7th Circuit Denies Secured Lenders' Request to Unscramble a Court-Approved Settlement that Rejected an Executory Contract Instead of Abandoning It to the Lenders
The Seventh Circuit has just issued a short, important decision in a case in which a chapter 11 debtor's secured creditors challenged the right of the chapter 11 trustee to settle an executory contract dispute with the contracting party instead of abandoning the debtor's rights under the contract to them. In re Resource Technology Corp., 2005 WL 3336525 (7th Cir., 12/9/05).
In this case, the debtor had entered into a prepetition agreement with a party (Chastang) to build a gas collections system for collecting methane gas from landfills. The contract was the subject of three successive adversary proceedings, with the final result being a settlement between the Chastang and the trustee whereby the Chastang would release the debtor/trustee from its executory obligations, forgive a promissory note, release any damage claims, and pay $75,000 in exchange. For its part, the trustee would release the debtor's rights under the contract to complete the gas collection system and collect the methane gas.
The debtor's principal secured creditors, holding $40 million in debt secured by a floating lien on the debtor's assets, objected to the settlement, offering to pay the estate $200,000 and release $2 million in debt in exchange for the debtor's contract rights. The trustee preferred this deal, and asked the bankruptcy court to permit it to abandon the contract rights to the lenders, who claimed a security interest in all the debtor's contract rights.
Judge Wedoff, Chief Judge for the Bankruptcy Court for the Northern District of Illinois, however, concluded that an executory contract cannot be abandoned under 11 U.S.C. § 554, and that the trustee could only assume or reject the contract 11 U.S.C. § 365. Further, Judge Wedoff held, once the contract has been assumed (as was the case here), the debtor's only options are to perform under the contract, or to breach. According to Judge Wedoff, "[a]bandonment would just break the debtor's promise and support a claim for damages; it could not transfer Resource Technology's rights to the lenders." Thus, Judge Wedoff approved the settlement with the Chastang and the district court affirmed. In re Resource Technology Corp., 2005 WL 2588860 (N.D. Ill., 3/18/05).
In affirming the lower courts' rulings, the 7th Circuit touched upon a number of important concepts that bankruptcy practitioners regularly consider. For starters, the Court addressed the ever-present issue of mootness in bankruptcy. Here, the lower courts denied all requests for a stay pending appeal, thus resulting in consummation of the settlement and a third party's assumption of the debtor's contract responsibilities for completion of the system and collection of gas. Notably, the 7th Circuit held that these changed circumstances did not moot the lenders' appeal. Judge Easterbrook, who delivered the opinion of the Court's panel that included fellow University of Chicago law professors Judge Richard Posner and Judge Diane Wood, wrote:
All requests for a stay were denied, and the settlement between Chastang and the Trustee has been consummated. The $75,000 has been paid; Chastang's claims have been released; someone else has taken over completion of the system and the collection of gas. Yet why should this end the controversy? A case is moot when no further judicial relief is possible. See Church of Scientology v. United States, 506 U.S. 9 (1992). By that standard, this dispute is live. A court could order the Trustee to return Chastang's money, reinstate its claims for damages and payment on the note, and direct Chastang to deliver the gas to the lenders. Unscrambling a transaction may be difficult, but it can be done. No one (to our knowledge) thinks that an antitrust or corporate-law challenge to a merger becomes moot as soon as the deal is consummated. Courts can and do order divestiture or damages in such situations. Perhaps Chastang has in mind not mootness but judicial reluctance to upset legitimate reliance interests. See 11 U.S.C. § 363(m); In re UNR Industries, Inc., 20 F.3d 766 (7th Cir. 1994). Appellees do not contend, however, that anyone who has relied on the settlement would be left in the lurch; the lenders could be ordered to compensate the firm that completed the system and collects the gas. So we must resolve the merits.
Judge Easterbrook's opinion then addressed "whether § 365 (which addresses the assumption or rejection of executory contracts) supersedes § 554 (which authorizes debtors to abandon assets)." While acknowledging these sections may be reconciled, the 7th Circuit held that contract performance rights are not the types of property interests that can be abandoned under § 554. Judge Easterbrook wrote:
Does either Illinois or Alabama (the two states involved in the contract between Resource Technology and Chastang) treat a duty of performance under a contract as a property right? Normally a duty is the opposite of a right. And that's the lenders' main problem. Resource Technology had a duty to complete the gas-collection system; it had a right to collect the gas only after fulfilling that duty. When the lenders asked the Trustee to "abandon" the contract, Resource Technology had not finished the collection system. Abandonment then would have been nothing but breach; and if Resource Technology repudiated its promise (already broken by delay), it would have lost any right to the gas. There was no property interest the Trustee could abandon.
If one were to treat a package of rights and duties as a single property interest, in the way a contract as a whole might be sold (in the absence of an anti-assignment clause), how would abandonment of that package give the lenders any entitlement to the gas? A right that is abandoned is gone. Once Resource Technology's right to harvest gas disappears, the entitlement reverts to the landfill's owner--Chastang. The lenders seem to think that their security interest would direct the gas to them, free from the anti-assignment clause, but their security is in the contract rather than in the gas. If the contract is abandoned, the security disappears. A contract right in this respect differs from real estate or chattels, which continue to exist even if a given party's stake is abandoned. When a contract terminates, the asset covered by the floating lien vanishes in a puff of smoke. So the bankruptcy judge was right to hold that the lenders' proposal is legally impossible.
Finally, Judge Easterbrook considered the lenders' argument that § 363(f)(3), which says that a trustee cannot dispose of a secured party's collateral over objection unless the price realized exceeds the value of the lien, forbids settlement between the chapter 11 trustee and Chastang, the nondebtor party to the executory contract. Judge Easterbrook dismissed this argument, stating:
Appellants maintain that this provision forbids the settlement between the Trustee and Chastang. Yet why should we treat the settlement as the disposition of collateral? Section 363(f)(3) deals with liens on specific assets. A floating lien does not attach to particular assets; a borrower remains free to transact in the course of its business, and if it sells gas--or settles a lawsuit--the proceeds become subject to the lien. Out of bankruptcy, Resource Technology and Chastang could have settled their dispute without any hindrance from the lenders; a Trustee has the same power in bankruptcy. Creditors that hold floating liens are protected by the requirement that the Trustee's decisions be beneficial to the estate. Judge Wedoff concluded, after a hearing, that this settlement is beneficial. This means that the lenders are better off than they would be if Resource Technology, having failed to complete the system, were exposed to liability on the note and damages for breach, while losing the right to harvest and sell the gas. Section 363(f)(3) does not block transactions that make creditors better off. These lenders are not as well off as they would be if they could harvest the methane, but as we have explained that is not an available option.
© Steve Jakubowski 2005
The seventh circuit seems to have confused abandonment by the estate to the debtor with abandonment completely. The obligations of RTC under the contract after abandonment are the same as the obligations of the estate. How can any party ever sell or transfer an executory contract given this ruling if a third party whether the debtor or any other successor or assign steps into the shoes of the estate? How can executory contracts ever be good collateral?
Thanks for your comment. You make a good point with your two rhetorical questions. In answering, I want to put aside any contractual anti-assignment issues that would significantly complicate the analysis. Thus, for purposes of this response, assume the contract was assignable. Let me ask a question in response to yours: why shouldn't a secured creditor that wants to foreclose on its contract collateral be required to go through the same assumption and assignment procedures that a debtor would be required to undertake under section 365? The problem I have with abandonment of a contract to secured lenders, is that generally collateral in bankruptcy is not abandoned to the secured creditor under 554 as inconsequential, but disposed of outside of the ordinary course under section 363, subject to section 363(f). Sale of such contract to the lender using appropriate fair auctioning standards assures the estate that value is maximized. Abandonment presumes there is no value to the estate, so what's to be gained from permitting abandonment of a contract? If anything, the lack of procedural protections for the third party contracting party coming from section 365 warrants against permitting abandonment to the secured creditor.
As a matter of judicial record the contract had already been assumed. There also was no evidence before the court that the system was incomplete; it in fact was completed and had begun to operate before being shut down due to what the Lender believed were tortious actions of the landfill operator - specifically that the landfill operator in breach had opened valves which sabotaged gas quality. Abandonment by the Ch. 11 estate to the debtor allows the Lender to able to pursue this COA amongst others in state court. In addition the Lender for reasons of its own wanted the contract abandoned by the DIP estate to the debtor, not to itself. If the contract were abandoned by the estate to the debtor the security does not disappear, it follows to the debtor. This is no different than what would occur under dismissal only limited to the specific asset. Subsequently the asset would have been administered by a state court receiver FBO the Lenders. An important point to the Lender's that it would NOT have been part of the estate & subject to Wedoff's jurisdiction. The rights and remedies of the contracting parties remain the same. In fact under the proposed schema the parties are exactly the same as they were at the outset. I understand there were other third-party non-debtor contractual rights that would have been affected, such issues entering into Lender's decision to effect what would be a 363 sale in the manner it proposed, only to the debtor outside the Ch. 11 estate as opposed to a third party, although the 7th doesn't feel so. Why is abandonment by the estate for payment different from a 363 sale; it is not. In fact Wedoff specifically ruled that the settlement was a sale. There was no briefing on this issue because there was no disute among the parties that the settlement was a sale. While abandonment is usually of worthless property there is no case or statutory law which requires this to be so. Abandonment from the estate to the debtor avoids any anti-assignment issues. If the contract had indeed been breached & an Alabama court had ruled so then the Lender's would have paid for something worthless; that is the Lender's problem not the estate's. Ergo whether or not the contract was in force THE ESTATE WOULD HAVE BEEN A MILLION DOLLARS BETTER OFF. Finally the Financing order and DIP Note as well as Lender's prepetition secured note specifically designated EACH landfill gas rights contract as Lender's collateral. Notwithstanding whether Lender's had a floating lien or not the court seems to have turned lien rights on its head. The CFA is going to love this.
IMHO Magistate Wedoff has totally FUBARed the RTC case