Almost every contract and lease contains a provision that says it terminates immediately if one of the parties files for bankruptcy. That provision is ubiquitous, but it is unenforceable under the Bankruptcy Code. Under section 365 of the Bankruptcy Code, the Debtor has the option to either assume or reject unexpired leases and executory contracts. (In simple terms, an executory contract is one under which at least one of the parties has obligations to perform.) Unless and until the debtor rejects your lease or contract, or you get some relief from the Bankruptcy Court, you must continue performing your obligations.
If the debtor wants to continue receiving the benefits of the lease or contract – for example, if the debtor wants to continue using its leased premises or needs to continue receiving supplies of necessary goods – it must “assume” the contract. In order to assume the contract, the debtor must cure any defaults (payment defaults as well as non-monetary defaults) and provide adequate assurance of future performance. In cases where the debtor sells all or substantially all of its assets, the purchaser will want to keep key contracts in place. If the debtor wants to assume an assign a contract, the debtor will have to cure all defaults and the purchasing party will provide the adequate assurance of future performance. If your contract requires your approval to assign a contract, that term is enforceable, but your consent to the assignment cannot be withheld unreasonably.
If the debtor does not want to continue receiving the benefits of the lease or contract – for example, if the debtor is closing underperforming locations or the contract is for goods that are not necessary to the continuing operations – the debtor will reject the contract. Shortly after the debtor files notice that it intends to reject the lease or contract, you will be required to file a proof of claim stating the amount of your rejection damages. Rejection damages are separate and apart from any claim you had as of the date of the bankruptcy filing, i.e., damages for prepetition defaults. When a lease is rejected, the damages are the lease payments that would have been received but they are statutorily limited to the lesser one year of payments or 15% of the payments over the remaining term of the lease. The debtor must also have surrendered the leased property, whether that property is real property or personal property. If the debtor rejects an executory contract, for example a license or services agreement, the damages are based on state law breach of contract damages. For example, the creditor may seek its lost profits as allowed under state law. Claims for rejection damages are unsecured claims, so the actual recovery is often significantly limited by the terms of the plan or reorganization, which may pay only a very small percentage to unsecured claims.
If you are a party to a lease or contract and the other party files for bankruptcy, you must continue performing your obligations while the debtor determines whether to assume or reject your contract. Consulting with a bankruptcy specialist will help you understand the debtor’s options, how you might respond to them, and your options for protecting your interests.