Executory Contracts

• Author: Stephanie Ben-Ishai; Thomas G. W. Telfer
• Pages: 203-249

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CHAPTER 6

Executory Contracts

I. INTRODUC TION

This chapter deals with the treatment of a special kind of contract — an executory contract —

in Bankruptcy and Insolvency Act, RSC , c B- (BIA) bankruptcies. Executory contracts are

contracts where both parties have only partly performed their obligations under the contract

at the date of bankruptcy. Recall that the broad denition of “property” for the purposes of

dening the bankrupt estate includes contractual rights held by the bankrupt, and that these

rights vest in the bankruptcy trustee. Where the debtor has fully performed a contract, the

contract is considered an “asset” of the bankruptcy estate and the trustee can therefore

demand performance by the counterparty. Where the debtor has not performed the contract,

but the counterparty has fully carried out its obligations under the contract, the trustee can

refuse to perform the contract. In that case, the counterparty can claim as a creditor in the

debtor’s bankruptcy and the contract would be considered a “liability” of the bankrupt estate.

In a case where both parties have only partly performed their contractual obligations, how-

ever, the situation is more complex. The partly performed contract is not simply an “asset”

or “liability” of the bankrupt estate. This is where the law governing executory contracts

comes into play.

Generally speaking, a trustee has three options in terms of how to deal with an exec-

utory contract in bankruptcy. The trustee can “disclaim” the contract, essentially putting

the debtor in breach of the contract and relieving the counterparty of further performance.

Alternatively, the trustee can “arm” the contract, opting to continue performance of the

contract and requiring the counterparty to do the same. Lastly, the trustee can “assign” the

contract, by nding another party to assume the role of the bankrupt vis-à-vis performing

the contract. The trustee’s decision of which option to elect is guided by the goal of maximiz-

ing the value of the bankrupt estate for the benet of creditors.

Historically there was relatively little legislative guidance on the treatment of executory

contracts in bankruptcy or insolvency, with the exception of commercial realty leases. The

 amendments to the BIA added three new provisions — sections ., ., and . —

which now provide statutory guidance on disclaimer, armation, and assignment of execu-

tory contracts in general, including commercial realty leases. However, the BIA still does not

provide a comprehensive scheme for the treatment of executory contracts in bankruptcy. Of

the new provisions, section . is limited to proposals and does not apply in bankruptcies.

Section . does not apply in individual bankruptcy proceedings unless the individual is

carrying on a business, and section . does not apply in corporate bankruptcy proceed-

ings. Therefore it is still necessary to rely on common law principles and provincial legis-

lation depending on the type of executory contract and what the trustee elects to do with

respect to the executory contract. Most notably, the treatment of commercial realty leases is

 BANKRUPTCY AND INSOLVENCY LAW IN CANADA: CASES, MATERIALS, AND PROBLEMS

largely determined by the application of provincial law (except in Quebec and Newfoundland

and Labrador), which is incorporated into the BIA by an express provision (s ). For other

kinds of executory contracts, the court must look to common law principles to resolve mat-

ters on which the BIA is silent. For an analysis of the reforms, see Anthony Duggan, “Partly

Performed Contracts,” in Stephanie Ben-Ishai and Anthony Duggan, eds, Canadian Bank-

ruptcy and Insolvency Law: Bill C-, Statute c. and Beyond (Toronto: LexisNexis, ), ch .

In , Parliament enacted amendments relating to the treatment of intellectual prop-

erty licences in insolvency proceedings as part of the Government of Canada’s new national

intellectual property strategy. These amendments are not yet in force. When the amendments

come into force, they will clarify and simplify the treatment of intellectual property licences

in BIA and Companies’ Creditors Arrangement Act, RSC , c C- (CCAA) proceedings.

This chapter discusses the law relating to Disclaimer, Armation, and Assignment of

executory contracts in BIA bankruptcies. It also discusses some of the special issues that

arise in the context of intellectual property licences. For a discussion of the treatment of

executory contracts in CCAA and BIA proposal proceedings, see chapters  and .

II. DISCL AIMER

A. Introduction

In bankruptcy, the trustee and the debtor are dierent legal persons. Therefore the trustee is

not automatically bound by the debtor’s contracts, and the trustee must arm a contract if

they want to obtain the benet of the contract for the estate. The ip-side is that, by arming

the contract, the trustee assumes responsibility for performing the debtor’s side of the bargain

and non-performance will give the contract counterparty a damages claim against the estate

which is payable in full as a post-ling administrative expense. The trustee may avoid this lia-

bility by disclaiming the contract. Disclaimer puts the debtor in breach of contract, giving the

counterparty a damages claim against the estate. However, as discussed further below, the

counterparty’s claim is a provable claim within the meaning of BIA, section (); the result

is that the counterparty will typically not be paid in full, but will receive only a pro rata share

of its entitlement. The ip-side of disclaimer is that it relieves the counterparty of its perform-

ance obligations and so the estate does not obtain the benet of the contract. In summary,

the trustee’s decision to arm or disclaim a contract requires an assessment of whether the

benets to the estate of performing the contract outweigh the costs of performance.

It follows from these principles that the trustee must elect within a reasonable time

whether to arm a contract, and if they fail to make an election one way or the other, they

are deemed to have disclaimed the contract: see Re Thomson Knitting Co (),  CBR 

(Ont SC), a’d (),  CBR  (Ont CA) and New Skeena Forest Products Inc v Don Hull &

Sons Contracting Ltd,  BCCA , both extracted below.

BIA, section (), provides as follows:

All debts and liabilities, present or future, to which the bankrupt is subject on the date

on which the bankrupt becomes bankrupt or to which the bankrupt may become subject

before the bankrupt’s discharge by reason of any obligation incurred before the day on which

the bankrupt becomes bankrupt shall be deemed to be claims provable in proceedings

under this Act [emphasis added].

Duncan explains the meaning of the italicized words as follows:

Chapte r : Executory Contracts 

The class of claims covered by [these words] includes cases of contract where the trustee

either disclaims or ceases to perform the contract. In such cases, the creditor may prove

against the estate for the damages occasioned by the breach of the contract, and this is

his only remedy.

B. Lessor and Tenant Agreements

BIA, section ()(k), provides that the trustee may, with the permission of the inspectors,

elect to retain or to assign or disclaim any lease of any property of the bankrupt. This pro-

vision is supplemented by BIA, section, which incorporates by reference the provisions

in provincial lessor and tenant statutes relating to the disclaimer, armation, and assign-

ment of commercial tenancy agreements. Sections  and  of the Commercial Tenancies

Act, RSO , cL., reproduced below, are reasonably representative. Section () gives

a trustee the right by notice in writing to surrender or disclaim a lease. This more or less

restates the common-law position. But assume the trustee makes no election either to dis-

claim or arm the lease: at common law, the default rule is that the trustee is deemed to

have disclaimed. Does the statute, by requiring notice in writing of disclaimer, displace the

common-law default rule?

BIA, section()(f ), limits the amount of the lessor’s claim following disclaimer of a

lease: it gives the lessor a claim for three months’ arrears of rent and three months’ accel-

erated rent. In Re Vrablik (),  CBR (d)  (Ont Ct J (Gen Div)) (Re Vrablik), extracted

below, the court held that the claim for three months’ accelerated rent was in substitution

for loss of bargain damages. In other words, lessors cannot claim loss of bargain damages

on top of the claim that section()(f) gives them.

The lessor’s claim under section ()(f) is a preferred claim. This means the trustee

must pay the lessor’s claim in full ahead of the ordinary unsecured creditors. On the other

hand, section () is “subject to the rights of secured creditors.” This means the lessor’s

preferred claim ranks behind the right of a secured creditor to enforce its security interest.

The preferred claim is for three months’ arrears of rent and three months’ accelerated rent.

Assume the tenant is more than three months in arrears of rent. Can the lessor le a proof

of claim for the balance? The answer is yes: section () provides that creditors whose

rights are restricted by section () are entitled to rank as unsecured creditors for any bal-

ance of claim due to them. Consequently, the lessor ranks as a preferred creditor for three

months’ arrears of rent and an ordinary unsecured creditor for any arrears of rent beyond

three months.

The preferred claim, under section ()f, shall not exceed the “realization from the

property on the premises under lease.” The reference is to the value of the tenant’s goods.

The Commercial Tenancies Act gives a commercial lessor a right of distress for non-payment

of rent. This means that, outside bankruptcy, the lessor can seize the tenant’s goods and sell

them, using the sale proceeds to pay o the rent. BIA, section (), takes away the lessor’s

right of distress when the tenant becomes bankrupt. The section ()(f) preferred claim

is meant to compensate the lessor for loss of the right of distress, hence the limitation.

Assume the value of the tenant’s goods is less than the three months’ arrears of rent. Can

the lessor claim the dierence? The answer is yes: again, section () applies.

 Lewis Duncan, The Law and Practice of Bankruptcy in Canada (Toronto: The Carswell Company Limited,

) at –. See Roderick J Wood & David J Bryan, “Creeping Statutory Obsolescence in Bankruptcy

Law” ()  Journal of the Insolvency Institute of Canada .