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A New Approach to Executory Contracts? Fifth Circuit Opens the Door for the Functional Approach

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In a decision holding that surety bonds are not executory contracts, the Fifth Circuit signaled that courts may in the future utilize the functional approach to determine if multiparty contracts are executory in nature. The case, filed in the United States Bankruptcy Court for the Middle District of Louisiana as In re Falcon V, L.L.C., concerned a $10.5 million surety agreement between the Debtor, Falcon V, L.L.C., and Argonaut Insurance Company (“Argonaut”).

The Debtor and its affiliates were involved in oil and gas exploration and development and the Debtor entered into an agreement for Argonaut to post four irrevocable performance bonds, which guaranteed the Debtor’s obligations to third parties related to plugging and abandonment and restoration of wells. If the Debtor failed to perform its obligations, Argonaut was obligated to pay the third-party obligee the amount of the obligation or to perform the obligation, up to the amount of the performance bond.

The bonds provided that regardless of whether the Debtor paid the premiums owed, Argonaut’s obligations continued and would not be discharged by the Debtor’s failure to pay such premiums. The Debtor agreed to make premium payments to Argonaut and to indemnify it for any payments made under the bonds. After filing its Chapter 11 case, the Debtor sought and received permission from the Bankruptcy Court to continue meeting its obligations to Argonaut under the bond program (referred to as the “Surety Bond Program”).

Argonaut filed a proof of claim in the bankruptcy case that included a statement that the Surety Bond Program could not be assumed and assigned because it was a “financial accommodation,” but reserved all rights in the event the Surety Bond Program was deemed an executory contract. The Debtor’s Plan, as approved, provided that all executory contracts not specifically rejected were assumed. The Surety Bond Program was not included on the list of rejected executory contracts.

After the Debtor was discharged, Argonaut requested that the Debtor provide an additional $7.3 million in collateral to secure the performance bonds. The Debtor refused. The Debtor argued that Argonaut’s claim had been discharged through the bankruptcy process. Argonaut claimed that the Surety Bond Program was an executory contract that was assumed, or alternatively, the Surety Bond Program “rode through” the bankruptcy case.

The Bankruptcy Court (Dodd, J.) determined that the Surety Bond Program was not an executory contract assumed by the approved Plan because Argonaut owed no continuing performance to the Debtor. Even if it was an executory contract, the Bankruptcy Court ruled that it was a non-assumable financial accommodation. The District Court (Jackson, J.) affirmed the Bankruptcy Court’s ruling. Argonaut subsequently appealed to the Fifth Circuit, arguing that the Surety Bond Program was assumed as an executory contract, or alternatively that it rode through the bankruptcy case.

In determining whether the Surety Bond Program was an executory contract, the Fifth Circuit first looked to the Countryman Test, which looks at whether each side to a contract has at least one material unperformed obligations as of the date the bankruptcy petition is filed and if a party’s failure to perform a material obligation would excuse compliance by the counterparty. The Bankruptcy Court and District Court both found there were not material obligations remaining on both sides on the petition date; the Debtor owed obligations to Argonaut, but Argonaut owed no obligations to the Debtor.

Argonaut pointed out that it still owed obligations to the third-party obligees under the Surety Bond Program, and argued that this multiparty contractual relationship justified a departure from the Countryman Test. The Fifth Circuit rejected this proposed approach, stating that it “seems designed simply to elevate the rights of sureties above those of other creditors.”

However, the Fifth Circuit agreed that the Countryman Test should be applied flexibly to account for obligations owed to all parties in multiparty agreements. Nonetheless, the Court found that even if the obligations owed by Argonaut to the third-party obligees would meet the material obligations portion of the Countryman Test, it failed the second requirement, as the performance bonds were irrevocable and the Debtor’s failure to perform its obligations would not excuse Argonaut from its obligations under the agreements.

In an important footnote, the Court noted that in future cases courts may be called upon to modify the Countryman Test and apply and adopt a more “functional approach” for multiparty contracts. The functional approach looks at the benefits that assuming or rejecting a contract would produce for the bankruptcy estate to determine if the contract at issue is executory in nature. This opens the door for a more flexible approach in determining whether multiparty contracts are executory and will have implications beyond the realm of surety contracts.

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