On May 21, 2021, the Third Circuit Court of Appeals (the “Court”) rendered a precedential opinion whereby they denied a producer’s assertion that a contract, in which the producer did not have outstanding material obligations, was an executory contract. In addition, the Court further clarified what are the cornerstones of an executory contract within the context of 11 U.S.C. § 365.
The Weinstein Company, and its debtor affiliates (“TWC” or the “Debtors”), filed for relief under chapter 11 of the Bankruptcy Code on March 19, 2018, in the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”), following numerous credible allegations of sexual improprieties committed by the co-founder of TWC, Harvey Weinstein. In September 2011, over six years prior to the bankruptcy petition being filed, TWC entered into an agreement with Bruce Cohen (“Cohen”) and his production company (the “Cohen Agreement”). The Cohen Agreement was originally entered into by Cohen and his production company, and a special purpose entity formed by TWC to make the film Silver Linings Playbook (the “Film”). The Cohen Agreement was structured as a “work-made-for-hire contract” which essentially meant Cohen did not own any of the intellectual property of the Film. Pursuant to the Cohen Agreement, Cohen was to be paid an initial amount of $250,000 in fixed compensation to produce the Film, as well as contingent future compensation in an amount equal to approximately 5% of the Film’s net profits. The Film was released in November 2012 and Jennifer Lawrence received an Academy Award for Best Actress for her critically acclaimed performance. As a result of the Film’s success, Cohen was entitled to an additional $400,000 in compensation.
As mentioned supra, the Debtors entered bankruptcy protection under a cloud of ominous allegations. This situation resulted in few opportunities for the Debtors to sell their assets. The Debtors were ultimately able to come to terms with Spyglass Media Group (“Spyglass”) which resulted in an Asset Purchase Agreement (the “Purchase Agreement”). The Bankruptcy Court approved the Purchase Agreement allowing Spyglass until November 2018 to designate executory contracts for assumption. Spyglass, believing (correctly) that the Cohen Agreement was not an executory contract, asked the Bankruptcy Court for a declaratory judgment that the Cohen Agreement was already sold to Spyglass pursuant to section 363 of the Bankruptcy Code and thus, falls outside the scope of section 365 of the Bankruptcy Code.
Section 363 of the Bankruptcy Code allows a purchaser to buy substantially all of a debtor’s property “free and clear of any interest in such property.” 11 U.S.C. § 363(f). Importantly, this section would allow a buyer to purchase a non-executory contract without the need to cure any pre-closing obligations. On the other hand, section 365 of the Bankruptcy Code governs the treatment of executory contracts, although it does not define the term “executory contract.”
If a contract is deemed to be executory, a debtor can either assume or reject the contract. If a debtor in possession chooses to assume and assign the executory contract, then the debtor is required to cure (or provide adequate assurance) all the prior defaults under the executory contract. Here, pursuant to the Purchase Agreement, Spyglass was responsible for the cure costs of the executory contracts assigned to them. Thus, at bottom, if the Cohen Agreement was an executory contract, Spyglass would have been the responsible party to pay Cohen $400,000 in previously unpaid contingent compensation. If the Cohen Agreement was not an executory contract, Spyglass would have only been responsible for the obligations that arose after the date upon which the sale closed. This result underscores the Court’s penultimate sentence in the opinion that “bankruptcy inevitably creates harsh results for some players.” Spyglass Media Group, LLC v. Cohen (In re Weinstein Company Holdings, LLC), Nos. 20-1750 and 20-1751, slip op., p. 25 (3d Cir. May 21, 2021). The Bankruptcy Court ultimately held that the Cohen Agreement was not an executory contract. A decision that was upheld by the United States District Court for the District of Delaware (the “District Court”). Cohen then appealed the District Court’s ruling to the Court.
To determine whether a contract is executory on non-executory, courts in the Third Circuit follow what has been termed the “Countryman test.” Pursuant to this test, an executory contract is defined as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that failure of either to complete performance would constitute a material breach excusing performance of the other.” Id. at 11 quoting Vern Countryman, Executory Contracts in Bankruptcy: Part I Minn. L. Rev. 439, 460 (1973). Thus, to be executory “both parties [must] have unperformed obligations that would constitute a material breach if not performed” on the date when the bankruptcy petition is filed. Id. State law is used to determine what actually constitutes a “material unperformed obligation.” Id. The Court then succinctly stated the rule in determining whether or not a contract is executory: “whether, under state law governing the contract, each side has at least one material unperformed obligation as of the bankruptcy petition date.” Id.
To further clarify the test, the Court analogized executory contracts to assets and liabilities. To the extent that a debtor has performed all the necessary material obligations under the contract, but the other party to the contract has not, the unperformed obligations owed to the debtor would constitute an asset to the debtor’s estate. By way of another example, if the debtor owed material obligations, but the other party has satisfied all of its obligations, this would constitute a liability to the debtor’s estate. As the Court noted, only “where there can be uncertainty if the contract is a net asset or liability for the debtor, [does the Court] invite the debtor’s business judgment on whether the contract should be assumed or rejected.” Id. at 12.
Applying the facts of this case to the aforementioned test, the Court affirmed the Bankruptcy Court and the District Court in holding that the Cohen Agreement was non-executory. Thus, Spyglass was not responsible for the $400,000 in contingent compensation owed to Cohen as Spyglass was only responsible for obligations that arose after the date upon which the sale closed.
The Court applied New York law to analyze if the Cohen Agreement “contained at least one obligation for [TWC and Cohen] that would constitute a material breach.” Id. at 15 (emphasis in the original). New York follows the substantial performance rule which states that “[i]f the party in default has substantially performed, the other party’s performance is not excused.” Id. at 15. citing Hadden v. Consol. Edison Co., 312 N.E.2d 445, 449 (N.Y. 1974). This doctrine is relevant because it defines what types of breaches are considered material. As the Court noted, “none of Cohen’s remaining obligations go to the ‘root of the contract’ or ‘defeat the purpose of the entire transaction’ if breached.” Id. at 17. Cohen had contributed almost all of his value six years earlier when he produced the Film. Any remaining obligations owed by Cohen were “ancillary after-thoughts in a production agreement.” Id. at 17. By way of example, in the Cohen Agreement, Cohen agreed: not to seek injunctive relief about the exploitation of the Film; to indemnify TWC against third-party claims arising from the breach of his representations, warranties or covenants; and to grant TWC the right of first refusal if Cohen assigned his rights under the Cohen Agreement. TWC had a material obligation remaining as they were obliged to pay Cohen the $400,000 in contingent compensation. However, since Cohen had no material obligations remaining, the Cohen Agreement was considered to be non-executory.
In addition, Cohen claimed that “even [a] breach of a technical provision [of the Cohen Agreement] would excuse TWC’s obligation to pay contingent compensation” because the Cohen Agreement contained language to this effect. Id. at 18. The Court did acknowledge that parties could place verbiage within a contract that could override a state’s default rule of substantial performance and render all obligations as material. However, the Cohen Agreement only contained a “nine-word phrase buried in a long covenant provision.” Id. at 19. Covenants in a contract are designed to “address the parties’ obligation (i.e., what they must and must not do) and typically are not a natural place to look when determining which of those obligations the parties consider to be material.” Id. at 20-21. The Court concluded that “[n]o provision in the contract clearly and unambiguously overrode New York’s default substantial performance rule that obligations are immaterial if they do not go to the root and purpose of the transaction.” Id. at 25. As such, the Cohen Agreement was subject to the substantial performance rule which, as stated supra, held that Cohen had no material obligations remaining under the Cohen Agreement. Thus, Cohen was left with only a potential unsecured claim on the $400,000 contingent compensation.
© 2021 Cousins Law LLC. All rights reserved. The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.