The Third Circuit Examines the Nature of Executory Contracts to Find a Work Made for Hire Contract Non-Executory

Executory contracts under the Bankruptcy Code are treated uniquely, compared to other contracts.[1]  The Code permits debtors to assume or reject executory, but not non-executory contracts.[2]    This disparate treatment arises from, among other things, the need to protect a debtor from making an error in judgment according to the Third Circuit in Weinstein Company Holdings.[3] 

Such an error could arise if a debtor were to reject a contract which was an asset, or to assume one which was a liability.  A contract is an asset when only the non-debtor has material performance obligations.  A contract is a liability when only the debtor has such obligations.    In such cases, the Bankruptcy Code fosters the debtor’s rehabilitation by refusing to allow a debtor to mistakenly assume (or reject) the wrong kind of contract. 

Executory contracts, on the other hand, are hybrids that are a combination of asset and liability.  It is only in the presence of this inherent uncertainty that the Bankruptcy Code defers to a debtor’s business judgment in deciding whether the contract provides a net benefit (or liability).  If the executory contract is beneficial to the debtor, it can be assumed (subject to curing pre-petition defaults) and assigned to a buyer of a debtor’s assets.

In Weinstein Company Holdings, the Third Circuit was asked to decide whether a work made for hire contract was executory.  Under the contract, a movie company (“TWC”) agreed to pay a producer a fixed fee to make a film and thereafter a percentage of the movie’s profits.  Before the bankruptcy, the producer made the film and TWC paid the fixed fee.  Upon the commencement of TWC’s bankruptcy filing, each party owed certain obligations to the other.

During bankruptcy, TWC engaged in a Section 363 sale, whereby Spyglass Media Group, LLC (“Spyglass”) agreed to purchase substantially all of TWC’s assets.  The sale closed in July 2018.  Spyglass was given until November 2018 to designate contracts for assumption.  Spyglass argued that the contract was non-executory and thus part of the assets transferred to Spyglass pursuant to the asset purchase agreement.  TWC disagreed and argued that both sides owed material obligations and that Spyglass was required to cure any default.

To decide whether these obligations were material (thereby making the contract susceptible to assumption and assignment), the Third Circuit examined the governing state law.  Under New York law, a material breach exists when the “failure to do something that is so fundamental to a contract that the failure to perform that obligation defeats the essential purpose of the contact.”  

TWC owed contingent compensation to the producer as of the petition date which the Third Circuit considered material.  But the producer’s only remaining obligations were mere “ancillary after-thoughts in a production agreement” and thus deemed non-material.  Since only one party owed a material obligation as of the petition date, the contract was non-executory. 

On one level, this conclusion is not particularly significant since it simply restates the law – that contracts can only be assumed if they are executory, and they are only executory  if each side owes material obligations as of the petition date.  More interesting is the opinion’s discussion   of how a contract can be written to make what would seem to an ordinary person to be an immaterial obligation into a material one. 

Like some other states, New York recognizes the substantial performance rule.  Where there has been substantial performance,  there can’t be a material breach.  Substantial performance and material breach are then “two sides of the same coin” and “if it is determined that a breach is material…it follows that substantial performance has not been rendered…and performance by the other party is not excused.”  In Weinstein Company Holdings, the producer had substantially performed by making the film pre-petition, so it followed there was no material breach which the producer could make which would have excused the debtor’s performance. 

The producer argued that a provision in the contract changed this result:

Contingent Compensation.  If the Picture is produced with [Producer] and [Producer] fully perform[s] all required services and obligations hereunder and in relation to the Picture, and [is] not otherwise in breach or default hereunder, [Producer] shall be entitled to receive the following “Contingent Compensation” 

Pursuant to the contract then, TWC’s payment of contingent compensation was contingent on the absence of any breach or default by the producer.  Since any breach or default by the producer would excuse TWC from performance, the producer argued that all his obligations were material. 

Of significance, the Third Circuit did not dismiss this argument out of hand.  Indeed, it  “recognize[s] that parties can contract around a state’s default contract rule regarding substantial performance, and by doing so they can also override the Bankruptcy Code’s intended protections for the debtor.”  But the court emphasized “that result can only be accomplished clearly and unambiguously in the text of the agreement.”

Fatal to the producer’s argument, the Third Circuit found that the contract failed to clearly and unambiguously avoid the substantial performance rule.  First, the language was in the wrong section of the contract to create an obligation excusing performance.  Specifically, it was inserted in the midst of a lengthy covenant section instead of in the contract’s remedies or termination section where material obligations excusing performance are usually found.

Second, the Third Circuit characterized the provision more as a condition precedent that a true convenant.  Here, the focus was on the word “if” and the conclusion by the Third Circuit that no New York legal opinion had concluded that the substantial performance rule could be avoided by use of a condition precedent.

Third, the contract involved making a film and thereafter the producer’s ongoing obligations to not interfere with TWC’s rights in the film.  Some of these obligations were described as potentially never ending.[4]  The Third Circuit described this type of argument as “highly unusual” since in effect the contract would remain executory forever “no matter how much [the producer] had performed.”

Takeaway

Bankruptcy attorneys frequently have to determine if a contract is executory.  Weinstein Company Holdings is a reminder that the analysis starts with the governing state law.  This law will help define whether the contract is an asset, liability or both.  Counsel must understand  the contract’s terms, as well as how the relevant state law defines the parties’ rights and obligations throughout the life of the contract. 

It is doubtful that the drafters of the contract in Weinstein Company Holdings intended that the producer’s obligations remain material no matter the extent of the producer’s performance.  However, the producer was able to credibly argue this based on the language of the contract.  The fact that producer lost highlights that bankruptcy courts will consider not only the terms themselves, but also the contract’s structure and organization.  Both will be read as interpreted by the relevant state law.