Disagreement regarding the interpretation of section 365(c) of the Bankruptcy Code has led to divergent rulings among the bankruptcy and federal circuit courts regarding whether a bankruptcy trustee or chapter 11 debtor can assume an executory contract or unexpired lease that is unassignable under applicable non-bankruptcy law without the counterparty’s consent—even where the debtor has no intention of assigning the agreement to a third party. Some courts, including several federal circuit courts, have ruled that, absent counterparty consent, the plain language of section 365(c) prohibits a bankruptcy trustee or chapter 11 debtor from assuming an executory contract or unexpired lease if the contract or lease cannot be assigned under applicable non-bankruptcy law. This is known as the “hypothetical test.”

However, one federal circuit court, and most bankruptcy courts outside of the circuits that have adopted the hypothetical test, apply what is known as the “actual test.” Under the “actual test,” a chapter 11 debtor, with bankruptcy court approval, can assume an executory contract or unexpired lease if the debtor intends to perform under the agreement itself, even if the agreement could not be assigned under applicable non-bankruptcy law and the counterparty does not consent to assumption.

A recent ruling by the U.S. Bankruptcy Court for the Southern District of Ohio has the potential to widen the existing circuit split if it is ultimately upheld on appeal by the U.S. Court of Appeals for the Sixth Circuit. In In re Welcome Group 2 LLC, No. 2:23-BK-53043, 2024 WL 3359379 (Bankr. S.D. Ohio July 10, 2024), the court concluded that the “actual test” both “comports with the plain language of the statute” and is consistent with “the overall objectives of chapter 11 relief and the purposes of the Bankruptcy Code.”

Limitations on the Ability to Assume or Assign Certain Contracts and Leases in Bankruptcy

Section 365(a) of the Bankruptcy Code allows a trustee or chapter 11 debtor-in-possession (“DIP”) (pursuant to section 1107(a)), with bankruptcy court approval, to assume or reject most kinds of executory contracts and unexpired leases. This broad power, however, is limited with respect to certain kinds of contracts. For example, section 365(c)(1)(A) of the Bankruptcy Code provides that a trustee or DIP may not “assume or assign” an executory contract or unexpired lease if “applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession” and such party does not consent to assumption or assignment. 11 U.S.C. § 365(c)(1). The provision is designed to “balance the rights of third parties who contracted with the debtor and whose rights may be prejudiced by having the contract or lease performed by an entity with which they did not enter into the agreement.” In re Lil’ Things, 220 B.R. 583, 591 (Bankr. N.D. Tex. 1998); see generally Collier on Bankruptcy (“Collier”) ¶ 365.07[1][d][i] (16th ed. 2024).

Courts have applied this provision to a wide variety of contracts. Among these are personal service contracts, including employment agreements; contracts with the U.S. government; certain kinds of franchise agreements; and licenses of intellectual property. See id. at ¶ 365.07[1]. Thus, many debtors (especially those in the technology industry) find that their rights with respect to certain executory contracts are significantly limited in bankruptcy.

The Statutory Muddle

Section 365(c)(1) of the Bankruptcy Code prevents a trustee or DIP from assigning a contract without the counterparty’s consent if applicable law prevents the contract from being assigned outside bankruptcy without consent. Section 365(c)(1), however, uses the distinctive phrase “assume or assign,” as opposed to “assume and assign,” which, at first blush, appears to mean that a trustee or DIP cannot assume such a contract and agree to perform under it, even if the trustee or DIP has no intention of assigning the contract to a third party.

Some courts construe the “assume or assign” language to mean that the statutory proscription applies to a trustee or DIP who seeks either to: (i) assume and render performance under the agreement; or (ii) assume the agreement and assign it to a third party. Under this literal interpretation, the court posits a hypothetical question: Could the debtor assign the contract to a third party under applicable non-bankruptcy law? If the answer is no, the trustee or DIP may neither assume nor assign the contract. This approach is commonly referred to as the “hypothetical test.” The Third, Fourth, Ninth, and Eleventh Circuits have adopted this approach. See In re West Elecs. Inc., 852 F.2d 79, 83 (3d Cir. 1988); RCI Tech. Corp. v. Sunterra Corp. (In re Sunterra Corp.), 361 F.3d 257, 265–71 (4th Cir. 2004); Perlman v. Catapult Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 749–55 (9th Cir. 1999); City of Jamestown, Tenn. v. James Cable Partners, L.P. (In re James Cable Partners, L.P.), 27 F.3d 534, 537 (11th Cir. 1994).

A leading bankruptcy commentator has characterized the hypothetical test approach as “troubling, as it may prevent a debtor in possession from being able to reorganize under circumstances that do not adversely affect the other party to the contract.” Collier at ¶ 365.07[1][d] (citation omitted). Moreover, according to the commentator, application of the hypothetical test is inconsistent with the overall objectives of chapter 11 of the Bankruptcy Code:

As a matter of policy, a refusal to permit debtors in possession to assume otherwise nonassignable contracts would present problems for debtors whenever the debtor’s business is one in which major contracts are nonassignable under non-bankruptcy law. Such debtors will not, as a practical matter, be able to avail themselves of the benefits of chapter 11 because they will not be able to perform their prebankruptcy contracts without permission from the nondebtor parties to the contracts.

Id. at ¶ 365.07[1][d][iii].

Other courts, having determined that the phrase “may not assume or assign” should be read to mean “may not assume and assign,” apply the statutory proscription only when the trustee or DIP actually intends to assign the contract to a third party. This approach is commonly referred to as the “actual test.” Its adherents include the First Circuit and the vast majority of lower courts considering the issue. See Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493–94 (1st Cir. 1997), abrogated on other grounds by Hardemon v. City of Boston, No. 97-2010, 1998 WL 148382 (1st Cir. Apr. 6, 1998), superseded by 144 F.3d 24 (1st Cir. 1998); Summit Inv. & Dev. Corp. v. Leroux (In re Leroux), 69 F.3d 608, 612–14 (1st Cir. 1995); In re Jacobsen, 465 B.R. 102, 105–06 (Bankr. N.D. Miss. 2011) (collecting cases).

In addition, the Fifth Circuit has applied the actual test in construing section 365(e)(2)—the Bankruptcy Code’s exception to the prohibition against enforcement of “ipso facto” clauses that act to terminate or modify a contract as a consequence of a bankruptcy filing. See Bonneville Power Admin. v. Mirant Corp. (In re Mirant Corp.), 440 F.3d 238, 248–51 (5th Cir. 2006). Many “actual test” courts have reasoned that a literal interpretation of section 365(c)(1) could defeat the policy considerations and underlying purposes of the Bankruptcy Code. See, e.g., In re Edison Mission Energy, No. 12-49219, 2013 WL 5220139, at *10 (Bankr. N.D. Ill. Sept. 16, 2013) (“The Court also finds that the actual test is more congruous with fundamental bankruptcy policy: the maximization of the value of the debtor’s estate.”); In re Mirant Corp., 303 B.R. 319, 334 (Bankr. N.D. Tex. 2003) (ruling that section 365(c)(1) is “not meant to aid creditors in penalizing an estate”); In re Cumberland Corral, LLC, No. 313-06325, 2014 WL 948473, at *10 (Bankr. M.D. Tenn. March 11, 2014) (concluding that a literal interpretation of section 365(c)(1) would produce an “outcome [that is] contrary to the purposes of the Bankruptcy Code”).

In In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005), the court agreed with the ultimate conclusion reached by the “actual test” courts but adopted a different reading of section 365(c)(1) that, in the court’s view, harmonized the plain meaning of the statute with the result obtained via application of the actual test. Expanding its analysis of section 365(c) beyond the phrase “assume or assign,” the Footstar court reasoned that the term “trustee” in section 365(c) should not automatically be read (as it is in many other provisions “as a matter of simple logic and common sense”) to be synonymous with the term “debtor-in-possession.” Id. at 570, 573.

Instead, the proscription of assumption and assignment is limited to situations where a trustee, rather than a DIP, seeks to assume an executory contract. Id. at 573–74. Under the Footstar approach, the DIP would be permitted to assume the contract because, unlike a bankruptcy trustee, the DIP is not “an entity other than” itself; nevertheless, the DIP would be precluded from assigning a qualifying contract because assignment would force the non-debtor contracting party to accept performance from or render performance to an entity other than the debtor. Id.; accord In re Adelphia Comms. Corp., 359 B.R. 65, 72 n.13 (Bankr. S.D.N.Y. 2007) (noting that Footstar is “plainly correct”); In re Aerobox Composite Structures, LLC, 373 B.R. 135, 141–42 (Bankr. D.N.M. 2007). Footstar thus articulated a rationale for the actual test that relies on the text of the statute itself rather than considerations of bankruptcy policy.

The U.S. Supreme Court declined to address the dispute regarding the proper interpretation of section 365(c)(1) when it denied a petition for certiorari in N.C.P. Mktg. Grp., Inc. v. BG Star Prods., 556 U.S. 1145 (2009). In a statement accompanying the order, Justice Kennedy, joined by Justice Breyer, noted that even though the case before it was not an appropriate vehicle for review, “[t]he division in the courts over the meaning of § 365(c)(1) is an important one to resolve for bankruptcy courts and for businesses that seek reorganization.” The Justices also emphasized that neither test is entirely satisfactory:

The hypothetical test is not … without its detractors. One arguable criticism of the hypothetical approach is that it purchases fidelity to the Bankruptcy Code’s text by sacrificing sound bankruptcy policy. For one thing, the hypothetical test may prevent debtors-in-possession from continuing to exercise their rights under nonassignable contracts, such as patent and copyright licenses. Without these contracts, some debtors-in-possession may be unable to effect the successful reorganization that Chapter 11 was designed to promote. For another thing, the hypothetical test provides a windfall to nondebtor parties to valuable executory contracts: If the debtor is outside of bankruptcy, then the nondebtor does not have the option to renege on its agreement; but if the debtor seeks bankruptcy protection, then the nondebtor obtains the power to reclaim—and resell at the prevailing, potentially higher market rate—the rights it sold to the debtor…. Of course, the actual test may present problems of its own. It may be argued, for instance, that the actual test aligns § 365(c) with sound bankruptcy policy only at the cost of departing from at least one interpretation of the plain text of the law.

Id. at 1146–47.

Welcome Group

Hilliard Hotels, LLC (the “Debtor”), an affiliate of Welcome Group 2, LLC, operated a 94-room inn in Ohio pursuant to a 2017 franchise agreement with a major hotel chain (the “Chain”). Welcome Grp., 2024 WL 3359379, at *1. The franchise agreement authorized the Debtor to use trademarks and operational systems owned by the Chain and obligated the Debtor to comply with certain “brand standards.” Id. The agreement also required the Debtor to make certain repairs and improvements to the hotel property no later than March 2023 in accordance with a “property improvement plan” (the “PIP”). Id. The Debtor expended more than $1.5 million to comply with the PIP, but the renovations were not done to the Chain’s satisfaction, leading the Chain to notify the Debtor that it was in default of the franchise agreement. Id. The Debtor responded by filing for chapter 11 protection on September 1, 2023, in the Southern District of Ohio with the intention of assuming (but not assigning) the franchise agreement. Id.

In February 2024, the Chain filed a motion for relief from the automatic stay to terminate the franchise agreement. Welcome Grp., 2024 WL 3359379, at *1. As grounds for relief from the stay, the Chain argued that: (i) the Debtor’s failure to complete the PIP was an incurable default under the franchise agreement; (ii) section 365(c)(1) of the Bankruptcy Code precluded the Debtor from assuming the franchise agreement; (iii) the Chain’s interest in the franchised hotel property was not adequately protected due to the Debtor’s failure to comply with the brand standards while operating the hotel; and (iv) the Debtor had defaulted on its obligation to pay postpetition fees under the franchise agreement. Id. at *2.

The Debtor agreed that the franchise agreement was an executory contract that could be assumed or rejected under section 365. Id. The parties disagreed, however, as to whether section 365(c)(1) of the Bankruptcy Code prohibited assumption of the agreement. Id. According to the Chain, the plain language of the provision required the bankruptcy court to apply the hypothetical test to determine whether the franchise agreement could be assumed without the Chain’s consent because applicable law (i.e., the Lanham Act, 15 U.S.C. §§ 1051-1141(n), which prohibits assignment of a franchise agreement without a franchisor’s consent) precluded assumption of the agreement, even if the Debtor had no intention of assigning it. Id.

The Debtor countered that the court should apply the actual test to section 365(c)(1) and hold that the Debtor could assume the franchise agreement despite the prohibition of assignment under applicable non-bankruptcy law because it had no actual intention of assigning it. Id. The Debtor also argued that it would suffer a significant financial burden if it were not able to continue operating the hotel as a branded inn under the franchise agreement. Id.

The court confined its ruling on the motion to the section 365(c)(1) dispute, leaving for another day the other grounds for automatic stay relief cited by the Chain.

The Bankruptcy Court’s Ruling

At the outset of her analysis, U.S. Bankruptcy Judge Mina Nami Khorrami noted that, if the Debtor were prohibited from assuming the franchise agreement as a matter of law under section 365(c)(1) of the Bankruptcy Code, the Chain would be entitled to relief from the automatic stay to terminate the agreement. Welcome Grp., 2024 WL 3359379, at *3. She also observed that the U.S. Court of Appeals for the Sixth Circuit has not weighed in on the application of either the actual test or the hypothetical test. Id. at *3 n.3.

The bankruptcy court concluded that the actual test, as articulated by Footstar, Adelphia, and Aerobox, “is the most faithful interpretation of the language in § 365(c)(1) … [and] preserves the evident purpose of § 365(c)(1), which is to protect a counterparty from being forced to do business with someone other than the debtor.” Welcome Grp., 2024 WL 3359379, at *8. According to the Judge Khorrami, the actual test is both the “better policy” and the “most faithful interpretation of the statutory language.” Id. By contrast, she wrote, as explained by the court in Footstar, “the plain meaning analysis of the ‘hypothetical test’ is itself flawed and leads to a contradictory, if not oxymoronic, result.” Id.

Judge Khorrami elaborated as follows:

Without assignment of the contract by the Debtor, there can be no entity other than the Debtor that will be accepting performance or rendering performance under the Franchise Agreement. It is a legal impossibility unless the executory contract is assigned. Based on the plain language of § 365(c)(1), the statutory condition that the creditor must be forced to accept performance from or render performance to an entity other than the debtor can only be triggered and thus make the limitation in § 365(c)(1) applicable if the debtor assigns the contract, because the debtor can never be an entity other than itself. Therefore, based on the plain language of the statute, a debtor is not prohibited from assuming an executory contract if it does not intend on assigning it. Interpreting § 365(c)(1) in this manner not only comports with the plain language of the statute, but it also is consistent with the overall objectives of chapter 11 relief and the purposes of the Bankruptcy Code.

Id.

Moreover, the bankruptcy court emphasized, adoption of the hypothetical test would render section 365(f)(1) of the Bankruptcy Code—which makes provisions in an executory contract that prohibit assignment, except as provided in sections 365(b) and 365(c), unenforceable—superfluous because, if a contract could never even be assumed under the hypothetical test under section 365(c)(1), there would be no need to provide an exception to the unenforceability of a prohibition of assignment in section 365(f)(1). Id.

Judge Khorrami also emphasized that barring the Debtor from assuming the franchise agreement would permit the Chain to obtain a windfall by relieving the Chain of its obligations under the agreement “simply by withholding its consent, as opposed to complying with the terms and conditions for termination of the Franchise Agreement which the Chain would be required to do if the Debtor has not filed for bankruptcy protection,” thereby essentially giving the Chain “veto power over the Debtor’s ability to reorganize.” Id. at *9. According to Judge Khorrami, because the Debtor had no intention of assigning the franchise agreement, the protections provided to non-debtor contracting parties like the Chain in section 365(c)(1) were neither necessary nor warranted. Id.

The bankruptcy court accordingly denied the Chain’s request for stay relief on the basis of section 365(c)(1).

Outlook

The ruling in Welcome Group is consistent with the approach adopted by the majority of lower courts—but only a single circuit court of appeals—concluding that the actual test should determine whether a trustee or DIP may assume or assign a contract that cannot be assigned under applicable law without the non-debtor counterparty’s consent in accordance with section 365(c)(1) of the Bankruptcy Code. The ruling is a positive development for debtors whose post-reorganization business is dependent upon the preservation for contract rights that are not assignable under applicable non-bankruptcy law.

Even so, the longstanding divide among bankruptcy and appellate courts on this issue highlights the need for clarification of the meaning of the statute by either Congress or the Supreme Court. Neither has acted so far to resolve an interpretive conflict that has existed for more than 30 years.

If the Sixth Circuit ultimately affirms the bankruptcy court’s ruling in Welcome Group, the widening circuit split may once again be an invitation for review by the U.S. Supreme Court, which, as noted, has yet to agree to hear a case on whether the hypothetical, the actual, or some other test is the proper one. With no resolution of this matter on the horizon, the practical challenges confronting parties to these kinds of contracts can only be accurately assessed on a case-by-case basis by reference to the particular court presiding over the debtor’s bankruptcy case.