The Bankruptcy Code can be an effective tool for reducing liabilities and enhancing asset value for the benefit of creditors. One of the more important tools is the right to not only assume favorable contracts pursuant to Section 365, but also to reject those which are not. Section 365 allows a debtor to pick and choose those agreements which it believes provide the best opportunity to reorganize or alternatively, sell its assets. However, any agreement subject to assumption or rejection must be executory, i.e., both parties must have material unperformed obligations on the date of the bankruptcy filing. A recent decision from the U.S. Bankruptcy Court for the District of Delaware which found two pre-petition employment separation agreements to be executory and subject to rejection, serves as a useful reminder to practitioners of this threshold requirement and the need to carefully identify and provide evidence of the ongoing obligations, or lack thereof, under any pre-petition contract in In re Rupari Holding, 2017 Bankr. LEXIS 4095 (Bankr. D. Del. Nov. 28, 2017).

The Rupari debtors entered Chapter 11 on April 10. Prior to filing, they signed separation agreements with two former employees claiming to have been unlawfully replaced by younger workers. The separation agreements, among other things, bound the former employees to: a noncompete clause for a term of six months after their respective separation dates; a nonsolicitation clause for a term of twelve months after their respective separation dates; a confidentiality clause; and a release of all claims against the Debtors arising out of their employment or termination. Under the separation agreements, the debtors agreed, among other things, to make installment payments to the former employees for hours worked and accrued, unused vacation through their respective separation dates of April 17 and May 26.

One day after filing their bankruptcy petitions, the Rupari debtors sought and subsequently obtained court authorization to sell substantially all of their assets, which did not include the separation agreements. The debtors thereafter ceased operations, and moved to reject a number of their pre-petition contracts, including the separation agreements, retroactive to the date of closing in June 2017. The former employees objected arguing that the separation agreements were not executory having been “virtually fully performed,” and therefore, not subject to assumption or rejection.

The court observed that the primary issue raised by the former employees was whether there were bilateral material unperformed obligations under the separation agreements on the petition date. The debtors highlighted their ongoing obligations to pay accrued vacation and additional consideration under the separation agreements, on the one hand, and to the former employees' obligations to continue working for the debtors until their respective (post-petition) separation dates and to adhere to the non-compete and non-solicitation requirements, on the other hand. The former employees, by contrast, argued that the separation agreements were no longer executory as of the petition date because the debtors had already derived the value they wanted through the release given by the former employees.

The court first addressed the former employees' argument that the primary value of the separation agreements to the Debtors was the former employees' obligation to release their claims. The court observed that there was “scant evidence” supporting this assertion. Determining the subjective intent of the debtors was unnecessary, however, because if the former employees' obligations to adhere to the noncompete and nonsolicitation clauses were material to the separation agreements, the former employees' argument regarding the release obligations failed. The court looked to Illinois law to determine whether a breach is material, finding that the inquiry could be broken into three separate questions: what was the bargained-for objective of the parties to the separation agreements; under Illinois law, is the breach of non-compete and nonsolicitation clauses generally considered material in the overall context of employment agreements; and would the former employees' breach of the noncompete or nonsolicitation clauses disproportionately benefit the Debtors by negating their obligation to pay the remaining unused vacation and additional consideration for which they were obligated?

Turning to the first question, the court noted that the starting point for determining the bargained-for objective of the parties was the “four corners” of the separation agreements. Each of the agreements provided that “Breach of any obligation or covenant set forth [therein] will have a material and adverse effect upon the company and will cause the company irreparable harm, and damages arising from any breach may be difficult to ascertain.” The debtors argued that this language was indicative of the import and materiality of the restrictive covenants in the separation agreements. The court, however, observed that this language applied to all obligations and covenants within the separation agreements, not just the noncompete and nonsolicitation clauses. Second, the court concluded that under Illinois law, the breach of noncompete and nonsolicitation covenants is material, even in the context of transactions and agreements much larger in scope than the separation agreements. Finally, the court found that there was nothing in the record indicating that, upon a breach of the noncompete or nonsolicitation clauses, the former employees would suffer a disproportionate harm or that the debtors would disproportionately benefit if they were able to then discontinue their own obligations under the separation agreements.

The court thus concluded that in light of the language of the separation agreements indicating that the parties intended to convey materiality to each restrictive covenant, Illinois law on the materiality of the breach of such provisions, and the absence of a disparity in the advantages upon a hypothetical breach of such provisions, the noncompete and nonsolicitation provisions of the separation agreements were material. Therefore the parties to each of the separation agreements had material unperformed obligations on the petition date which rendered them executory and subject to rejection or assumption under Section 365 of the Bankruptcy Code.

Turning to whether the rejection of the separation agreements was a valid exercise of the debtors' business judgment, the court reasoned that the buyer elected not to assume the agreements, and given the sale of substantially all of their assets, the cessation of operations, and focus on winding down their estates, the record was clear that the agreements no longer provided any benefit to the debtors or their estates. Their rejection was therefore, a sound exercise of the debtors' reasonable business judgment. Finally, citing principles of equity under the circumstances, the court authorized the rejection of the separation agreements, retroactive to the date of closing.

The former employees in Rupari may have underestimated the importance of their ongoing noncompete, nonsolicitation and confidentiality obligations under the separation agreements, which the court found determinative as to their executory nature. The Rupari decision reminds practitioners that the threshold question underlying the right to assume or reject a contract under Section 365 of the Bankruptcy Code is whether bilateral material obligations remain outstanding, and therefore, practitioners must identify for and provide evidence to the court of any and all such ongoing obligations that may exist as of the petition date.

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice on national bankruptcy matters and workouts, including the representation of major energy and health care companies in bankruptcy proceedings and general litigation throughout the United States.

Michael J. Custer is an associate in the corporate restructuring and bankruptcy practice group of the firm, resident in the Wilmington office.