The Internal Logic of Assumption of Executory Contracts

Abstract

Executory contracts are a pivotal element of bankruptcy, forming some of the most vital economic values for a debtor's business. Bankruptcy law allows a trustee to choose whether to assume an executory contract or to reject it. While this is well settled statutory law, the theoretical foundations of assumption have been discussed rather sparingly. This paper aims to fill this gap by offering an analytical framework for the concept of assumption. The paper explores the theoretical justifications for termination of a contract by an injured party upon its breach by the other part. It argues that the two primary justifications are the concern about recurring breaches and deterrence against potential breachers. I contend that both justifications lose force in the context of insolvency and bankruptcy and thus assumption of executory contracts is warranted. The judicial oversight in bankruptcy reduces the likelihood of recurring breaches. The deterrence rationale is relevant with respect to willful breaches, but less applicable with respect to no-fault, insolvency related, breaches. However, identifying the nature of a specific breach is practically difficult and lengthy. Given this difficulty on one hand and the importance of executory contracts to a debtor's reorganization on the other, I argue that bankruptcy law is correct in its curtailing the injured party's termination rights and substituting them with a monetary remedy. That remedy is curing past defaults. The paper defends the Bankruptcy Code's requirement of curing past defaults prior to assumption. I show that this prerequisite is justified both in debtor friendly and in creditor friendly bankruptcy regimes. In the former regime, curing past defaults combats the moral hazard of willful breaches. In the latter, it reflects a matter of fairness. According effective priority to the non-debtor party is defensible because that party is the only claimant which is being legally compelled to perform future obligations to the debtor. Finally, the paper discusses the roles of the bankruptcy courts in reviewing the assumption of executory contracts. I call for subjecting the priority status of the non-debtor party to the court's discretion. The courts should take into account that party's bona fide adhering to the terms of the contract during the bankruptcy case prior to upholding its priority status with respect to the payment of past contractual defaults.