One of the quandaries of Chapter 11 bankruptcy law is understanding what is an “executory contract” and what is not; the distinction is critical for appreciating what obligations can be scraped off, like mud from your shoes, if you decide to take this route as a tactical way to save your business or your assets (if you’re out of business). The bankruptcy code is not helpful in defining an executory contract, although everyone has an intuition what it is. The intuition usually is that an executory contract is one that isn’t “completed on both sides.” An executed contract, by contrast, is one that is finished; no performance by anybody remains, in other words.

Seems elementary enough; if someone has additional obligations left, then the contract is executory, right? Under the bankruptcy rules, a debtor who is a party to an executory contract may either reject the contract, affirm it (continuing performance following affirmation) or affirm and assign the contract to a third party (passing on the obligations to the assignee). Where real property-driven agreements are concerned, the waters of clarity are murky. This is because at times, bankruptcy courts, particularly appellate ones, will interpret certain types of contracts as conveying “real property rights” or “interests,” at which point there is doubt whether the election of a bankruptcy debtor persists. There is some irony here; for years in the commercial leasing context, American appellate courts have been eschewing the application of “property rights” concepts in favor of treating leases as contracts, without property heritage obeisance. For example, commercial leases in Arizona incorporate an implied covenant of good faith and fair dealing; this is unusual, because in a strict property rights milieu, good faith isn’t relevant. Think of fiefdoms and lords and vassals. Good faith in medieval times? What?

About 18 months ago, the 9th Circuit Bankruptcy Appellate Panel (“BAP”) weighed in on this issue. The Debtors, named Hayes, wanted to reject restrictive covenants relating to lakeside residential subdivision lots that lowered their property value (because they had a deterrent effect on the sale of the property), or merely were a source of aggravation. The bankruptcy court ruled that residential restrictive covenants do not make an executory contract that could be rejected under Bankruptcy Code §365(a). Hayes appealed; and three judges on the BAP considered the issue. The panel referred to a 1998 opinion from the 9th Circuit Court of Appeals (In re Robert L. Helms Construction) in finding that a contract is executory if the obligations of each party are “so unperformed” at the date of the bankruptcy filing that either party’s failure to complete performance constitutes a material breach of the agreement at issue. In the 1998 Helms opinion, the 9th Circuit held that an option contract is not executory because the optionee’s only true obligation, payment for the option right, is discharged at the time the option arrangement is made. In other words, one party was essentially “done” performing when that bankruptcy was filed; and at least some further performance by each party is required to find an executory contract.

So, the BAP in Hayes’ instance found that while the debtors had an ongoing obligation to comply with the CC&Rs, the Association had few if any continuing obligations. (The only one cited by the judges was the Association’s right – not obligation, in the perspective of the BAP panel – to expel any offending landowner in the subdivision.) The BAP panel pointed out that this didn’t rise to the level of “mutual obligations” at the time the bankruptcy petition was filed or afterwards. The bankruptcy court’s decision was therefore affirmed.

Hmm. So much for the reach of contract law into the realm of real property rights. The BAP panel neglected to comment upon the multiparty dimension of CC&Rs; these actually are “group contracts” among all landowners who are subject to the restrictive covenants – apart from the Association as a party. In other words, each owner has an ongoing obligation to every other landowner in the subdivision not to violate the restrictions on use and other CC&Rs requirements, like maintenance of and insuring their lots, or payment of common area assessments. (That’s why most CC&Rs state that enforcement may be had by the owners’ association or any individual owner or owners.) I suspect that this is a convention of common law in every state in the U.S., although such a convention may have been changed by statute in some jurisdictions. Those obligations to behave in a neighborly way continue in effect every day of a subdivision’s existence. Well, never mind the neighbors. But, be careful if you think that a “property right”-oriented agreement like an option to purchase/lease or a right of first refusal is dischargeable in your bankruptcy, at least in the 9th Circuit states.

-MNW