May/June 2013

Option Contracts in Bankruptcy — Flexibility with Risk

Sophisticated market participants are increasingly using option contracts to provide flexibility to traditional borrowing or purchase and sale agreements. However, as Lowenstein Sandler’s S. Jason Teele and Tania Ingman point out, there are a number of interesting complications to this type of transaction when one party is distressed.

Far from the days of the limited use of options in securities or commodities contracts, sophisticated market participants increasingly use option contracts to provide flexibility to traditional borrowing or purchase and sale agreements. Where, for example, a traditional lending agreement may provide for the recovery of assets on default by foreclosure, the parties may use an option to provide that upon default the lender can exercise the option and take title to the assets. Alternatively, if the seller needs immediate liquidity but the purchaser needs time to conduct diligence, the potential purchaser may be willing to extend some or all of the financing on a temporary basis with the option to convert such financing into the purchase price at the conclusion. There are a number of interesting complications to this type of transaction where one party is distressed.

In general, §365 of the Bankruptcy Code allows a debtor to assume or reject most executory contracts. Although §365 of the Bankruptcy Code gives the debtor flexibility to determine which contracts it will continue to perform, only “executory” contracts are subject to this treatment. Accordingly, defining what constitutes an executory contract can become of paramount importance in a bankruptcy case.[1] The Bankruptcy Code does not define “executory” for purposes of §365; however, most U.S. courts have adopted the definition first proffered by Professor Vern Countryman in a 1973 law review article. Professor Countryman proposed that a contract is executory “if the obligations of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete the performance would constitute a material breach excusing the performance of the other.”[2] Courts adopting the Countryman definition, have determined that if the optionee commits no breach by doing nothing, then the agreement is not executory.[3] Similarly, where one party only has to collect money or perform ministerial duties, courts have held that the agreement is not executory.[4] However, some courts have viewed contingent obligations, such as potential indemnification obligations, as sufficient to render an agreement executory, as long as the triggering event could still occur after the commencement of the bankruptcy case.[5]

Although the Countryman definition is by far the predominant test, some courts have employed a more flexible approach, which looks at whether assumption or rejection would have value to the estate in determining its executoriness.[6] While it is unsurprising that courts holding option contracts are executory often employed the functional approach, courts have also used this line of reasoning to determine the opposite.[7]

Two recent bankruptcy cases, In re Roomstore Inc.,[8] and In re ATLS Acquisitions, LLC,[9] demonstrate both the creativity parties use in integrating options into their transactions and the unpredictability of a court’s determination of the executoriness of such agreement when one of the parties files for bankruptcy protection.

In Roomstore, Raymond Bojanski (Bojanski) and the debtor, RoomStore (RoomStore), entered into a limited liability company operating agreement creating Mattress Discount Group (MDG). Two years later, the parties entered into an additional “buy-sell” agreement. The buy-sell agreement provided, in part, that if either member of MDG filed for bankruptcy, MDG had the option to purchase such member’s interest in MDG for 180 days after the petition date. After filing for bankruptcy protection, RoomStore filed a motion arguing that the buy-sell agreement was an executory contract that could be rejected. RoomStore argued that MDG was a profitable business with no long-term debt and the debtor’s interest in it represented an important asset in the bankruptcy estate. MDG and Bojanski objected to this classification and cited numerous cases in which option contracts were deemed non-executory.

The bankruptcy court agreed with the debtors, basing its decision on multiple factors. First, employing a Countryman-like test, the court found that unlike cases cited by MDG, the agreement imposed continuing obligations on all parties. The court specifically mentioned the negative covenants by which all parties were required to refrain from transferring or encumbering its interest in MDG. In addition, employing a functional approach-like test, the court reasoned that if the contract were not deemed executory, then a valuable asset, the debtor’s interest in MDG, would be removed from the bankruptcy estate.

In the case In re ATLS Acquisition, LLC the United States Bankruptcy Court for the District of Delaware was also asked to determine if an option contract was an executory contract. In this case, the debtors, ATLS Acquisition (ATLS) and FGST Investments (FGST), borrowed $40 million from Alere Inc. (Alere) to finance a management buyout of numerous interconnected medical supply organizations referred to as the “Liberty Business.” In addition to the usual financing documents, the promissory note, the security agreement and the guaranty agreement, ATLS and Alere entered into an option agreement. The option granted Alere the right to purchase all or a portion of the assets of the Liberty Business in exchange for the forgiveness of the loan. The option term was 75 days, with Alere possessing the unilateral right to extend the option period for another 30 days (for a total of 105 days).

On February 4, 2013, Alere provided written notification to ALTS and FGST that it would exercise the option.  That same day, ALTS and FGST filed for Chapter 11 protection. ATLS and FGST filed a motion seeking to reject the option agreement under §365 of the Bankruptcy Code.

The debtors first argued, consistent with the Countryman test, that the agreement is executory because both parties have material unfulfilled obligations due to each other on the petition date. To support this argument, the debtors cited the obligations Alere owes them, including the delivery of the cancelled note, joint and several indemnification obligations to FGST and ATLS, and the debtors’ obligations to provide files and documents pertinent to the conversion of medical records.

In addition, the debtors argued, consistent with the “functional” analysis, that valuable assets would be lost from the bankruptcy estate unless the option agreement was rejected. The debtors argued that not allowing rejection could cost the estate and the unsecured creditors substantial amounts of money.

As would be expected, Alere vehemently contested the debtors’ characterization of the agreement. Alere contended that the option had been exercised prior to the filing of the bankruptcy petition and therefore any obligations owed to the debtor by Alere would be considered “post-closing” obligations, the non-performance of which would not constitute a material breach. Alere further argued that such obligations as delivering closing documents or having an indemnification agreement were ministerial and nonmaterial in nature and not completing them before the petition date should not render the agreement executory. Finally, Alere disagreed with the debtors as to the economic impact of both the potential rejection or assumption of the contract. The debtors claimed that the bankruptcy estate would benefit greatly from a finding that the agreement was executory and could be rejected. Citing the $40 million promissory note that would be forgiven, Alere claimed that there would be no equivalent benefit to the bankruptcy estate if the agreement were rejected.

Here, the bankruptcy court agreed with the non-debtor, Alere. Although the court declined to issue a written opinion, the court took the view the option was not executory because it had been exercised pre-petition and, presumably, therefore, no material performance remained outstanding on Alere’s side.

While each case presents a unique set of facts, parties considering the use of an option contract as part of a distressed transaction (or a potentially distressed transaction) must be aware of the various tests of “executoriness” and their application to how a court would determine whether an option agreement is an executory contract. However, as ATLS Acquisition shows, where the option has been exercised before the bankruptcy, an “executoriness” analysis may be irrelevant.

Of course, a finding that an agreement is or is not executory does not end the analysis. A debtor seeking to avoid its obligations under a contract could seek to attack such transfer of the debtor’s interest in property as a preference or fraudulent conveyance. In particular, in cases where a debtor could prove, under a “functional” analysis that the estate would lose significant value if the transaction were enforced, the debtor may also be able to meet a difficult element of a fraudulent conveyance action — namely, failure to deliver reasonably equivalent value in exchange for the debtor’s assets.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm or its clients. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

S. Jason Teele is a partner and Tania Ingman is counsel in Lowenstein Sandler’s bankruptcy, financial reorganization and creditors’ rights department. They may be reached by calling 973.597.2500 or by e-mail to steele [at] lowenstein [dot] com or tingman [at] lowenstein [dot] com.


[1] The Bankruptcy Code also precludes certain specific contracts, such as financial accommodations, from assumption or rejection. Those limitations are outside of the scope of this article.

[2]  Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439.

[3]  In re Robert L. Helms Constr. & Dev. Co., Inc., 139 F.3d 702, 706 (9th Cir. 1998).

[4] BNY, Capital Funding LLC v US Airways, Inc., 345 B.R. 549, 555 (E.D. Va. 2006), In re Kmart Corp., 290 BR 614, 617 (Bankr. N.D. Ill. 2003).

[5] Lubrizol Enterprises, Inc. v Richmond Metal Finishers, Inc., 756 F.2d 1043, 1046 (4th Cir. 1985), In re Safety-Kleen Corp., 410 B.R. 164, 167 (Bankr. D. Del. 2009).

[6] In re Robert L. Helms Constr. & Dev. Co., Inc., 139 F.3d 702, 706 (9th Cir. 1998).

[7] See, e.g., Helms, 139 F.3d at 706.

[8] In re RoomStore, Inc., 473 B.R. 107 (Bankr. E.D. Va. 2012).

[9] In re: ATLS Acquisitions, 2013 WL 772228 (Bkrtcy.D.Del. 2013).