B. Executory Contracts

Author:Roderick J. Wood
Profession:Faculty of Law. University of Alberta

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The trustee is under a duty to take possession and control of the assets of the bankrupt estate and dispose of them. The wide definition of property used in the BIA sweeps in contractual rights held by the bankrupt. If the bankrupt’s side of the bargain has been fully performed, the contractual right is a pure asset that vests in the trustee and permits the trustee to call for the other party’s performance. If the other party has fully performed but the bankrupt has not, the other party cannot demand performance from the trustee. Instead, the party is limited to proving a claim for damages for breach of contract or for recovery of the price in the bankruptcy.

A more difficult case arises where neither the bankrupt nor the other party has fully performed their contractual obligations. The trustee may want to obtain the third party’s performance, but it comes at a price. To obtain it, the trustee must fulfil the bankrupt’s part of

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the bargain. Alternatively, the trustee may decline to perform the contract, thereby giving the other party the right to terminate any future performance and to prove a claim for contractual damages in the bankruptcy. In order to preserve the value of the bankrupt estate, the trustee must move quickly and elect which course to take.

An executory contract, as the term is used in bankruptcy law, is one in which neither party has fully performed and the contractual obligations are linked so that performance by one is not required unless the other is willing and able to perform.48Executory contracts are said to have characteristics of both assets and liabilities arising out of the same transaction.49The trustee can turn the contract into a pure liability against the bankrupt estate by disclaiming the contract. This gives the other party the right to terminate any future performance and to prove a claim for contractual damages in the bankruptcy. Alternatively, the trustee may affirm the contract by indicating to the other party that the trustee is willing to perform it. The consideration that is earned through this contractual performance is an asset that is divisible among the creditors who prove their claims in the bankruptcy.

Canadian bankruptcy legislation is largely silent when it comes to setting out the rules and principles that govern executory contracts. This task has been left to the judiciary to work out. The one exception is where the executory contract takes the form of a lease of real property. Canadian bankruptcy law expressly incorporates provincial statutes that set out in detail the right of the trustee to affirm or disclaim a real property lease. Here, the discussion will begin with the general principles that govern executory contracts in bankruptcy and will follow with an examination of the special treatment that is afforded to real property leases.

1) The General Principles Governing Executory Contracts

The occurrence of bankruptcy does not of itself cause the contract to come to an end or constitute a breach of the contract.50This is subject to two qualifications. First, the parties to the contract may expressly stipulate events that constitute a breach of the contract or that bring the contract to an end, and these provisions are generally effective in

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bankruptcy.51Second, bankruptcy of an employer has the effect of terminating contracts of employment.52

If the contract has not been terminated, the trustee must elect between two courses of action. The trustee can affirm the contract or disclaim it.53The choice will very much depend upon whether the contract is a profitable one for the bankrupt estate. If a trustee decides to affirm the contract, the decision to affirm must be communicated to the other party within a reasonable time. If the trustee fails to do so, the other party can treat the contract as having been breached and may refuse further performance under it.54If the decision to affirm the contract by calling for performance is communicated within a reasonable time, the other party will be bound to perform it.

There are two exceptions to this rule. First, a trustee is not able to affirm a personal services contract. A person who enters into a contract with an artist to have her portrait painted cannot be forced to accept performance by another person. She contracted for the skill or personal ability of the bankrupt and is not compelled to accept substitute performance from the trustee or anyone else.55Second, an affirmation of the contract by the trustee will, in some cases, result in a modification of the contractual obligation owed by the other party. A contracting party who agrees to supply goods on credit to a buyer is not required to extend credit once the buyer is insolvent, but is entitled to demand to be paid cash before the property is delivered.56In order to affirm a contract for the sale of goods in instalments, it is not enough that the trustee pay the price for the post-bankruptcy deliveries. The trustee must also pay for any past deliveries that were made on credit terms.57

This illustrates the principle that the trustee must affirm the entire contract and cannot cherry-pick its favourable portions.

The trustee may instead choose to disclaim the contract. The trustee will communicate to the other contracting party that the trustee is not prepared to perform the contract. The trustee does not incur any

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personal liability by doing so. Instead, the contracting party may prove a claim for contractual damages in the bankruptcy.

A disclaimer does not involve a rescission of the contract in the sense that the contract ceases to exist. The contract remains alive. A disclaimer simply notifies the other party that future performance of the contract will not be forthcoming. This distinction is of vital importance. A disclaimer by the trustee does not undo the contract or cause property that has vested under an executory contract to revest in the bankrupt. This is well illustrated in agreements to purchase land in which the vendor has not conveyed the property and the purchaser has not paid the price. Because a contract for the sale of land is specifically enforceable, the purchaser acquires an immediate equitable interest in the land.58The vendor’s trustee cannot simply disclaim the contract and keep the land. The vendor holds the land for the purchaser under a constructive trust, and the trustee in bankruptcy is in no better position than the vendor.

The situation is different in respect of a contract for the sale of goods. Sale of goods statutes provide a complete codification of rules governing the transfer of proprietary rights to goods under a contract of sale, and this ousts the operation of equitable principles.59A buyer cannot obtain a proprietary right in the goods under the contract of sale until legal title passes to the buyer. The buyer has merely a contractual right to call for the delivery of the goods. This is a personal right that is converted into a right to prove for a bankruptcy dividend. Without a proprietary right, the buyer will be able to acquire the goods only if the trustee affirms the contract. If the trustee disclaims the contract, the trustee keeps the goods and the buyer has merely a right to prove a claim in bankruptcy for contractual damages or for the recovery of the purchase price.

The effect of bankruptcy on technology licensing agreements has been a topic of concern for many licensees.60The worry is that a trustee might be able to disclaim a technology agreement and thereby extinguish obligations that bound the bankrupt licensor.61This involves a

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misunderstanding of the trustee’s right to disclaim a contract. When a trustee disclaims a contract, the other party is notified that the trustee is not prepared to perform the obligation required under the contract in order to obtain performance by the other party. Upon a disclaimer by the trustee, the other party will often elect to treat the disclaimer as a breach of the contract and treat the contract as terminated. When this occurs, performance of the future obligation is no longer required. The other party has a claim for contractual damages, and this claim can be proved in the bankruptcy. But it does not follow that the other party must elect to treat the contract as terminated. Bankruptcy does not fundamentally change the position of a contracting party following a breach of contract. The party can elect to terminate future performance under the contract but is not compelled to do so. In respect of a technology licence, a licensee can elect not to treat the contract as at an end and may continue to use the technology as permitted by the...

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