The owner of property that had been leased to a chapter 7 debtor for operation of a restaurant brought an adversary proceeding to compel specific performance of its option to repurchase a liquor license from the debtor. The chapter 7 trustee objected, arguing that (1) the agreement was an executory contract that had been rejected, and (2) it was unenforceable under state law on public policy grounds.
The debtor bought the liquor license from the owner (Mitsuwa) for $700,000, paying $50,000 in cash and executing a promissory note for the balance. The sale agreement gave Mitsuwa an option to repurchase the liquor license for $700,000 with the option triggered by a debtor default. The repurchase price was payable either in cash or by crediting amounts due under the promissory note and/or the lease.
The trustee argued that the repurchase option was an executory contract that had been rejected. In response Mitsuwa contended that the option was not executory since (1) it exercised the option prior to bankruptcy by demanding return of the liquor license in a state court complaint, and (2) it did not owe the debtor any cash because of its offset right.
Generally, a contract is defined as executory if both parties have unperformed obligations that would constitute a material breach if they failed to perform. The test is applied on the date the petition is filed and is determined using state law contract principles. The court noted that there were cases going both ways on the question of whether an option is an executory contract. However, it concluded that if a party has announced that it is exercising an option but has not yet completed the purchase, the option may be executory.
The court did not agree that demanding return of the license in a complaint constituted exercise the option. But even if the option had been exercised, the license transfer had not occurred and both parties had contractual obligations to facilitate the transfer that required time and money. A failure to perform by either party would have been a material breach. Thus, the court concluded the repurchase option was an executory contract.
Since this was a Chapter 7 case, any executory contract that was not assumed within 60 days was deemed rejected. So, the purchase option was rejected and the issue became the effect of that rejection. Mitsuwa argued that rejection did not eliminate its substantive rights under the repurchase option, such as specific performance. The trustee countered that upon rejection Mitsuwa was limited to an unsecured claim for damages.
The court began its analysis by noting that under the Bankruptcy Code rejection constitutes a breach of an executory contract that gives a party a claim the same as if it was a prepetition claim. Further, the Bankruptcy Code defines “claim” to include a right to an equitable remedy for breach if the breach gives rise to a right to payment. The court then has the power to estimate the right to payment.
Thus, the Congress anticipated that parties might have equitable remedies and provided a mechanism to convert those remedies into claims for money. There are certain limited exceptions (such as the right of a licensee of intellectual property continue to use the intellectual property), but none were applicable in this case.
The court acknowledged that the U. S. Supreme Court held in the context of a trademark license that rejection by the licensor did not constitute a rescission of the license, but only a breach of the license agreement that did not deprive the licensee of its right to use the trademark. However, the court distinguished that case as allowing a non-debtor party to retain a right that it had already obtained. The Supreme Court did not say that a debtor had to continue to perform its obligations.
Granting specific performance would allow Mitsuwa to apply its claim to the purchase price. In effect, that portion of its claim would be paid in full to the disadvantage of other creditors. Consequently, the court denied the request for specific performance.
The trustee also argued that the repurchase option was in effect a lien that was unenforceable under state law. A state statute provided:
Under no circumstances … shall a [liquor] license, or rights thereunder, be deemed property, subject to inheritance, sale, pledge, lien, levy, attachment, execution, seizure for debts, or any other transfer or disposition whatsoever …
The purpose was to assure that a liquor license would not be subject to the control of anyone other than the licensee.
Mitsuwa argued that state law had evolved so that agreements to transfer liquor licenses are now specifically enforceable. After analyzing state case law, the court concluded that governmental approval of the license transfer was considered an implied condition of the sale, and with that condition contracts for the sale of licenses would be specifically enforceable.
However, the repurchase option coupled with the right to credit bid looked more like a lien than a sale. Given the very broad language in the statute, including the reference to “any other transfer or disposition whatsoever,” the court concluded that the repurchase option would violate state law and would be unenforceable even though it was not literally a lien or pledge.
Accordingly, the court denied Mitsuwa’s request to compel performance of the repurchase option and turnover of the liquor license.
Parties are always on the lookout for creative ways to protect their claims so that they receive payment in full. Creating an opportunity for recoupment – i.e. set off of claims arising in the same transaction – can give a creditor stronger rights that may lead to the desired result. The creative structure was not successful in this case, but it was close.
Vicki R Harding, Esq.