What Makes a CEO Perk Executory and the Circuits' Split Over the Definition of an Executory Contract
Back in the early to mid-1990's, while Conseco's profligate CEO, Steve Hilbert, was on his way to becoming America's highest paid CEO (with a whopping $277 million between 1991 and 1996), Hilbert was (forever?) smitten with the lovely 25 year old Indy stripper Tomisue Tomlinson as she jumped out of a cake at his stepson's bachelor party.
Unlike Hilbert's five previous marriages, this one has survived the test of time (and loss of money). Conseco's bankruptcy appears to have joined them at the hip (or maybe the prepetition asset transfer to Tomisue did), as evidenced by a recently decided case in Conseco's post-confirmation bankruptcy saga, here involving the rights of the Hilberts' "irrevocable trusts" to four "split-dollar" life insurance agreements established in 1998. In re Conseco, 2005 WL 2737507 (N.D. Ill., 10/18/05).
Under these self-dealt policies, Conseco agreed to pay annual premiums owing under the policies (worth between $12.5 million and $25 million each). The Hilberts were also required to pay a portion of the policy premiums (presumably the minimum required to maximize tax benefits). If the Hilberts failed to pay their portion, the trusts could pay on their behalf. The Court noted that the Agreements had early termination provisions if Conseco went bankrupt, or if the Hilberts or their trusts failed to pay Conseco a share of the premiums. Upon termination, the trusts could repurchase the policy from Conseco by reimbursing Conseco for premium payments made. If, within 60 days, the trusts did not exercise this repurchase option, Conseco could either become the owner of the policy or surrender the policies and get its premium payments back.
In December 2001, Conseco stopped making payments on the insurance policies, believing the Hilberts owed Conseco millions of dollars in defaulted D&O loans. Apparently, after Conseco stopped making payments, the trusts responded by converting the policies into paid-up policies with lower death benefits so that no further payments were due under the insurance policies.
One year later, Conseco filed for bankruptcy, and on September 10, 2003, it's reorganization plan went effective. Notably, neither the Hilberts nor their trusts exercised their option to purchase the policies from Conseco within 60 days of the bankruptcy filing, but rather filed claims against Conseco in the bankruptcy case seeking damages for alleged breach of the Agreements. (Perhaps they were thrown off by the ipso facto clauses in the Agreements that provided for termination in the event of bankruptcy, which every bankruptcy lawyer knows will not alone terminate an executory contract.)
The trusts asserted in their proofs of claims that Conseco's bankruptcy filing did not terminate the Agreements. Conseco objected to the claims, smartly asserting that the Agreements were not executory, and thus were terminated because neither the Hilberts nor the trusts exercised their option to purchase the policies from Conseco within 60 days of the bankruptcy filing (the ipso facto clause notwithstanding). In September 2004, Conseco's attorneys advised the trusts that the Agreements were terminated and that Conseco intended to enforce its rights to recoup the premium payments made. Counsel for the trusts responded that the trust "would consider your taking of the cash value of the policies not only to be an additional breach of the [Agreements], but also to be conversion as well."
The Bankruptcy Court, however, disagreed with the trust counsel's assessment, holding that the Agreements were not "executory contracts" under Bankruptcy Code section 365, and thus were automatically terminated when Conseco filed for bankruptcy in December 2002. The Bankruptcy Court also found that "because Conseco was not attempting to enforce a contract, its material breach of the Agreements in December 2001, when it stopped making premium payments, was of no consequence."
The District Court, reviewing the bankruptcy court's rulings and conclusions of law de novo, ruled that the bankruptcy court correctly adopted the "Countryman definition" of an exectuory contract as one in which "the obligation of both the bankruptcy and the other party are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance by the other." (Citing Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn L. Rev. 439, 460 (1973)). The District Court also concurred with the Bankruptcy Court's logical extension of the Countryman definition in concluding that "if any of the parties' duties is deemed immaterial, then the contract is deemed not executory."
As regards whether a contract is "executory," the District Court noted the split in the circuits between the majority Countryman "material breach" test and the minority "functional test" (with the Seventh Circuit following the Countryman definition), stating as follows:
Most courts, including the Seventh Circuit, have adopted Professor Countryman's "material breach" test. See, e.g., Matter of Superior Toy & Mfg. Co., Inc., 78 F.3d 1169, 1172 n. 3 (7th Cir. 1996); In re Streets & Beard Farm P'ship, 882 F.2d 233, 235 (7th Cir. 1989); see also In re Bradless Stores, Inc., 2001 WL 1112308, at *6 (S.D.N.Y. Sept.20, 2001) (collecting cases). In the instant case, the parties do not dispute that the Countryman test applies. Rather, the Trusts assert that Judge Doyle failed to apply to Countryman test and applied the "functional test" instead. Alternatively, the Trusts argue that she applied Countryman incorrectly.
A minority of courts, treating the Countryman test as "helpful but not controlling," hold that the determination of whether a contract is "executory" requires a more "functional" approach, "with an eye towards furthering the policies of the Bankruptcy Code." In re La Electronica, Inc., 995 F.2d 320, 322 n. 3 (1st Cir. 1993) (collecting cases); see also In re Jolly, 574 F.2d 349 (6th Cir. 1978), cert. denied, 439 U.S. 929, 99 S.Ct. 316, 58 L.Ed.2d 322 (1978). Under this approach, whether a contract is executory is decided according to the impact that the answer would have on the bankruptcy case. In re Gen. Dev. Corp., 84 F.3d 1364, 1374 (11th Cir. 1996)....
The Seventh Circuit has held that under the Countryman test, the unperformed obligations must be material to render a contract executory. "While almost all agreements to some degree involve unperformed obligation on either side, such an expansive definition of the term 'executory' is not what Congress enacted through its choice of language in § 365." Gouveia v. Tazbir, 37 F.3d 295, 298-99 (7th Cir. 1994) (internal citations omitted). If the court finds that one party did not have unfulfilled material obligations, a contract not executory. See In re Kmart Corp., 290 B.R. 614, 617 (N.D. Ill. 2003) ("Under Countryman, a contract that has been fully performed by either side is not executory."); American Network Leasing Corp. v. First Data Merchant Servs. Corp., 1997 WL 534827, at *9 (N.D. Ill. Aug.21, 1997) (agreement "not executory" because it was "fully performed by one side.").
Finally, in agreeing with the Bankruptcy Court that the insurance agreements were not executory, the District Court took note of the following important facts in concluding that the Hilberts and the trusts did not have material, unperformed obligations that would render the Agreements executory:
In the instant case, the court agrees with Judge Doyle that because the unperformed obligations of Hilbert and/or the Trusts were not material, the Agreements were not executory. Hilbert's duty was to pay his share of the premiums, and the Trusts were obligated to make the payments if Hilbert did not. The Agreements provided that they terminated automatically if Hilbert's portion of the premiums was not paid, and Conseco could not compel Hilbert to pay premiums or sue Hilbert or the Trusts for material breach. This makes sense, as Conseco points out, because the Agreements provided life insurance for Hilbert, and Conseco "had no interest in continuing to make payments if Hilbert stopped making his." That is, the purpose of the mutual payments was to provide Hilbert with an employment benefit, of which Conseco had no incentive to force him to take advantage.
A material breach is one that "worked to defeat the bargained-for objective of the parties or caused disproportionate prejudice to the non-breaching party." Morton v. Arlington Heights Fed. Sav. and Loan Ass'n, 838 F.Supp. 477, 482 (N.D. Ill. 1993). Hilbert's failure to pay his share of the premiums would not interfere with Conseco's stated purpose for entering the Agreements--to retain a valuable employee--and would not cause prejudice to Conseco. Accordingly, payments by the Trusts and/or Hilbert were not a material obligation, and Hilbert had no unperformed, material obligations at the time of the bankruptcy filing.
In addition to making payments in Hilbert's stead, the Trusts were also obligated to cooperate upon the deaths of the insureds. Contrary to the Trusts' argument, this obligation was ministerial only and not an unperformed, material obligation. Courts have routinely held that similar administrative obligations are not material and do not render a contract executory. See, e.g., Sparks, 206 B.R. at 488 (ex-spouse's remaining obligations to execute transfer documents not material); In re Fitch, 174 B.R. 96, 102 (S.D. Ill. 1994) (contract for sale of real estate with installment payments was non-executory because seller's only remaining obligation, to deliver good title, was not material). The Agreements did not enumerate any specific duties that the Trusts must perform and, as Judge Doyle noted, it is likely that proof of death is all that would be required to collect the benefits. As in Sparks, even though this obligation was necessary to carry out the intent of the agreement, it was purely administrative and not material. 206 B.R. at 488....
Because the court finds that Hilbert and the Trusts did not have material, unperformed obligations, the court need not address the Trusts' argument that Conseco's obligation to make its share of the payments was material. See Kmart Corp., 290 B.R. at 617.
UPDATE (8-14-06): The 7th Circuit affirmed this decision, as reported in this post.
© Steve Jakubowski 2005