Executory Contracts and Leases

The reality of a bankruptcy proceeding is that creditors often receive less than a full distribution on their claims, forcing them to absorb such losses or look for new avenues to make themselves whole.  The “bankruptcy haircut” is more often the case for general unsecured creditors and occurs less often for secured creditors (when they are not undersecured) and lessors (when they are not underwater on their lease).  Sometimes creditors have the luxury of looking to guarantors to mitigate their losses when the guarantors are not insolvent or otherwise judgment proof.  Otherwise, creditors are forced to find additional means to mitigate the haircut they received on their bankruptcy claims.  This was almost the case in Sierra Equipment, Inc. v. Lexington Insurance Co. where a heavy equipment lessor attempted to utilize the Texas Equitable Lien Doctrine to mitigate its loss by establishing standing to bring suit against a debtor’s insurance carrier post-confirmation.

In the context of an equipment lessee/lessor relationship, the Texas Equitable Lien Doctrine creates a right in favor of a lessor to pursue proceeds from an insurance policy covering its property in certain circumstances.  The doctrine can be used to compel the turnover of insurance proceeds in the hands of a lessee policyholder when the lessor is entitled to such proceeds.  The same doctrine can also operate as a procedural exception to the general rule that a non-party to a contract does not have standing to sue under such contract.  That is, the Texas Equitable Lien Doctrine grants a lessor standing to pursue a recovery directly from a lessee’s insurance carrier, without being a party to the insurance contract, if the lease agreement contains a loss payable clause in favor of the lessor.  While the doctrine does not create a new cause of action against an insurance carrier in this instance, it does provide a procedural mechanism for the lessor to pursue insurance proceeds in the place of the lessee as the policyholder.  Courts have interpreted the loss payable clause requirement of the doctrine to be satisfied by either specifically obligating the lessee to include the lessor as an additional insured or making clear that the lessee is obtaining the insurance “for the benefit of” the lessor.  Although the requirement that a lessor be named as an additional insured seems somewhat cut and dry, the alternative requirement that insurance be “for the benefit of” a lessor is somewhat less clear.  It was this “for the benefit of” requirement that the Fifth Circuit was asked to weigh in on in Sierra Equipment.

In Sierra Equipment, an equipment lessor, Sierra, entered into an agreement to lease heavy equipment to LWL Management worth several million dollars.  Among other things, the lease agreement provided that LWL would keep the leased equipment insured under terms satisfactory to Sierra and would deliver a copy of such insurance policy to Sierra.  Notably, the lease agreement did not explicitly require that Sierra be listed as an additional insured nor did it explicitly state that the insurance was to be obtained for Sierra’s benefit.  In accordance with the lease agreement, LWL obtained insurance on Sierra’s equipment from Lexington Insurance Company.

About a year after entering into the lease agreement, LWL and certain of its affiliates filed Chapter 11 in the United States Bankruptcy Court for the Northern District of Texas.  Sierra was very active throughout the bankruptcy case, which included conducting an inventory of the equipment it leased to LWL.  After conducting the inventory, Sierra determined that much of its equipment had been lost, damaged, or destroyed.  Sierra brought multiple motions for an administrative claim for such damages but ultimately settled with the Debtors for allowed administrative and general unsecured claims.  When Sierra took a larger haircut on the distributions on its claims than it anticipated, it began looking for other sources from which to recover.

After some diligence, Sierra discovered the insurance policy LWL obtained from Lexington covering Sierra’s equipment.  Thereafter, Sierra contacted Lexington about making a claim under LWL’s policy.  When Sierra was unsuccessful in making a claim, it filed a declaratory judgment action in Texas state court.  Lexington timely removed the state court action to the United States District Court for the Northern District of Texas and subsequently filed a number of dispositive motions, alleging a variety of procedural maladies.  In one of those motions, Lexington argued that Sierra lacked standing to file the declaratory judgment action because it was not a named insured and was not a party to the insurance policy.  Sierra countered that the terms of its lease agreement with LWL satisfied the requirements of the Texas Equitable Lien Doctrine and thereby conferred standing upon it to bring suit.  More particularly, Sierra argued that the substantial insurance requirements contained in the lease agreement implicitly made clear that LWL was obtaining insurance “for the benefit of” Sierra.  While the District Court was not convinced that the Texas Equitable Lien Doctrine applied to the lessee/lessor context, it held that if the doctrine did apply, the terms of the lease agreement and the insurance policy were insufficient to allow Sierra standing to bring suit against Lexington.  Sierra appealed.

The Fifth Circuit affirmed the District Court.  As an initial matter, the Fifth Circuit clarified that Texas courts do recognize the applicability of the Texas Equitable Lien Doctrine to the lessor/lessee relationship.  The Fifth Circuit then turned to determine whether or not Sierra satisfied the requirements of the doctrine.  Here, there was no debate that the lease agreement did not explicitly require that Sierra be included as an additional insured, so the Fifth Circuit focused its analysis on whether or not LWL obtained the insurance policy “for the benefit of” Sierra.  In examining the “for the benefit of” requirement, the Fifth Circuit looked to the underlying purpose of the doctrine.  The Fifth Circuit found that the purpose of the doctrine was limited to treating what should have been done under the express terms of the agreement, as done.  Said differently, where an agreement between two parties expressly lays out a lessee’s obligation to name the lessor as an additional insured or expressly states that the insurance requirements of the lease agreement were for the benefit of the lessor, the Texas Equitable Lien Doctrine confers standing on the lessor as if the lessee had complied with the lease agreement.  Accordingly, the Fifth Circuit dismissed Sierra’s argument that the lease agreement’s substantial requirements regarding insurance implicitly made clear that the insurance policy was obtained for Sierra’s benefit and found the absence of explicit language creating a loss payable clause to be determinative of the issue.

Although the Fifth Circuit ultimately ruled against Sierra, its holding provides some comfort for other prudent equipment lessors.  By clarifying the ambiguous language of “for the benefit of” requirement of the doctrine, the Fifth Circuit provided a road map for lessors to protect their rights and preserve every opportunity they can for a recovery in the event a deal goes south.  That is, the Fifth Circuit made clear that in order to preserve rights to utilize the benefits of the Texas Equitable Lien Doctrine, the cautious lessor should explicitly require in its lease agreements that the lessor be listed as an additional insured or otherwise explicitly state that the insurance the lessee is obligated to obtain, is obtained for the benefit of the lessor.


Section 365 of the Bankruptcy Code provides that a debtor “subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.”  11 U.S.C. § 365.  This provision is a powerful tool because it allows a chapter 11 debtor to assume agreements that will be beneficial to restructuring efforts while rejecting agreements that are burdensome.  Given its importance, the application of section 365 is not without challenge and subject to interpretation.

Two recent bankruptcy court decisions, In re Cho, 581 B.R. 452 (Bankr. D. Md. 2018) and In re Thane International, Inc., No. 15-12186-KG, 2018 WL 1027658 (Bankr. D. Del. Feb. 21, 2018), examine the fundamentals of executory contracts — when a contract is “executory” and whether there can be an “implied” assumption and assignment of an executory contract.

In re Cho

Considering whether a prepetition settlement agreement was an executory contract that could be rejected, the Maryland bankruptcy court, in Cho, observed: “whether a contract is executory depends on the facts of the particular matter, the language of the subject agreement, and the consequences under applicable nonbankruptcy law of either party ceasing to perform any ongoing or remaining obligations under the contract.”  Cho, 581 B.R. at 454.

In Cho, the debtors were defendants in state court litigation prior to filing bankruptcy.  Id.  The parties to the state court litigation agreed to a settlement that was reduced to writing, but the defendants refused to sign and maintained that the plaintiffs violated a certain non-disparagement provision in the settlement.  Id.  The state court ruled that there was a valid agreement and compelled the parties to execute the agreement.  Id.  Thereafter, the defendants filed for chapter 11 relief and moved to reject the settlement agreement as an executory contract under section 365 of the Bankruptcy Code.  Id.

Based on the facts and state court ruling, the bankruptcy court initially determined that there was a valid and enforceable contract under Maryland law.  Id. at 460.  Then, the court considered whether the contract was an “executory contract” for purposes of rejection under section 365 of the Bankruptcy Code.  Id. at 461.  Applying the Countryman test, the court evaluated whether both parties had unperformed obligations under the contract, which if not performed would result in a material breach of the contract.  Id.  Under the settlement agreement, the debtors were required to, in part, transfer a dry-cleaning business to the plaintiffs and make a cash payment.  Id. at 462-463.  The plaintiffs were required to dismiss litigation and note a certain judgment was satisfied.   Id. at 463.  In addition, both parties had non-disparagement obligations.  Id.

The main issue for the court was whether the obligations, and in particular the plaintiff’s obligations, were material under Maryland law.  Id. at 462.  The court noted this question depended on the primary purpose of the contract, which the court found to be settling the litigation and providing finality and certainty to the parties, and the non-disparagement provision bolstered and served this purpose.  Id. at 463-464.  Accordingly, the court held that the agreement could be rejected as an executory contract and the record supported the debtors’ business judgment and request to reject.  Id. at 466.  The court also observed that rejection generally does not eviscerate the non-breach party’s state law rights under the contract but any nonbankruptcy rights that the plaintiffs retain do not include the right to request specific performance of the agreement.  Id. at 467-68 citing Newman Grill Sys., LLC v. Ducane Gas Grills, Inc., 320 B.R. 324, 337 (Bankr. D. S.C. 2004).

In re Thane International

 In Thane, Delaware bankruptcy court considered “whether an executory contract that was neither affirmatively assumed nor rejected was included and assigned in a sale transaction.”  Thane, 2018 WL 1027658 at *1.  In Thane, the court had approved a sale of substantially all of the debtor’s assets under section 363 of the Bankruptcy Code.  Id.  A contract with a producer of informercials was not included as a contract to be assumed and assigned as part of the sale.  Id. Several months after the sale closed, the producer filed suit against the purchaser alleging it was owed royalties under a production agreement with the debtor.  Id.  The producer argued that the purchaser’s post-closing conduct and use of the contract effectuated a valid assumption and assignment of the contract.  Id. at *4.  The purchaser moved to dismiss the action on the basis that the producer failed to “distinguish pre- and post-closing royalties” and argued, in part, that an assumption and assignment did not occur because the “strictures” were not met, and “course of conduct cannot substitute.”  Id. at *1 and 2.

The bankruptcy court rejected the producer’s argument that the purchaser’s course of conduct constituted an implied or tacit assumption.  Id. at *6.  The court held that “there is no assumption” of an executory contract “absent a motion” as required under section 365 of the Bankruptcy Code.  Id.  In so ruling, the court observed that “there simply cannot be an assumption without providing the necessary cure and adequate assurance of one”, which the producer did not receive.  Id. at *7 citing 11 U.S.C. § 365(b)(1)(A)-(C).  As summarized by the court, section 365 allows a debtor “to do three things with an executory contract: (i) reject it, (ii) assume it or (iii) assume and assign it.”  Thane at *10.

The Cho and Thane decisions provide helpful guidance in determining whether an agreement is executory and a debtor’s options under section 365.  Cho is a reminder of the power of section 365 to a debtor while Thane is a reminder to adhere to the Code’s procedural requirements to obtain the benefits of section 365.