Executory contract

What Is Executory contract?

An executory contract is an agreement between two or more parties where significant performance remains outstanding from all sides. In the realm of contract law and business law, this means that neither party has fully completed their promised obligations. The ongoing nature of an executory contract distinguishes it from a completed agreement. The failure of either party to fulfill their remaining duties would constitute a material breach of contract, excusing the other party from their performance¹⁶. This concept is particularly relevant in financial contexts, especially within bankruptcy proceedings, where the treatment of such agreements can significantly impact a debtor's financial restructuring.

History and Origin

While the term "executory contract" is widely used in legal and financial circles, the U.S. Bankruptcy Code itself does not explicitly define it¹⁴, ¹⁵. Instead, its working definition largely stems from academic interpretation, most notably from Professor Vern Countryman's 1973 law review article, "Executory Contracts in Bankruptcy: Part I." Countryman defined an executory contract as "a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other." This "Countryman test" has been widely adopted by courts to determine which contracts fall under the special provisions of the Bankruptcy Code, specifically Section 365, which allows a debtor to either assume or reject certain agreements¹³. The Bankruptcy Reform Act of 1978 provided a uniform federal framework for handling executory contracts in bankruptcy proceedings, addressing prior inconsistencies¹².

Key Takeaways

• An executory contract involves ongoing, material unperformed obligations by both parties.
• If one party has fully performed, the contract is generally not considered executory.
• The concept is crucial in bankruptcy law, allowing a debtor or trustee to assume or reject such agreements.
• Common examples include leases, ongoing service agreements, and licensing contracts.
• Its interpretation can be complex and is often subject to legal dispute.

Interpreting the Executory Contract

The interpretation of an executory contract primarily revolves around identifying whether both parties still have significant, unfulfilled obligations that would lead to a material breach of contract if not performed¹¹. In the context of bankruptcy, this determination is critical for both the debtor and the creditor. For a debtor filing for bankruptcy, Section 365 of the U.S. Bankruptcy Code grants the option to either perform the contract (known as assumption of contract) or cease performance (known as rejection of contract)¹⁰. The goal is to allow the debtor to shed burdensome agreements while retaining beneficial ones to aid in financial reorganization. A contract where only one party's obligation remains, typically a monetary payment, is generally not considered executory for bankruptcy purposes.

Hypothetical Example

Consider a software development company, TechSolutions Inc., that enters into an agreement with ClientCorp to develop a custom enterprise resource planning (ERP) system. The contract stipulates that TechSolutions will deliver the software in phases over 18 months, and ClientCorp will make milestone payments upon the completion of each phase.

At the 12-month mark, TechSolutions has delivered two of the three main modules, and ClientCorp has made payments for those modules. However, the final module is still under development, and the final payment has not yet been made. In this scenario, the agreement between TechSolutions Inc. and ClientCorp is an executory contract because both parties still have significant unperformed obligations: TechSolutions must deliver the final software module, and ClientCorp must make the final payment. If either party were to fail in their remaining duty, it would constitute a material breach of contract, allowing the other party to seek remedies.

Practical Applications

Executory contracts are ubiquitous in the business world, appearing in various commercial transactions and legal frameworks. Their treatment is particularly significant in the following areas:

• Bankruptcy Proceedings: As noted, the U.S. Bankruptcy Code, specifically 11 U.S. Code § 365, provides specific rules for how a debtor can assume or reject executory contracts and unexpired leases.⁹ This flexibility allows debtors to restructure their liabilities and potentially reorganize their businesses, shedding unprofitable agreements while retaining those that are essential for future operations.
• Mergers and Acquisitions (M&A): During M&A activities, due diligence involves reviewing all existing executory contracts of the target company. These contracts, which can include supply agreements, customer contracts, employment agreements, or intellectual property licenses, can significantly impact the value and future operations of the acquired entity. Special attention is paid to clauses that might trigger a default or require consent from third parties upon a change of control.
• Real Estate Leases: Commercial and residential real estate leases are classic examples of executory contracts. Both the landlord and tenant have ongoing material obligations: the landlord to provide and maintain the property, and the tenant to pay rent and abide by lease terms.⁸
• Franchise Agreements: Franchise agreements are also executory, as the franchisor provides ongoing support, brand usage, and operational guidelines, while the franchisee continues to pay fees and operate according to the franchisor's standards.⁷
• Licensing Agreements: Contracts for the licensing of software, patents, or trademarks are generally executory, as the licensor grants rights and the licensee continues to pay royalties and adheres to usage terms.⁶

The Uniform Commercial Code (UCC), a comprehensive set of laws governing commercial transactions in the United States, also addresses aspects of sales and leases which can involve executory contracts.⁵

Limitations and Criticisms

Despite their widespread application, executory contracts present several challenges, particularly in legal interpretation. The absence of a precise statutory definition in the Bankruptcy Code has led to complex and sometimes contradictory jurisprudence.⁴ Courts have adopted various tests, primarily the Countryman test, but applying it to diverse contractual scenarios can still lead to ambiguity. For instance, determining what constitutes a "material unperformed obligation" can be subjective and subject to extensive legal debate.³

Another limitation arises in bankruptcy when a debtor decides to assume or reject an executory contract. While this power offers flexibility for reorganization, it can impose burdens on the non-debtor party, who may be forced to continue performance without immediate payment or face uncertainty regarding the contract's future.² Furthermore, certain clauses in executory contracts, such as those prohibiting assignment or allowing termination upon bankruptcy filing, are often subject to scrutiny and may not be enforceable under federal bankruptcy law. The intricacies involved in these legal determinations can lead to protracted and costly litigation, making the treatment of executory contracts a significant point of contention in many bankruptcy cases.¹

Executory Contract vs. Executed Contract

The distinction between an executory contract and an executed contract lies in the completion of obligations by the parties involved.

An executory contract is one where both parties still have substantial, unperformed duties. The agreement is ongoing, and a failure by either side to fulfill their remaining responsibilities would result in a material breach of contract. For example, a consulting agreement where the consultant is still providing services and the client is still making payments is executory.

In contrast, an executed contract is an agreement in which all parties have fully performed their obligations. There are no remaining material duties to be fulfilled. The contract's terms have been completed, and the agreement is effectively "closed." An example would be the purchase of a car where the buyer has paid in full and taken possession of the vehicle, and the seller has transferred title. The confusion often arises because "executed" can also refer to the act of signing a contract; however, in contract law, "executed" implies completion of performance, not just signing.

FAQs

What happens to an executory contract in bankruptcy?

In bankruptcy, a debtor or bankruptcy trustee has the option to either assume (continue) or reject (terminate) an executory contract, subject to court approval. This power, granted by 11 U.S. Code § 365, helps the debtor shed burdensome agreements or retain beneficial ones to aid in reorganization.

Can an executory contract be assigned?

Yes, generally, an executory contract that is assumed by a debtor in bankruptcy can subsequently be assigned to a third party. However, there are limitations, and the assignee must typically provide adequate assurance of future performance to the non-debtor party.

What are common examples of executory contracts?

Common examples include real estate leases (both residential and commercial), ongoing service agreements (e.g., maintenance, consulting), software or intellectual property licensing agreements, and franchise agreements. In all these cases, both parties typically have unfulfilled, material obligations.

Is an executory contract legally binding?

Yes, an executory contract is a legally binding agreement. The term "executory" simply refers to the state of performance, indicating that obligations on both sides are still outstanding. Like any other valid contract, it creates enforceable rights and duties for the parties involved.