Chapter 11 debtors frequently are parties to and must decide how to maximize value from various contracts. Typically, a debtor choosing to assign valuable rights under a contract must also transfer the liabilities under that contract. This means that a potential acquirer of a debtor's business under a Section 363 asset sale must generally take the good with the bad as to any contracts that the acquirer would have the debtor assign. In certain circumstances, however, a bankruptcy court may sever a single contract into multiple agreements, thereby enabling a potential purchaser to acquire valuable contractual rights free and clear of related contractual liabilities.
One court's recent decision to sever a single contract into a separate "good contract" and a separate "bad contract" highlights this judicial discretion and the opportunities it may present for a savvy purchaser of a debtor's assets. In re American Home Mortgage Holdings Inc., (No. 07-11047(CSS) (Bankr. Del. March 13, 2009)), the U.S. Bankruptcy Court for the District of Delaware allowed one master agreement to be severed into distinct contracts, thereby permitting the Section 363 sale of the beneficial aspects of a nonexecutory agreement, free and clear of ongoing obligations that would have diminished value. The dispute in In re American Homes Mortgage Holdings centered on the debtors' ability to sell certain rights under a nonexecutory contract free and clear of contractual liabilities under the same agreement.
The key facts and background of American Homes are as follows. The contract was a May 1, 2006, master agreement governing the sale and post-sale servicing of various mortgage loans. The parties to the master agreement were American Home Mortgage Corp. (AHM Corp.) as seller, AHM SV Inc. (AHM SV) as servicer and DB Structured Products Inc. (DBSP) as purchaser. Under the sale portion of the master agreement, AHM Corp. had previously sold various mortgage loans to DBSP and remained contractually liable for specific warranties ensuring that mortgagors would neither repay the loans early nor default in payment of the loans before a specified date (the warranty liabilities). Under the servicing portion of the master agreement, AHM SV retained the rights to service the loans purchased by DBSP.p>On Aug. 6, 2007, AHM Corp., AHM SV and various affiliates (debtors) filed voluntary Chapter 11 petitions, as well as an emergency motion to sell various servicing assets (including the servicing rights under the master agreement) free and clear of all encumbrances (including the warranty liabilities). On Sept. 25, 2007, the debtors filed an executed stalking-horse asset purchase agreement (APA), which included the sale of all servicing rights under the master agreement free and clear of any nonservicing liabilities (including the warranty liabilities).
The question before the bankruptcy court was whether, as contemplated by the APA, AHM SV could sell its servicing rights under the master agreement free and clear of the warranty liabilities. The bankruptcy court's decision ultimately hinged on whether, as the debtors argued, the master agreement should be severed into a separate "sale agreement" and a separate "servicing agreement."
To determine whether the master agreement could be severed into two distinct agreements, the bankruptcy court looked to the parties' intent as determined from the language of the master agreement. Specifically, the bankruptcy court employed a three-pronged approach used in a case from the 11th Circuit, In re Gardinier Inc. (831 F.2d 974 (11th Cir. 1987)). Under the Gardinier analysis (which, unlike American Homes, involved an executory contract) the bankruptcy court considered whether (i) the nature and purpose of the agreements were different, (ii) the consideration for each agreement was separate and distinct and (iii) the obligations of each party were not interrelated.
Ultimately, the bankruptcy court held that the master agreement was severable into separate sale and servicing contracts because the nature and purpose of the sale and servicing agreements were different, the consideration for each was separate and distinct, and the obligations of each party were not interrelated. For this last determination, the bankruptcy court focused on the fee structure and payment provisions of the master agreement. Citing the separate fees earned for sales versus servicing of mortgages, the bankruptcy court held that a waterfall provision defining each of the parties' respective payment rights and an indemnity provision requiring joint indemnification of DBSP by each of AHM SV and AHM Corp. were not enough to make the sales and servicing agreements "economically interdependent."
Bankruptcy courts classify contracts as either "nonexecutory" or "executory." The category into which a contract fits depends on the extent of each party's performance. Nonexecutory contracts are those under which one party has fully performed its obligations. By contrast, executory contracts are those under which each party has remaining material obligations to perform.
As noted above, the American Homes decision concerned the debtors' ability to sever a nonexecutory contract into two agreements, and thereby transfer only the beneficial portion of the agreement (the servicing arrangements), free and clear of the warranty liabilities under the sale portion of the agreement. In the context of a Section 363 asset sale by a debtor that is party to nonexecutory contracts, the take away from American Homes is clear. The debtor and the purchaser should be alert to the possibility of severing each of the debtor's nonexecutory contracts into a "good contract" and a "bad contract," enabling the debtor to transfer its severed "good contracts" for maximum value to the estate and leaving the counterparties to the severed "bad contracts" with unsecured prepetition claims.
Interestingly, the American Homes decision relied on case law involving executory contracts in determining the severability of a nonexecutory contract. In the context of executory contracts, the potential severability of agreements creates intriguing additional possibilities for bankruptcy M&A transactions. Section 365 of the Bankruptcy Code gives a debtor three options (subject to certain exceptions) with respect to an executory contract: The debtor may reject the contract (leaving the counterparty with an unsecured claim), assume the contract and continue to perform under its terms, or assume the contract and assign it to a third party (in each of the latter two cases, the debtor must generally cure past defaults and provide the counterparty with adequate assurance of performance in order to assume an executory contract under which the debtor has defaulted).
The potential severability of an executory contract into two contracts thus has important consequences for a purchaser's flexibility in acquiring assets from the debtor's estate. If a single executory contract with both valuable and burdensome aspects can be severed into two contracts, a purchaser may be able to direct the debtor to reject the burdensome severed executory contract and assume and assign to the purchaser the valuable severed executory contract. Alternatively, if a single executory contract can be severed into two executory contracts, one with substantial cure costs and the other with minimal cure costs, a purchaser may be able to direct the debtor to reject the severed executory contract with significant cure costs and assume and assign the severed executory contract with minimal cure costs. It might also be possible to sever a single contract into two agreements, one that is executory and another that is nonexecutory, giving the purchaser the option to acquire the nonexecutory portion in a Section 363 sale without complying with the additional requirements of Section 365. Conversely, a counterparty to multiple individual contracts might persuade a bankruptcy court to treat those contracts as one contract for purposes of a Section 363 sale.
From a planning perspective, corporate counsel should consider severability potential at the drafting stage of any important contract. Because courts inquire as to the intent of the parties in determining whether a single contract should be divisible into multiple contracts, or whether multiple contracts should be aggregated into one, the drafter of a contract is in the best position to shape the outcome that best serves the interests of his or her client.
Ben Bodamer is an associate and Joseph Basile is a partner in the corporate department of Weil, Gotshal & Manges LLP. Jeff Tanenbaum, a partner in the business finance and restructuring department of Weil Gotshal, reviewed this article.