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Executory Contracts in Entertainment Bankruptcy Cases

Introduction
When negotiating and documenting entertainment transactions, especially in this time of uncertainty over the global economy, it is essential to be familiar with the treatment of executory contracts in bankruptcy cases. Careful planning for what might happen to licenses, production agreements, distribution agreements or artist contracts in a possible future bankruptcy case by either party to the deal is essential to protecting a client's rights and remedies.

The bankruptcy trustee or debtor in possession in a bankruptcy case has a number of important rights with respect to an executory contract that can override the rights and remedies of the other party under the contract and under applicable law. For example, under certain circumstances, regardless of the terms of the contract and state law, an executory contract can be assumed or rejected and an executory contract that is assumed can then be assigned to a third party.

Interestingly, the Bankruptcy Code does not provide a statutory definition of what is an "executory contract," but the courts almost uniformly follow what is known as the Countryman definition, named after Harvard Law School professor Vern Countryman. This definition provides that an agreement is an executory contract if, as of the commencement of the bankruptcy case, performance remains due on both sides of the contract such that a failure of either party to complete performance would result in a material breach of the contract that would excuse the other party from performing. Generally, the courts will look to the substance of the transaction and the parties remaining rights and obligations to determine whether the contract is executory when one of the parties goes into bankruptcy.

In In re Qintex Entertainment, Inc., 950 F.2d 1492 (9th Cir. 1991), the Ninth Circuit applied the Countryman test and found that an acting contract with George C. Scott was not executory because Mr. Scott had already completed performance by the time the other party filed a bankruptcy case. On the other hand, the court also found that several licensing agreements with Otto Preminger Films were executory because they required future performance of material obligations by both parties. Generally, executory contracts include licensing agreements where the licensor promises to license the rights to the copyright to the licensee in certain media, in certain territories for a certain time, and to defend the copyright against attack by third parties, and the licensee promises to provide reports of the usage of the copyright, make royalty payments, and not exploit the rights outside the terms of the license.

The trustee or debtor in possession can make the election either to assume or reject the contract. If the contract is assumed, the bankruptcy estate is bound to perform the contract on an ongoing basis and any breach will be treated as a priority administrative claim. If the contract is rejected, the estate will be relieved on any obligation to perform the contract and the other party will be left with a prebankruptcy (called "prepetition") general unsecured claim that will usually be paid pro rata with all the other prepetition claims in tiny prepetition cents on the dollar.

To assume an executory contract, section 365(b)(1) of the Bankruptcy Code requires that the trustee or debtor in possession must cure any defaults, compensate the other party for any pecuniary loss arising from the default and provide adequate assurance of future performance under the contract. The requirement that defaults be cured warrants close analysis. In Worthington v. General Motors Corp. (In re Claremont Acquisition Corp.), 113 F.3d 1029 (9th Cir. 1997), the Ninth Circuit held that a default that cannot be cured can prevent the assumption of a contract. In that case, the car dealership franchisee had ceased operations for several weeks in violation of the franchise agreement. When the trustee later sought to assume and assign the franchise agreement to a third party, the franchisor argued that the historical default could not be cured because the trustee could not go back in time and change the fact that the dealership had ceased operations for several weeks, even though the trustee had resumed dealership operations.

The use of nonmonetary historical defaults that cannot be cured to control whether a counterparty in bankruptcy can assume or assume and assign an executory contract is one area that requires careful planning for bankruptcy purposes. Unless the other party waives the default, it can prevent the trustee or debtor in possession from enjoying the benefits of the contract by assumption. Examples might include: (1) Requiring minimum levels of distribution or exploitation in certain media or certain territories; (2) Requiring that certain actions must be performed within a set period of time; and (3) Requiring that certain persons or entities remain in management or control of the counterparty.

Section 365(c) of the Bankruptcy Code provides that a trustee or debtor in possession may not assume or assign an executory contract if applicable law excuses the nondebtor from accepting performance from or rendering performance to party other than the debtor, whether or not the contract prohibits or limits the assignment of rights or the delegation of duties, unless the nondebtor consents to the assumption or assignment. The express terms of the statute state that if nonbankruptcy law would not allow the assignment of rights or the delegation of duties under the contract, then the contract may not assumed or assigned. This provision has given rise to many issues because it can prevent the debtor in possession from assuming its own contract in bankruptcy even if there is no intent to assign it.

Not surprisingly, there is a split among the circuit courts about how this section should be applied. Some circuits, like the Third, Ninth and Eleventh circuits apply the express language of the statute and prohibit even assumption by the very same debtor if a hypothetical assignment would be prohibited under nonbankruptcy law. These courts apply the so called "hypothetical test." See, Perlman v. Catapult Entertainment, Inc. (In re Catapult Entertainment, Inc.), 165 F.3d 749 (9th Cir. 1999). Other courts, like the First and Fifth circuits, apply an "actual test" and hold that the debtor can assume its own contract unless there is an actual assignment that would be prohibited by nonbankruptcy law. See, In re Mirant Corp., 440 F.3d 238 (5th Cir. 2006).

The classic example of a contract that would fall into this category is the personal service contract that is generally not assignable outside of bankruptcy without the other party's consent. The typical illustration of a personal service contract is the contract with Picasso to paint a house that Picasso then seeks to assign and delegate to a house painter. The owner of the house hired Picasso because of his unique talent and skills so Picasso is not allowed to assign and delegate the responsibilities to another painter. But, personal service contracts are really just a subset of contracts that cannot be assigned under common law principles if the assignment or delegation would create a material risk that the other party would not receive the bargained for performance from the other side or would materially increase the burden of performance by the other party.

These rules create an opportunity for important bankruptcy planning issues. Writing into the contract provisions that emphasize the importance of the special and unique characteristics, capabilities, skills, talents, management and qualities of the debtor can later be used by to protect the counterparty if the debtor later files a bankruptcy case. In a jurisdiction that applies the hypothetical test, the counterparty can then argue that the contract cannot be assumed without its consent because the debtor would not be permitted to assign the contract under nonbankruptcy law.

Another area of nonbankruptcy law where assignments of contracts are prohibited involves licenses of copyrights, trademarks and patents. Most federal courts treat a nonexclusive copyright, trademark or patent license as a promise by the licensor not to sue for infringement that is limited to the licensee and not assignable. Therefore, if a company relies on a nonexclusive license of copyrights, trademarks or patents, it may not be able to assume or assign these licenses in a bankruptcy case. Everex Sys., Inc. v. Cadtrak Corp. (In re CFLC, Inc.), 89 F.3d 673 (9th Cir. 1996) (holding nonexclusive patent nonassignable under section 365(c) and federal nonbankruptcy law). In fact, based on the decision by the Ninth Circuit in Gardner v. Nike, Inc., 279 F.3d 774 (9th Cir. 2000), even an exclusive copyright license cannot be assigned under applicable nonbankruptcy law in some jurisdictions.

Ipso facto clauses are provisions in agreements that are automatically triggered by one party becoming insolvent or filing a bankruptcy case or having a receiver or other custodian appointed for some or all of the assets owned by the debtor. Typically, the contract provides that the triggering bankruptcy event constitutes a default and can result in the termination or modification of the debtor's rights under the contract. Under section 365(b) and (e) of the Bankruptcy Code, ipso facto clauses in executory contracts are generally unenforceable and need not be cured in connection with the assumption of the contract. Under sections 363 and 541 of the Bankruptcy Code, ipso facto clauses also cannot be used to prevent property of the debtor from becoming property of the bankruptcy estate or to prevent the trustee or debtor in possession from selling that property in a bankruptcy case.

Entertainment lawyers frequently ask why, if ipso facto clauses are unenforceable, they still appear in so many contracts. There are a couple of good answers to this question. First, the law might change. Under the 80 or so years the Bankruptcy Act of 1898 was in effect, the law on the enforceability of ipso facto clauses changed three times. Initially they were not enforceable, then they were enforceable and then they were unenforceable again. So they are included in contracts just in case the law changes to make ipso facto clauses enforceable again.

The other reason is that there are two express exceptions in the Bankruptcy Code that allow the enforcement of ipso facto clauses in bankruptcy. First, section 365(c) states an ipso facto clause in a contract to make a loan, extend other debt financing or other financial accommodation is enforceable. This is based on the premise that a lender should not be forced to extend credit after the borrower files for bankruptcy. Second, an ipso facto clause in a contract under which applicable law excuses the other party from accepting performance from or rendering performance to a party other than the debtor is enforceable. This category of contracts is discussed above.

It is important, however, to be very careful in deciding how to proceed after the other party to a contract becomes a debtor in a bankruptcy case, whether voluntarily or involuntarily. The prudent course to follow is to seek an order from the Bankruptcy Court rather than ever taking unilateral action and running the risk of being forced to pay damages, attorneys fees or other sanctions for violating the automatic stay in section 362(a) of the Bankruptcy Code or the prohibitions regarding the enforcement of ipso facto clauses in section 365. In the case of Computer Communications, Inc., 825 F. 2d 725 (9th Cir. 1987), the Ninth Circuit affirmed the imposition of over $5 million in sanctions and damages against the nondebtor party that unilaterally tried to terminate an executory contract without court approval.

The trustee or debtor in chapter 11 generally has until the confirmation of a chapter 11 plan of reorganization to decide whether to assume or reject an executory contract. This leaves the potential for a significant amount of time to go by before the nondebtor party knows what is going to happen to the contract. We call this postbankruptcy and pre assumption or rejection period the "twilight zone" because of the uncertainty that can exist during this time.

Generally, the nondebtor party is required to continue its performance during this period and is entitled to be paid for its postbankruptcy performance on an administrative priority basis for the benefits conferred on the bankruptcy estate. This is not necessarily the contract price, although the Bankruptcy Court will use the contract as a guide. If the nondebtor party is concerned about the risk of getting paid for its ongoing performance during the bankruptcy case, or if there is real prejudice to having to wait for the trustee or debtor to make a decision whether to assume or reject the contract, the nondebtor party has a number of possible remedies available. The nondebtor party can file a motion for an order requiring the trustee or debtor to make the assumption or rejection decision by a date certain. The nondebtor party also can make a motion for relief from the automatic stay to terminate the contract. And finally, the nondebtor party can make a motion to compel the trustee or debtor to pay the administrative claim based on benefits to the estate from the ongoing performance rendered by the nondebtor party.

The rejection of an executory contract, like assumption, requires an order of the Bankruptcy Court. Rejection relieves the bankruptcy estate from having any future performance obligations. Under section 365(g) of the Bankruptcy Code, rejection is treated as a breach of the contract immediately before the filing of the bankruptcy petition, leaving the nondebtor party with a prepetition unsecured claim for damages from the rejection.

There are many reported decisions that address the question whether rejection of the executory contract terminates the contract. Under one view, rejection terminates the contract and may be used like an avoiding power. See, e.g., Richmond Leasing Co. v. Capital Bank, N.A., 762 F.2d 1303, 1311 (5th Cir. 1985). Under the other view, however, rejection does not cancel or repudiate the contract, but merely creates a claim for damages. In response to the decision in the Richmond Leasing case, section 365(n) of the Bankruptcy Code was adopted to protect the nondebtor party from losing valuable rights under a rejected executory license agreement for intellectual property. Section 365(n) gives the licensee of rejected contract for intellectual property an option. The licensee can elect to treat the license as terminated and file a prepetition claim for damages, or the licensee may elect to retain its rights under the contract so long as it continues to pay royalties to the licensor. The licensee only retains the rights in existence under the contract as of the filing of the bankruptcy case for the duration of the contract and any extensions under the contract. But the licensee may not get the benefit of any future development or improvement to the rights, such as rights to sequels, prequels and remakes. For purposes of section 365(n), "intellectual property" is defined in section 101 of the Bankruptcy Code to include copyright and patent rights, but it does not include trademarks.

One possible approach to enhance the nondebtor party's position in case a contract is rejected is to take a security interest in the rights or underlying property that is the subject of the contract. This may discourage rejection of the contract because the rejection damage claim that will arise will be secured by the property, leaving the debtor with an encumbered asset that will minimize or eliminate any benefits that could otherwise come from rejecting the contract.

A security deposit or other credit enhancement in favor of the nondebtor party, such as a letter of credit that can be drawn upon if the debtor defaults or breaches the contract, can provide additional protection that may discourage the debtor from rejecting the contract.

There have been a number of bankruptcy cases by artists in which the artist seeks to reject a performance contract so they can perform for someone else, usually for more money. In these cases, the courts use two different approaches. In cases such as In re Carrere, 64 B.R. 156 (Bankr. C.D. Cal. 1986) the court found the trustee cannot reject the contract in a chapter 7 case because the artist's postbankruptcy earnings are not property of the bankruptcy estate under section 541 of the Bankruptcy Code. Section 541(a) of the Bankruptcy Code states that postbankruptcy earnings are not property of the debtor's bankruptcy estate. Under this reasoning, the Bankruptcy Court has no interest in dealing with the artist's contract because anything earned under it will not be available to creditors. In 2005, Congress changed the rules for chapter 11 cases and made an artist's postpetition earnings property of the bankruptcy estate that are available to pay creditors under a chapter 11 plan, so the result may now be different in a chapter 11 case.

Other courts apply a more traditional business judgment test to allow the artist to reject the contract if it is burdensome. But that just begs the question of whether the artist can then enter into a more lucrative contract to perform for someone else. This issue is resolved by determining whether the nondebtor party holds a claim from the rejection that is discharged in bankruptcy or does the nondebtor party hold a right to an equitable remedy that is not a claim discharged in bankruptcy. If the equitable remedy is available to enjoin the artist, or to enforce a noncompete or similar obligation, then the rejection of the contract does not give the artist the relief he or she is seeking in the first place. The analysis can also involve policy issues regarding giving the debtor a fresh start in bankruptcy, which is what bankruptcy is all about, and the potential for unconstitutional involuntary servitude by requiring the artist to perform for a studio or record company for the term of the contract regardless of the bankruptcy filing.

The resolution of this issue turns upon the definition of "claim" in section 101 of the Bankruptcy Code. "Claim" is defined to include a "right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured." The courts that apply this definition generally find that if a right to payment is an alternative or substitute to the equitable remedy under nonbankruptcy law, then the nondebtor party holds a claim that is discharged and is no longer enforceable. Otherwise, if the right to an equitable remedy does not give rise to a right to payment, then, notwithstanding the bankruptcy, the nondebtor party may be able to enforce its equitable remedy against the debtor performing for someone else if the requirements under state law are satisfied.

Another aspect of the rejection of an artist's contract is the question of whether the studio or recording company can setoff or recoup any royalties it may owe to the artist against the advances owed studio or record company. This issue requires an understanding of the differences between setting off amounts owed under different transactions, which is subject to the automatic stay and mutuality requirements under the Bankruptcy Code, and recoupment, which is the netting of amounts owed between the parties in a single transaction and is generally permitted in bankruptcy cases.

In this time of economic uncertainty, entertainment lawyers and their clients need to anticipate the possibility that the other party to any contract, no matter how big or small, may find itself in a bankruptcy case. Artist contracts, licensing and distribution agreements and other contracts can all fall within the category of executory contracts in bankruptcy that receive special treatment. Drafting each agreement with the understanding that it may be treated as an executory contract in a bankruptcy case requires a basic understanding of the fundamental rules governing assumption, assignment and rejection of executory contracts in bankruptcy cases.

_{© Howard J. Weg
Peitzman, Weg & Kempinsky LLP
10100 Santa Monica Boulevard, Suite 1450
Los Angeles, California 90067}

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