Opinion
No. 87-0042.
June 25, 1987.
Executory Contracts — Rejection — Test — Balancing of Equities. — A balancing of the equities test must be used by courts considering a debtor's request to reject an executory contract. Under this test, the interests of general unsecured creditors are foremost, while the impact of rejection on the non-bankrupt contracting party must be evaluated. Specifically renounced is the business judgment test under which a debtor could reject an executory contract based only on the effect that it will have on its fortunes, provided its decision is not based on bad faith, whim or caprice.
See Sec. 365(a) at ¶ 8629.
Infosystems Technology. Inc. ("ITI") has appealed the decision of the Bankruptcy Court. Gabriel. J., to allow Debtor Logical Software ("Logical") to reject its Distribution Agreement with ITI. Oral argument was heard before this court on June 19, 1987. For the reasons stated in detail in court on June 19, and pursuant to Rule 8013 of the Bankruptcy Rules, this court has decided to remand this case to the Bankruptcy Court for proceedings consistent with this decision.
In an Order issued on November 7, 1986, the Bankruptcy Court granted Logical's motion for authority to reject its agreement with ITI under 11 U.S.C. § 365(a). In evaluating Logical's decision to reject the Distribution Agreement, the Bankruptcy Court began with the principle that "in the bankruptcy context, the debtor's decision to reject an executory contract should be accepted by the court unless it is shown to be `so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice.'" Order at 7 (quoting Lubrizol Enterprises v. Richmond Metal Finishers, 756 F.2d 1043, 1047 (4th Cir. 1985), cert. denied, 106 S.Ct. 1285 (1986)). In applying this principle to the case at hand, the Bankruptcy Court considered the likelihood of continuing legal battles between Logical and ITI, the absence of significant payments from ITI to Logical in 1986, and the parties' irreconcilable differences over the amount of royalties due, to conclude that Logical's decision was not so manifestly unreasonable as to suggest bad faith, whim, or caprice. Order at 7.
ITI advanced an argument to the Bankruptcy Court that the court should use a "balancing of equities" approach under In re Petur, 35 B.R. 561 (W.D. Wash. 1983), to determine whether to allow Logical to reject the Agreement. The Bankruptcy Court relied on Lubrizol, 756 F.2d at 1048. to find that the Bankruptcy Code did not permit a balancing of equities, even though the rejection of executory contracts by companies in bankruptcy will have adverse consequences for the contracting parties such as ITI. Id. at 9. The Bankruptcy Court concluded that Logical's limited staff, its possibly limited ability to market its software, and ITI's business success were all irrelevant, and it thus declined to consider those factors. Id. at 10.
This court must apply a de novo standard of review to a Bankruptcy court's legal conclusions. See Richmond Leasing Co. v. Capital Bank, 762 F.2d 1303, 1307 (5th Cir. 1985); In re Cricker, 46 B.R. 229, 230 (N.D. Ind. 1985). For the reasons explained in the opinion rendered at the hearing on June 19, 1987, this court has found that in this uncertain area of law the Bankruptcy Court adopted an erroneous legal standard when it applied the Lubrizol test to the question whether Logical should be allowed to reject its agreement with ITI. In deciding this issue on remand, the Bankruptcy Court should apply the test adopted by the courts in cases such as In re Huang, 23 B.R. 798, 801-02 (9th Cir. 1982); In re Meehan, 59 B.R. 380, 385 (E.D.N.Y. 1986); In re Midwest Polychem, 61 B.R. 559, 562 (N.D. Ill. 1986); In re Chipwich, 54 B.R. 427, 431 (S.D.N.Y. 1985); In re Turbowind, 42 B.R. 579 (S.D. Calif. 1984); and In re Petur, 35 B.R. 561, 563-64 (W.D. Wash. 1983).
More specifically, based on the reasoning of the foregoing decisions, this court finds that, on remand, the primary issue for the Bankruptcy Court to consider is whether rejection will benefit the general unsecured creditors. This may involve a balancing of interests. The Bankruptcy Court may disallow rejection if it finds that ITI, as the party whose contract is to be rejected, would be damaged disproportionately to any benefit to be derived by general creditors. Thus, in this case, the Bankruptcy Court may want to consider the probable size of ITI's damage claim against Logical if rejection is allowed, Logical's likelihood of reorganizing, and the extent of damage to ITI's business caused by rejection.
As noted in the oral opinion rendered on June 19, 1987, while the primary issue to be addressed by the Bankruptcy Court in this case is whether rejection would damage ITI disproportionately to any benefit to be derived by the general creditors, this is not the only relevant issue and the Bankruptcy Court may give secondary weight to other equitable and practical considerations in deciding this case.
Accordingly, this case is hereby REMANDED.
As explained on June 19, 1987, the court intends to grant ITI's motion for a partial stay of the Bankruptcy Court's initial decision while the case is being reconsidered. Briefs concerning the scope of the stay, the terms of the related escrow, and the appropriate amount, if any, of a bond shall be filed by the close of business June 26, 1987.