The Fifth Circuit Reminds Buyers To Beware Of Buying “Deemed Rejected” Contracts
The recent decision by the Fifth Circuit Court of Appeals in In re Provider Meds, L.L.C. is a stark reminder to chapter 7 trustees that they have an affirmative obligation to examine a debtor’s assets. A trustee’s failure to conduct a sufficient and timely examination may deprive the estate of significant value.
The issue before the Court in Provider Meds was whether the assumption and assignment of an intellectual property license agreement (the “License Agreement”) conveyed any intellectual property rights since the Agreement had not been timely assumed by the trustee. The facts were not in dispute. Multiple related debtors filed chapter 11 cases, and those cases were later converted to chapter 7. None of the debtors listed the License Agreement in their bankruptcy schedules. The License Agreement had been executed as part of a settlement of a 2010 patent litigation in which Tech Pharmacy Services, LLC (“Tech Pharm”) had alleged that multiple defendants, including several of the debtors (pre-petition), had infringed its patent. Under the License Agreement, all but one of the debtors obtained a non-exclusive perpetual license to use Tech Pharm’s patent. Following conversion of their cases to chapter 7, RPD Holdings, L.L.C. (“RPD”) purchased all of the assets of three of the debtors under section 363 of the Bankruptcy Code. The orders approving the sales provided that to the extent that any of the subject property was an executory contract, the contract was assumed by the estate and immediately assigned to RPD under section 365 of the Bankruptcy Code.
RPD’s problems began shortly thereafter, when Tech Pharm sued for patent infringement. In its defense, RPD argued that the License Agreement had been assigned to RPD under the terms of the sale orders. Unfortunately for RPD, a chapter 7 trustee has a limited period of time in which to assume an executory contract before that contract is deemed rejected. Specifically, pursuant to section 365(d)(1) of the Bankruptcy Code, after a chapter 7 case is filed, or after a case is converted to chapter 7, the trustee has only 60 days in which to assume an executory contract. Failure to timely assume an executory contract leads to the contract being automatically rejected (i.e., deemed rejected).
Here, the sale orders were entered after the 60-day time period had run, and the chapter 7 trustee had not assumed the License Agreement within the 60-day period provided for by section 365(d)(1). Tech Pharm therefore argued that RPD had acquired no rights to Tech Pharm’s patent under the License Agreement. In response, RPD argued that the License Agreement was not executory, and that even if it was, the time limits established by section 365(d)(1) should not apply when the debtors failed to list the License Agreement in their bankruptcy schedules and when the trustee was therefore unaware of its existence.
The Fifth Circuit began its analysis by holding that the License Agreement was executory. In order to be executory, parties to the contract must both, at the time of the bankruptcy filing, have some performance obligations remaining which if not completed would constitute a material breach of the contract. Here, the License Agreement was executory since (a) Tech Pharm had certain continuing obligation to refrain from suing its counterparties for patent infringement, and (b) the licensees under the License Agreement had continuing reporting obligations and had to refrain from making statements about the settled lawsuit.
The Court also rejected RPD’s argument that it should read an implicit exception in section 365(d)(1) for when a debtor fails to include an executory contract in its bankruptcy schedules and when the trustee is unaware of the contract within the 60-day period. The Court approved an earlier Ninth Circuit opinion decided under the Bankruptcy Act where that court had held that “a trustee has an affirmative duty to investigate for unscheduled executory contracts” and that the “statutory presumption of rejection by the trustee’s nonaction within the sixty day period following his qualification is a conclusive presumption.” According to the Fifth Circuit, section 365(d)(1) does not impose an actual or constructive notice requirement for the 60-day period. Therefore, because the License Agreement had not been assumed within 60 days of conversion to chapter 7, the License Agreement was deemed rejected and was not part of the bankruptcy estate. This meant that the License Agreement could not be sold under section 363, which permits a trustee to sell only “property of the estate.” The fact that the trustee had no knowledge of its existence was irrelevant for purposes of section 365(d)(1).
Importantly, the Court did not reach the question of whether the 60-day deadline applies where a debtor intentionally conceals the existence of an executory contract from a trustee. As noted by the Fifth Circuit, some courts have refused to hold that the executory contract is deemed rejected in such circumstances.
The Court’s decision in Provider Meds is a wake-up call to chapter 7 trustees. Chapter 7 trustees have an affirmative obligation to thoroughly investigate a debtor’s assets, including those assets that may not be scheduled. If the trustee suspects that the debtor is hiding assets, he or she can seek an extension of the 60-day period, but they cannot let the period run without ensuring that all executory contracts have been identified. Failure to do so could deprive the estate of value, since the trustee could not then assume and assign an executory contract which may have value. Further, the Provider Meds decision reminds parties acquiring executory contracts under section 365 in chapter 7 cases to ensure that the contracts have been timely assumed by the chapter 7 trustee. Otherwise, they run the risk that they will have paid value for a contract that no longer exists.