No Discharge of Default Amounts Under An Assumed Contract
The United States Court of Appeals for the Fifth Circuit recently clarified the operation of the Bankruptcy Code where two sections of the Code intersect: section 1141(d), which provides for the discharge of certain debts arising before the date a plan is confirmed, and section 365, which deals with the assumption of executory contracts. In Century Indemnity Company v. NGC Settlement Trust (In re National Gypsum Company), the Fifth Circuit held that the discharge provisions of the Bankruptcy Code cannot be read to provide for the discharge of amounts in default under assumed contracts in a manner that would nullify the cure requirements of section 365 of the Bankruptcy Code. In addition, the Fifth Circuit held that the debtor has responsibility to assure that the nondebtor party to a contract is on notice of the debtor's intention to assume the contract.
Section 365 of the Bankruptcy Code grants debtors the right to assume or reject their executory contracts, subject to court approval. An executory contract is defined as one where neither party to the contract has fully performed the contract. Because a debtor's assumption of an executory contract forces the nondebtor party to continue to perform under the contract when a bankruptcy filing might make it hesitant to do so, the Bankruptcy Code provides certain protections for the nondebtor party. If a debtor wishes to assume an executory contract, it must cure any existing defaults or it must provide adequate assurance that any defaults will be cured promptly. In addition, it must provide adequate assurance that it will continue to perform under the contract.
Section 1141(d) of the Bankruptcy Code states that, except as otherwise provided in the plan or the order confirming the plan, the confirmation of a plan of reorganization discharges the debtor from any debt that arose before confirmation. The issue in National Gypsum was whether the discharge provisions of section 1141(d) could be interpreted so as to extinguish the cure requirement of section 365 of the Code.
As part of its plan of reorganization, the debtor, National Gypsum Company, sought to assume an executory contract. National Gypsum represented that it was not in default under the contract and, therefore, the cost to cure all defaults was $0. Subsequently, the bankruptcy court entered an order confirming National Gypsum's plan of reorganization.
Approximately two years after the debtor's plan was confirmed, and following attempts by the nondebtor party to the assumed executory contract to recover more than $5 million in cure amounts allegedly due, National Gypsum brought suit in bankruptcy court seeking a declaration that its contract obligations to the nondebtor party had been discharged in the chapter 11 case. National Gypsum asserted that any amounts previously due to the nondebtor party were discharged for $0, pursuant to section 1141(d) of the Bankruptcy Code, because the nondebtor party had sufficient notice of the bankruptcy case but failed to timely file a proof of claim. National Gypsum also asserted that the confirmation order precluded relitigation of the issue because the provisions of a confirmed plan are binding upon all creditors. That is, they are considered to be conclusively decided (res judicata).
The bankruptcy court first found that the nondebtor party was provided sufficient notice to be bound by the confirmation order which discharged its claims. Upon re-examination of the issues on a motion to set aside the judgment, the bankruptcy court determined that confirmation of the plan did not discharge the nondebtor party's right to payment under the assumed contract. However, the bankruptcy court held that the nondebtor party's mere knowledge of the pendency of the bankruptcy case was sufficient to trigger the doctrine of res judicata, which precluded it from asserting that any amount other than $0 was due. The district court affirmed the bankruptcy court's holding that the nondebtor party's right to payment was not discharged, but it reversed the rulings of the bankruptcy court on the notice and res judicata issues. National Gypsum appealed to the Fifth Circuit.
On appeal, National Gypsum argued that the nondebtor party failed to file a proof of claim to protect its claim to cure payments and, therefore, the claim was discharged. The Fifth Circuit agreed with both the bankruptcy and district courts that the nondebtor party's claim was not discharged. The Fifth Circuit noted that the Bankruptcy Code provides special rules for the treatment of executory contracts during a bankruptcy case. Section 365 provides a guarantee to nondebtor parties to executory contracts, who may be forced to continue relationships they would rather terminate, that as a condition to assumption, any defaults will be satisfied. The Fifth Circuit held that section 1141(d) of the Bankruptcy Code cannot be read to provide for a discharge of amounts in default under assumed executory contracts, thereby nullifying the cure requirements of section 365 of the Code. It observed that interpreting the discharge provisions as National Gypsum suggests would strip the protections the Bankruptcy Code offers to nondebtor parties. The Fifth Circuit stated that a nondebtor party should not have to file a proof of claim to protect its right to cure payments because such a requirement would be contrary to the Bankruptcy Code protections for nondebtor parties to assumed executory contracts.
National Gypsum also argued on appeal that the nondebtor party received sufficient notice of the debtor's intention to assume the contract and, therefore, the nondebtor party's claim should be barred. The Fifth Circuit held that mere knowledge of the pendency of the reorganization is not sufficient. It concluded that a debtor has the responsibility to assure that the nondebtor party is on notice of the debtor's specific intent to assume the contract. Although the nondebtor party was aware that National Gypsum had commenced a reorganization proceeding, there was insufficient evidence in the record to find that the nondebtor party was aware of National Gypsum's intent to assume the executory contract with a $0 cure amount. Accordingly, the Fifth Circuit found that the notice provided to the nondebtor party was inadequate. The Fifth Circuit did not reach the res judicata issue because res judicata cannot operate to bar the nondebtor party's claim if the notice was inadequate.
The decision is a reminder to debtors to make sure that they provide adequate notice to nondebtor parties of their intention to assume executory contracts. Otherwise, nondebtor parties may not be bound by cure amounts that debtors have scheduled. It also serves as a warning that courts will not allow the cure requirements for assumption of executory contracts, intended as a shield for nondebtor parties, to be used as a sword by debtors.