Court in Puerto Rico case adopts alternative test to find settlement agreements were executory

Hogan Lovells

Hogan Lovells

[co-author: Kaitlyn Hittelman]

Section 365 of the Bankruptcy Code creates a framework through which a debtor can elect to either assume or reject an executory contract. Because the Bankruptcy Code does not define “executory,” courts utilize various tests to determine if a debtor can assume a contract—and thus be obligated to perform—or reject a contract—and thus the contract is deemed breached immediately prior to the bankruptcy filing date. The Countryman test is overwhelmingly the most commonly applied test to determine a contract’s executory nature.

The test, named after Professor Vern Countryman, characterizes a contract as executory if “obligation[s] 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.”[1]

In a recent decision, In re Financial Oversight and Management Board for Puerto Rico, Case No. 17-3283 (LTS) (D. P.R. June 29, 2021), ECF No. 17186, Judge Laura T. Swain, the district court judge presiding over the 2017 Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”) proceedings, declined to utilize the Countryman test, instead adopting an alternative test to determine whether the settlement agreements at issue were executory and properly assumed according to sound business judgment.

The dispute surrounded settlement agreements for two class action suits. The plaintiffs claimed that the Commonwealth of Puerto Rico (the “Commonwealth”) did not reimburse or credit plaintiffs for their duplicate premium payments to both the government’s insurance scheme and private insurers—a reimbursement mandated by Puerto Rican law. In 2016, the Commonwealth entered into settlement agreements that required the creation of procedures by which the class members could submit claims for reimbursement for the duplicate premium payments.

While the Commonwealth’s plan involved assuming these settlement agreements, the Official Committee of Unsecured Creditors (the “Committee”) objected to the assumption, claiming that (1) the agreements were not subject to assumption because they are not executory and (2) assumption was not made in the Commonwealth’s sound business judgment.

Judge Swain disagreed with both of the Committee’s arguments. Although the court noted there was a “basis upon which the Court might find the Settlement Agreements to be executory under the Countryman test,” the court instead applied the “functional approach” to reach the same conclusion that the contract was executory. In re Financial Oversight and Management Board for Puerto Rico, Case No. 17-3283 at *11. The functional approach works backwards by asking the court to first analyze whether assumption (or rejection) of the contract would benefit the debtor’s estate and is thus aligned with the purposes of section 365 of the Bankruptcy Code. If so, then the contract should be deemed executory and assumable. Accordingly, the court’s primary inquiry focused on whether the settlement agreements would benefit the estate, thus making assumption merited.

The court also applied a deferential business judgment standard to determine if assumption was justified. Dismissing the Committee’s arguments to the contrary, the court found that the Commonwealth’s decision to cease expending estate resources on litigation costs and instead bring the class actions to a close was a reasonable exercise of its business judgment and provided an efficient benefit to the estate. Therefore, the settlement agreements merited assumption.

This decision is among many recent cases that have relied on non-Countryman tests to determine whether a contract is executory,[2] with the “functional approach” appearing to be the most prevalent Countryman alternative. By placing the focus on postpetition benefit to the estate rather than prepetition obligations in the contract itself, proponents of the functional approach argue it affords the debtor more flexibility and aligns the analysis with the economic realities of the case, instead of determining executory status through contractual obligations often negotiated well before the debtor’s bankruptcy case. Judge Swain also noted that the functional test often avoids substantial litigation costs and judicial resources that often accompany efforts to determine whether material obligations remain under a contract with the Countryman standard. This shift away from Countryman reflects a judicial willingness to rely on the debtor’s decisions for maximizing value of the estate rather than on upholding bargained-for contractual provisions.

[1] Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1973).

[2] See, e.g., Cohen v. Spyglass Media Group LLC (In re Weinstein Company Holdings LLC), Case No. 20-1750 (3d Cir. May 21, 2021) (combining the Countryman test with state law); In re Brick House Properties LLC, Case No. 20-26250 (KRA) (Bankr. D. Utah June 11, 2021) (applying the significant remaining obligations test); In re Redondo Constr. Corp., Case No. 02-02887 (ESL), 2019 WL 1549726, at *12 (Bankr. D.P.R. Apr. 8, 2019) (applying the functional approach).

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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