What is an Assumption of Contract?
Assumption of contract refers to the transfer of contractual obligations and rights from one party (the "transferor") to another (the "transferee") with the consent of both the transferor and the non-transferring counterpart (the "counterpart"). A common example of an assumption of contract is a sale of a business that includes the assumption by the purchaser of the seller’s obligations under various contracts with customers, vendors, warehouse operators and others. Also known as "delegation and assumption," the concept places the risks and benefits of the sale squarely on the transferee.
More typically, transferors seek to restrict or negotiate against such transfers of liabilities due to creditors’ actual or potential claims against the transferor. Also, from a counterparty’s perspective, a fundamental objective is the avoidance of a substitution of parties to the contract without the counterpart’s control or approval. Thus, such transfers customarily are subject to counterpart-imposed requirements, such as the use of an assumption agreement in a prescribed form approved by the counterpart, and the exercise by the counterpart of its right to consent or object to the proposed transaction. In this regard , courts are more likely to enforce such limitations if there is an express provision prohibiting assignment of rights or delegation of performance or that otherwise imposes contractual conditions to such transfers.
The differences among the various types of transfers are often important. For example, an assignment of rights is often enforced without a burden to the assignee (i.e., the assignee will be entitled to collect on any contract without being subject to the obligations of the assignor). A delegation of performance is more complicated: if a delegation is not ineffective under the contract, the counterparty can then hold either the delegating party or the delegate accountable for performance. A novation effectively releases the transferor from liability on the relevant contract and substitutes the transferee in its place. The law, in certain circumstances, gives statutory effect to a novation with respect to a new incorporator or a new partner in an existing partnership.
Each of these differences is characterized by the manner in which the particular identity of a party is material to the quality or value of the contract. If that identity is not material, then an assignment or delegation may be effective without the counterpart’s consent; with that consent, a novation can be effected if the parties wish to eliminate liabilities and obligations under the contract.
Legal Framework for an Assumption of Contract
The assumption of contract liability is generally governed by federal and state court decisions that restate the common law. While many courts nationally have spoken to this issue, the depth and breadth of the specific legal framework governing the assumption of contracts will likely depend on the jurisdiction in which the issue arises.
In the federal bankruptcy context, the U.S. Supreme Court’s "true test" for assumption of contracts is whether a debtor "rescue[s] an asset from the machinery of reorganization or liquidation and use[s] that asset for fresh purpose." Lubrizol Enterprises, Inc. v Richmond Metal Finishing, Inc., 756 F.2d 1043, 1046 (4th Cir. 1985). As the Bankruptcy Code does not define "assumption" or "contract," courts have come to justify such "true test" as being the practical effect of an order allowing the assumption of a contract or lease. A debtor that has assumed a contract or lease retains the benefits and burdens of that contract. The debtor "assumes the contract and the duties but does not affect or impair the non-debtor’s rights thereunder." Id. at 1047. Under this view, assumption of a contract also is considered a "precondition" to assignment of that contract. See In re At Home Corp., 392 B.R. 529, 537-539 (Bankr. N.D. Cal. 2008).
Notwithstanding the case law interpreting the scope and effect of contracts assumption, courts are aware of the "vulnerabilities of the assumption process and the window dressing that can infect it.’" Clear Channel Comms., Inc. v. Knupfer (In re WW Productions, Inc.), 452 B.R. 367, 372 (9th Cir. BAP 2011). Moreover, representatives for a debtor searching for a "white knight" or stalking horse bidder should be cognizant of the effect of a successful post-petition takeover attempt by a bidder prior to "a debtor’s assumption and assignment of a contract to a third party". See id. at 373.
Common Circumstances of Assumptions of Contracts
Assumption of contracts commonly happens in a variety of post-closure procedures. For example, when a merger or an acquisition occurs, the new entity may choose to preserve prior contractual obligations through assumption. For instance, if a company enters into an agreement with a manufacturer to develop a product, but later mergers with another company before manufacturing and taking delivery of the product, the new company may assume the agreement with the manufacturer. Note that the underlying contract must specifically allow for assumption. In this example, the successor company’s assumption of the agreement would come in the merger agreement.
Another example of assumption of contracts is where a company goes bankrupt. When a company declares bankruptcy, it may elect to close its doors. However, that company may have numerous ongoing contracts, such as leases, service agreements, manufacturing agreements, and other obligations it must manage post-closure. It will also have obligations to its creditors, which could be superior to conflicting obligations under its contracts. In this case, the company could assume some of its contracts and reject others as a means of paying off its creditors.
In certain limited circumstances, it is not even necessary for a new entity to expressly assume an agreement in order to become bound by its terms. This can happen where partners withdraw from a partnership—depending on the circumstances.
Contractual Rights and Obligations Under an Assumption of Contract
In an assumption of contract, the portion of the contract that is the subject of the assumption is binding on the parties in exactly the same way and to exactly the same extent as if the assumption had never occurred. This means that the obligations of the original contracting parties will attach to the new contracting party.
While the assumption will transfer rights and obligations of the parties in relation to the subject matter contained in the assumption, it does not transfer rights and obligations with respect to the entire contract as an entity. For example, an assumption of a residential lease might convey the landlord’s right to receive rent and the tenant’s obligation to pay rent, but would not carry with it other obligations imposed on the landlord or tenant as a result of the original contract that relate only to the landlord or solely the tenant. This can be important where, as is common, the parties to the assumption enter into an entirely new contract setting forth their business relationship, the transaction to which the assumption relates, and the assumptions of contract.
How to Properly Assume a Contract
Effectuating a valid assumption of the contract can be an arduous process. While a debtor may have the sizeable bargaining power in the negotiation of a deal, once the deal is made, it requires additional consent from third parties prior to the assumption becoming effective. First, the contract must provide the debtor or the estate with an option to assume the contract, such that a pre-existing right to assume was granted. If not, the debtor must seek a court order to assume the contract. Fed. R. Bankr. P. 6006 and 9019. To begin, the debtor should consider sending out assumption proposals to all parties to contracts that might be assumed. Then, the debtor should file an assumption motion with the bankruptcy court and schedule a hearing on 21 days. Upon the expiration of the 21-day period, if no creditor objects to the proposed assumption, then the assumption is deemed granted without a court order. Fed. R. Bankr. P. 6006 (c). However, if at least one objection is filed, the motion will be heard by the bankruptcy court.
Upon prior consent of the parties to the contract, such as by a provision contained in the contract itself, or upon entry of a court order, a contract is deemed assumed once the assumption takes effect. One of the biggest challenges to effectively assuming the contract, and one that can be easily overlooked , is obtaining consent to the assumption. What if a debtor is unable to obtain consent from everyone to the assumption? The answer is that a debtor can assume some of the provisions in the contract but not others. "Thus, provisions limiting the debtor’s compensation or benefits under a contract can be stricken, while the remaining provisions are enforced." 3 Collier on Bankruptcy ¶ 365.03[5], (15th ed. rev.) This is often a very expensive process, but sometimes necessary when a party will not consent to have provisions struck. In addition to stricken provisions, the debtor may also be required to satisfy other conditions not found in the contract, such as post-petition requirements for payment, or other modifications.
After contracts are assumed, they remain subject to rejection, just like any other executory contracts of the bankruptcy estate. Accordingly, because assumption does not bind third parties to the provisions of a contract, the third parties to the contract are still free to pursue their remedies against the debtor post assumption, and the debtor is free to pursue its business remedies once it is out of bankruptcy. In the context of a Chapter 11 bankruptcy, before the confirmation of the plan, if a debtor defaults under an assumed contract, the other party to the contract must obtain an order from the bankruptcy court before exercising its remedies. After confirmation of the plan, the creditor may treat the contract as rejected unless the confirmation plan provides otherwise.
Potential Issues Associated with an Assumption of Contract
As with any area of the law, where there are rules and standards, there will be disputes regarding their application and effect. The same holds true for assumption of contract. In most (if not all) situations, the assumption of obligations under a contract will come with litigation in some form or fashion. It is important to note that the nature of disputes relating to assumption is quite different depending on whether the action is brought before or after the bankruptcy filing. For disputes arising prior to the bankruptcy filing, the remedies sought and issues presented are largely dependent upon the underlying contractual relationships at issue in the dispute. For example, a party may seek to enforce its contractual rights through a breach of contract or enforcement action. However, while before the bankruptcy filing, a party may seek to hold the other party liable for fraud when the other party misrepresented its ability to pay or do something before assuming contractual obligations. State law causes of action may be used to enforce a party’s rights and obligations under and assumption agreement. For example, a party may seek to enforce a guaranty or enforcement of a contract through specific performance. Each of these causes of action is highly fact specific to the particular circumstances of the parties involved and the underlying contract at issue. One thing to be aware of however, is the potential availability of an award of attorneys’ fees in various situations. Your state may be a "fee shifting" state, meaning that if you are the recipient of a judgment, you may be entitled to have your attorney’s fees paid by the other party.
Disputes arising after the bankruptcy filing are, in many cases, easier to digest from a legal standpoint, simply because bankruptcy law is federal law and is more true across the board than state law solutions. The majority of Courts tend to take a pretty dim view of those who choose not to assume or that fail to pay post-assumption obligations contemplated by the treatment of a contract in the plan. For example, in the recent decision in In re Mums, Inc., Equity Partners IV, L.P., the Court rejected a challenge to the assumption of four leases on two pieces of property. The Court rejected the argument that there was a "failure of consideration" since each lease was assumed subject to the possibility that "additional rent amounting to a minimum of $400,0000" may be assessed. The Court also found that the Debtor’s proposed treatment of the leases in its Plan was adequate since any provision of the leases that provided that nonbankruptcy law would apply to the leases was preempted by the Bankruptcy Code and that the leases were assumed subject to any preemption. Other post-bankruptcy filing disputes arise during the bankruptcy process. Parties to assumed contracts may seek to enforce the terms of the confirmed Plan, seeking to require payments to them or challenging whether a proposed execution of a contract is appropriate or may seek sanctions for the failure to comply with the Plan. The Bankruptcy Courts generally welcome this type of enforcement action, since enforcement of the Plan is one of the primary duties of a Bankruptcy Court. However, as with any litigation matter, it is important to understand your rights and obligations under your contract, as well as your rights under the Bankruptcy Code.
Key Considerations for a Business
There are a number of important business considerations to assess prior to assuming a contract. Assuming an existing contract may cause certain liabilities previously specific to the original contracting party to now be imposed on the assignee. One’s obligations under the assumed contract must be balanced against the anticipated benefits and underlying financial health of the target company. If there are undisclosed liabilities, assuming a contract can strain a company’s financial health and resources and lead to litigation.
In assessing potential contract liabilities, public companies can review filings with the Securities and Exchange Commission to verify liabilities or any potential repercussions . There may, however, be undisclosed matters that require the undertaking of a thorough due diligence review, which should include a review of e-mails, communications, and other contracts that may be relevant to understanding the scope of the contract proposed to be assumed. One should not assume the truthfulness of a statement made by the other contracting party or accept the assumptions and conclusions of the parties who prepared the contract. A redraft of the contract may be advisable if the assumptions in the contract have changed, if the assumptions are no longer valid, or if there are substantial changes that one negotiating the contract intends to make.