surrounding the negotiations and the bidding process, including the outright lies told by the agent and the mistreatment of Klairmont. The bankruptcy court noted that the dispute concerning the ground lease—which involved at most approximately $2 million to $3 million—risked unraveling a multibillion-dollar sale transaction involving far more than the ground lease.

The bankruptcy court authorized JCP to reject the ground lease. In doing so, it found that: (i) JCP sold the designation rights to OpCo under the APA; (ii) the tainted bidding process between the ground lessor/investor and Klairmont was not relevant to the question of JCP's exercise of sound business judgment; (iii) the decision to reject the ground lease was the result of an exercise of prudent business judgment; and (iv) although Klairmont was treated unfairly, the unfair treatment had no bearing on JCP's decision.

Klairmont appealed to the district court, arguing that JCP's process for arriving at the decision to reject the ground lease was "outside the bounds of business judgment" and that JCP's decision to reject the ground lease was not timely in accordance with the terms of the APA. The district court affirmed the bankruptcy court's ruling. In addition to finding that the ground lease was timely rejected, the district court concluded that JCP's decision to abide by OpCo's direction to reject the ground lease reflected sound business judgment.

In so ruling, the district court noted as follows:

Any consequences to JCP of OpCo's decision [to reject the ground lease] paled in comparison to JCP's duties under the APA to honor OpCo's choice. So even if the offer accepted did not yield the highest amount of money or there was some defect in the process, such as the alleged passing of deadlines, it was within JCP's business judgment whether to stand or fall on a challenge to OpCo's decision—whether as a substantive or procedural matter. Given the competing concerns, which involved much more than the $3 million Klairmont offered, the Court cannot conclude that the Bankruptcy Court abused its discretion or clearly erred as a matter of fact in finding that JCP's decision was within the bounds of appropriate business judgment.

Klairmont Korners, LLC, 2022 WL 2136902, at *15 (S.D. Tex. June 10, 2022), aff'd sub nom. Matter of J. C. Penney Direct Mktg. Servs., L.L.C., 50 F.4th 532 (5th Cir. 2022).

Klairmont appealed to the Fifth Circuit.

The Fifth Circuit's Ruling

The Fifth Circuit affirmed the district court's ruling in a per curiam opinion.

Initially, the Fifth Circuit noted that the business judgment standard applied to JCP's decision to reject the ground lease. It declined to adopt the "bad faith, whim, or caprice" standard, but ruled that Klairmont's appeal failed under both standards.

According to the Fifth Circuit, "Klairmont misapprehends the lens through which courts view the business judgment rule." "The question," it wrote, "is not whether the debtor's decision reasonably protects the interests of other parties, but rather whether the decision 'appears to enhance a debtor's estate.'" J.C. Penney, 50 F.4th at 534 (quoting Richmond Leasing, 762 F.2d at 1309).

The Fifth Circuit explained that Klairmont's challenge to rejection of the ground lease foundered because it failed to argue that JCP's decision to reject the ground lease did not enhance the bankruptcy estate, nor did it contend that JCP's action on the estate's behalf was "clearly erroneous, too speculative, or contrary to the Bankruptcy Code." Id. Moreover, the Fifth Circuit noted, even under the "bad faith, whim, or caprice" standard, Klairmont's position was untenable because that standard does not require disapproval of a debtor's decision to assume or reject a lease upon any showing of bad faith. Instead, it hinges on "'whether the decision of the debtor that rejection will be advantageous is so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice.'" Id. at 535 (quoting Lubrizol, 756 F.2d at 1047) (emphasis added). According to the Fifth Circuit, that standard also "revolves around benefit to the debtor, not bad faith affecting third parties." Id.

The Fifth Circuit acknowledged that bad-faith dealing prejudiced Klairmont in its negotiations with JCP's agent regarding assumption of the sublease. Even so, it wrote, "Klairmont will not find relief … in asserting that JCP's decision deserves no deference under the business judgment rule." Id.

Outlook

In J.C. Penney, the Fifth Circuit reaffirmed that the business judgment standard applies to the decision to assume or reject an executory contract or an unexpired lease. Although the court declined to adopt the "bad faith, whim, or caprice" test used by some courts, the Fifth Circuit clarified that, under either standard, the bankruptcy court's inquiry should be directed at whether the decision to assume or reject benefits the bankruptcy estate, rather than any bad faith impacting third parties. Thus, the Fifth Circuit concluded that, under the circumstances, the DIP's decision to reject the ground lease was an exercise of sound business judgment, even though its agent acted in bad faith during the course of negotiations concerning the fate of the ground lease. Although the agent's bad faith in dealing with the sublessee was not a basis for denying deference to the DIP's business judgment in rejecting the ground lease, the sublessee might have other avenues of redress, such as an action against the agent for damages. 

J.C. Penney represents the fourth time in 2022 that the Fifth Circuit has provided what traditionally has been rare appellate guidance on executory contracts. In Matter of Falcon V, L.L.C., 44 F.4th 348 (5th Cir. 2022), the Fifth Circuit affirmed lower court rulings determining that a surety contract was not executory because the surety had already posted irrevocable surety bonds and did not owe further performance to the debtors. In so ruling, however, the Fifth Circuit adopted a flexible approach to the "Countryman test" for executoriness in cases involving multiparty contracts. According to the Fifth Circuit, courts "should apply the Countryman test to multiparty contracts in a flexible manner that accounts for the various obligations owed to all of the parties, rather than focusing exclusively on the flow of obligations between the debtor and the creditor." Id. at 354.

In In re Ultra Petroleum Corp., 28 F.4th 629 (5th Cir. 2022), the Fifth Circuit held that, although a bankruptcy court faced with a motion to reject a filed-rate contract regulated under the Federal Power Act (the "FPA") or the Natural Gas Act (the "NGA") must invite the Federal Energy Regulatory Commission ("FERC") to participate in the bankruptcy case, there is no requirement that FERC be allowed to conduct a hearing before the court can decide on rejection. In addition, in Gulfport Energy Corp. v. FERC, 41 F.4th 667 (5th Cir. 2022), the Fifth Circuit tripled down on its nearly two-decades-long view that filed-rate contracts regulated under the FPA and the NGA can be rejected in bankruptcy without FERC's consent.