In re Hernandez

• Decision Date: 23 December 2002
• Docket Number: No. 99-01192-YUM-EWH.,99-01192-YUM-EWH.
• Citation: 287 B.R. 795
• Parties: In re Andres HERNANDEZ and Dorothy Hernandez, Debtors.
• Court: U.S. Bankruptcy Court — District of Arizona

Page 795

287 B.R. 795

In re Andres HERNANDEZ and Dorothy Hernandez, Debtors.

No. 99-01192-YUM-EWH.

United States Bankruptcy Court, D. Arizona.

December 23, 2002.

John A. Weil, Esq., Yuma, AZ, for Debtors.

Riley C. Walter, Esq., Gregory S. Powell, Esq. Fresno, CA, Jeffery R. Gilles, Esq., Paul W. Moncrief, Esq., Lombardo & Gilles, PLC, Salinas, CA, for Great Northern Equipment Company.

MEMORANDUM DECISION

EILEEN W. HOLLOWELL, Bankruptcy Judge.

In this case, the court must determine whether it must issue an order directing the Debtors to reject an unassumable executory contract pursuant to 11 U.S.C. § 365(d)(2) upon the request of the non-debtor party to the contract. For the reasons set forth below, the court holds that: (1) the Debtors are not required to reject the contract, but may instead elect not to address the contract in their Chapter 11 plan; (2) the contract may ride-through the bankruptcy; and (3) the automatic stay is lifted with respect to the contract.

PROCEDURAL HISTORY

On September 9, 2002, the court issued a Memorandum Decision holding that the Debtors, Andres and Dorothy Hernandez could not assume a License Agreement dated January 17, 1997 (the Agreement). The Agreement granted Andres Hernandez, Steve Wolfe and Andrew Smith "exclusive" licenses to use a patented technology which extends the shelf life of lettuce.¹ The September 9, 2002, decision sets forth, the factual history surrounding the execution of the Agreement and the court will not repeat that history in this decision. However, a brief review of the proceedings in this case is warranted:

In November of 1999, involuntary petitions under Chapter 11 were filed against the Debtors, Andres and Dorothy Hernandez. Orders for relief in both cases were entered in January of 2000, and the cases were consolidated shortly thereafter. In February of 2001, the Debtors filed a Plan of Reorganization which provided for the assumption of the Agreement. Both the Monterey Leaf Creditors as well as the licensor under the Agreement, Great Northern Equipment Company (Great Northern), opposed confirmation of the Debtors' Plan.²

In their Objections to the Debtors' Plan, the Objectors contended that the Ninth Circuit's holding in In re Catapult Entertainment, Inc., 165 F.3d 747 (9th Cir.1999) bars the Debtors from assuming the Agreement. In Catapult, a case involving a non-exclusive software license, the Ninth Circuit held that a debtor cannot assume a contract which falls under the provisions of 11 U.S.C. § 365(c)(1) unless it can be demonstrated that the contract could be assigned to a hypothetical third party, even if the debtor has no intention of assigning the contract.³ The Objectors further asserted that, if the Agreement could not be assumed, it must be deemed rejected.

At the June 14, 2002 hearing on Plan Confirmation, the court requested additional briefing from the parties on the applicability of Catapult to the Agreement, which by its terms purported to grant Hernandez an exclusive license. In their brief, the Debtors presented several arguments in support of their effort to assume the Agreement. The Debtors also raised an alternative argument in support of confirmation of their Plan. According to the Debtors, even if assumption of the Agreement was not a viable option, they should not automatically be forced to reject the Agreement. The Debtors argued that in addition to the affirmative acts of assumption and rejection, § 365 permits a debtor to allow an executory contract to "ride through" a Chapter 11 bankruptcy case.

In its September 9, 2002 Memorandum Decision, the court held that the Debtors could not assume the Agreement. The court found that: (1) even though the license granted to Hernandez was purportedly exclusive rather than non-exclusive, the Agreement nevertheless fell within the provisions of § 365(c)(1) and the requirements for assumption set forth in Catapult; and (2) the terms of the Agreement did not permit assignment to a hypothetical third party absent the consent of the licensor. Consequently, the court ruled that the Agreement fails the "hypothetical test," and as such, could not be assumed by the Debtors.⁴ However, the court deferred ruling on the "ride-through" issue raised by the Debtors until after the parties had an opportunity to submit supplemental briefs on that issue.

On October 16, 2002, Great Northern filed a Motion to Compel Rejection of the Agreement pursuant to § 365(d)(2), and a Motion to Lift the Stay pursuant to 11 U.S.C. § 362 to permit it to terminate the Agreement. The Monterey Leaf Creditors joined Great Northern in both of these Motions. The issues raised in the motions to compel rejection and to lift stay are directly affected by the court's determination of the "ride-through" issue, and as such, those motions are addressed by the court in this Memorandum Decision. Both sides have filed their briefs and the matter is now ready for decision.

JURISDICTION

The court has jurisdiction in this matter pursuant to 28 U.S.C. §§ 1334(a) and 157(a) and (b).

DISCUSSION

I. Introduction

The facts of this case create an unusual problem: If the court determines that the Agreement must be rejected, then the Debtors will have forfeited their rights under the Agreement regardless of whether the Debtors actually committed a breach. See § 365(g)(providing that rejection of an executory contract constitutes a breach of that contract as of the date immediately preceding the filing). In essence, the Debtors will have forfeited their rights under the Agreement simply by having consented to the entry of an order for relief after an involuntary bankruptcy case was initiated against them.⁵ On the other hand, had the Debtors not been forced into bankruptcy, their rights under the Agreement could only be terminated upon a demonstration of a material breach. This case, therefore, presents the unusual situation where a debtor has fewer rights in bankruptcy than outside of bankruptcy. The court finds such a result to be inconsistent with the reorganization principles of Chapter 11. At the same time, the rights afforded under Chapter 11 to non-debtor parties to executory contracts are entitled to protection. With these concerns in mind, the court now addresses the "ride-through" theory raised by the Debtors.

II. The Ride-Through Doctrine

The treatment of executory contracts by a Chapter 11 debtor is governed by 11 U.S.C. §§ 1123 and 365. § 1123(b)(2) provides that a Chapter 11 plan may "subject to 365 of this title, provide for the assumption, rejection, or assignment of any executory contract or unexpired lease of the debtor not previously rejected under this section." In turn, § 365(a) provides that the debtor "subject to court approval, may assume or reject any executory contract."

The "ride-through" doctrine advocated by the Debtors is purely a creature of case law; the doctrine is not provided for in §§ 1123 or 365, or anywhere else in the Bankruptcy Code. Simply stated, the ride through doctrine provides that executory contracts that are neither affirmatively assumed or rejected by the debtor under § 365, pass through the bankruptcy unaffected. See e.g., In re Polysat, Inc., 152 B.R. 886, 890 (Bankr.E.D.Pa.1993)("In a chapter 11 case, where a debtor has failed to expressly assume or reject a[n] ... executory contract, that ... contract will be unaffected by the bankruptcy filing"); In re Day, 208 B.R. 358, 368 (Bankr.E.D.Pa.1997)(holding that "[i]t has long been the rule in bankruptcy that an executory contract that is neither assumed nor rejected continues in place between the parties, passing through the bankruptcy to the reorganized debtor").

Ride-through finds its origin in the pre-Bankruptcy Code case of Consolidated Gas, Elec. Light and Power Co. of Baltimore v. United Railways and Elec. Co. of Baltimore, 85 F.2d 799 (4th Cir.1936). In that case, the Fourth Circuit held that an "executory contract remains in force until rejected, and unless rejected it passes through with other property of debtor to reorganized corporation." Id. at 805.⁶ Since Consolidated Gas, the ride-through doctrine, which has also been described as the "pass through" or "continuing contract" theory, has been applied by several Circuits Courts of Appeal. See e.g., In re O'Connor, 258 F.3d 392 (5th Cir.2001); Boston Post Road L.P. v. FDIC, 21 F.3d 477, 484 (2d.Cir.1994) cert. den. 513 U.S. 1109, 115 S.Ct. 897, 130 L.Ed.2d 782 (1995); In re Greystone III Joint Venture, 995 F.2d 1274 (5th Cir.1991); In re Public Service Co. of New Hampshire, 884 F.2d 11 (1st Cir.1989). The doctrine has also been recognized by commentators in law journals,⁷ and treatises including Collier "If the debtor fails to either assume or reject the contract by separate order or in its plan, it appears that the contract would continue in existence .... if the debtor continues operating, arguably the contract passes through the bankruptcy and remains a liability of the reorganized entity." 3 Collier on Bankruptcy, § 365.02[2][d] (15th Ed. Rev.1999); see also 7 Collier on Bankruptcy, § 1123.02[2] (15th Ed. Rev.1999).

Ride-through has also been recognized by the United States Supreme Court in dicta, and has been alluded to by the Ninth Circuit as well. In his concurring and dissenting opinion in National Labor Relations Board v. Bildisco, 465 U.S. 513, 546 n. 12, 104 S.Ct. 1188, 79 L.Ed.2d 482 (1984), Justice Brennan wrote:

In the unlikely event that the contract is neither accepted nor rejected, it will "ride through" the bankruptcy proceeding and be binding on the debtor even after a discharge is granted. The nondebtor party's claim will therefore survive the bankruptcy proceeding.

(Citations omitted). In Smith v. Hill, 317 F.2d 539, 543 n. 6 (9th Cir.1963), the Ninth Circuit discussed the implications of a debtor's failure to affirmatively assume an executory contract under § 365(c):

In Chapter XI proceedings failure to assume affirmatively an executory...