SCOTUS Resolves the Disagreement Between Lower Courts: Rejection is a Breach, Not a Rescission
Section 365 of the Bankruptcy Code gives a trustee or debtor-in-possession the statutory right to reject executory contracts during bankruptcy proceedings. The Code further explains that rejection of an executory contract amounts to a pre-petition breach of contract, conferring a claim for damages on the non-debtor counterparty. Lower courts have disagreed, however, on whether rejection also amounts to rescission of the contract, allowing the debtor to both terminate its own obligations under the contract and retract the nonbankrupt party’s rights under the contract. In an 8-1 decision, the U.S. Supreme Court confirmed that rejection of an executory contract under Section 365 functions as breach of the contract but does not rescind it.
In Mission Product Holdings Inc. v. Tempnology, LLC, a Chapter 11 debtor-in-possession sought to terminate its own obligations under a contract involving a trademark license and retract the licensee’s right to use the debtor’s trademark during bankruptcy proceedings. The bankruptcy court held that rejection of the contract revoked the licensee’s right to use the trademark. The Bankruptcy Appellate Panel reversed, but the First Circuit Court reinstated the bankruptcy court decision that rejection of the contract effectively revoked the licensee’s rights under the contract.
The U.S. Supreme Court reversed the First Circuit’s decision. In doing so, it relied on the plain language of Section 365(g), which states that rejection constitutes a breach of a contract occurring immediately prior to the filing of the bankruptcy petition. The Court concluded that “breach” is not defined uniquely to bankruptcy and, accordingly, it has the same meaning in bankruptcy as in ordinary contract law. Breach of contract does not equate to rescission of contract. The choice to rescind the contract is reserved to the nonbankrupt, nonbreaching party. Hence, the Court’s ruling is in keeping with general bankruptcy principal that a bankrupt’s estate does not acquire greater substantive rights than the debtor held outside of bankruptcy.
In short, rejection of an executory contract under Section 365 does not rescind contracts rights previously granted to its counterparty. Following Mission Product Holdings, trustees and debtors-in-possession will need to carefully consider the consequences of non-debtor counterparties opting to exercise contract rights under otherwise validly rejected contracts.
Disclaimer: The article in this publication has been prepared by Eastman & Smith Ltd. for informational purposes only and should not be considered legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney/client relationship.