Most M&A transactions that are structured as asset sales and that involve the acquisition of a going concern contemplate the assignment to the buyer of the seller’s rights under key executory contracts. Outside of bankruptcy, "anti-assignment" clauses in such contracts can put the non-seller parties in a powerful position, enabling them to negotiate concessions for their consent to the desired assignments or to withhold their consent altogether. When an asset sale is effected under the Bankruptcy Code, Section 365(f) permits a debtor to assume and assign an executory contract or unexpired lease without the consent of the counterparty even if the contract or lease includes an anti-assignment provision. The debtor’s ability to assume and assign such a contract or lease is not without limit, however. Unless the non-debtor party receives "adequate assurance" that the proposed assignment will not materially and adversely affect that party's bargained-for benefit, courts generally will not authorize the transaction.
A recent decision by the Court of Appeals for the Third Circuit denying the debtor's motion for authorization to assign an executory contract illustrates just such a situation. In re Fleming Cos., Inc., No. 05-2365, 2007 WL 2390776 (3d Cir. Aug. 22, 2007), involved the appeal by Associated Wholesale Grocers (the prospective assignee) of the denial of a motion by Fleming Companies, Inc. (the debtor), a wholesale supplier of groceries to supermarkets, seeking authorization to assume and assign its executory contract for grocery products distribution with Albertson’s, a Midwestern supermarket chain. This decision illustrates the importance of carefully analyzing specific contractual terms in the context of an M&A transaction in which the ability to assign executory contracts is critical to the business deal.
Albertson’s originally built a large distribution facility in Tulsa, Oklahoma, (the "Tulsa Facility") to supply certain of its stores throughout the Midwest. The Tulsa Facility incorporated technology and infrastructure that Albertson’s designed to be compatible with its own electronic supply and marketing system. After operating the Tulsa Facility at only 60% of capacity for a short time, Albertson’s sold it in 2002 to Fleming. At the time of the purchase, Fleming and Albertson’s entered into the Tulsa Facility Standby Agreement (the "TFSA"), a long-term agreement providing for Fleming to supply Albertson’s with groceries for its Oklahoma stores. The TFSA provided that Fleming would supply Albertson’s Oklahoma stores from the Tulsa Facility.
Fleming and Albertson’s operated under the TFSA for less than one year before Fleming filed for bankruptcy in April 2003. Throughout that time, Fleming was unable to meet the required service levels specified in the TFSA. As part of the agreement, Albertson’s was to pay Fleming a fixed weekly stipend to help defray the operational costs of the Tulsa Facility. However, because of Fleming’s inability to perform its contractual obligations, by August 2003, Albertson’s stopped ordering grocery products from Fleming and ceased paying the fixed weekly charge.
On August 15, 2003, the Bankruptcy Court entered an order approving the sale of Fleming’s assets to C&S Wholesale Grocers, Inc. ("C&S"). The sale order authorized C&S to designate third-party purchasers for certain assets, including Fleming’s executory contracts with Albertson’s. Pursuant to the order, C&S designated Associated Wholesale Grocers ("AWG") as a third-party entitled to acquire the TFSA.
Fleming subsequently filed a motion to assume and assign the TFSA to AWG pursuant to Section 365 of the Bankruptcy Code. AWG proposed to supply Albertson’s Oklahoma stores from AWG’s own Oklahoma City distribution center. At the hearing on the motion, AWG’s representatives testified that AWG was capable of fully performing the TFSA since Albertson’s would be able to purchase the same products at the same prices and on the same terms as it expected to receive from Fleming. The Bankruptcy Court nonetheless denied Fleming’s motion to assign the TFSA to AWG on the basis that "fulfillment from the Tulsa Facility was an essential element of the agreement." The District Court affirmed, giving rise to the appeal.
Section 365 of the Bankruptcy Code is intended to allow the trustee (or the debtor-in-possession) to maximize the value of the debtor’s estate by assuming and assigning executory contracts that benefit the estate while rejecting those that do not. The Bankruptcy Code gives a bankruptcy court considerable discretion to excise or waive a bargained-for element of a contract, but Congress clearly intended that bankruptcy courts not exercise such discretion lightly, and that they be sensitive to the rights of the non-debtor contracting party and the related policy requiring that the non-debtor receive the full benefit of its bargain. A central element of this calculus, contained in the text of Section 365(f)(2)(B), is that a debtor can assign an executory contract only if, among other things, the non-debtor party receives "adequate assurance of future performance by the assignee of such contract." The Court of Appeals noted that "‘[a]dequate assurance of future performance’ are not words of art; the legislative history of the [Bankruptcy] Code shows that they were intended to be given practical, pragmatic construction … and must be determined by a consideration of the facts of the proposed [contract] assumption." Further, the Court noted that an assignment is intended to change only who performs an obligation, not the obligation to be performed, and, accordingly, the rights of the non-debtor party to receive the benefit of its bargain must be respected.
While the Bankruptcy Code does not define "adequate assurance", the Court of Appeals stated that Congress imported the phrase from Section 2-609(1) of the Uniform Commercial Code, which provides that "when reasonable grounds for insecurity arise with respect to the performance of either party, the other may in writing demand adequate assurance of future performance." The Court noted in Fleming that adequate assurance need not be given for every term of an executory contract, but that such assurance must be provided in respect of those provisions that are "material and economically significant." This analysis requires the balancing of competing interests: the right of the contracting non-debtor to receive its bargained-for performance, and the entitlement of the debtor’s creditors to the benefit of the debtor’s bargain. The Court explained that the focus of this balancing is rightly placed on the importance of economic materiality within the overall context of the bargained-for exchange — in this case, whether the requirement of supply from the Tulsa Facility was integral to the bargain struck in the TFSA between the parties (its materiality) and whether performance of that provision would be required to give Albertson’s the full benefit of its bargain (its economic significance).
In seeking to resolve this question, the Court of Appeals drew an analogy to the often-encountered "time is of the essence" contractual provision, noting that "it is not inherently material or obviously economic, but such a term can be integral to a contract, and certainly, delay can cause economic detriment." So, too, reasoned the Court, would AWG’s failure to supply Albertson’s from the Tulsa Facility cause economic detriment because the replacement supply arrangement through AWG’s Oklahoma City distribution center would not utilize the trained staff for which Albertson’s had bargained or the proven electronic system of record-keeping which furthered Albertson’s marketing and pricing plans, all of which were only available "from the Tulsa Facility."
The Fleming Court’s ruling that the contractual provision requiring supply from a specific facility was material, economically significant and enforceable under Section 365’s requirement of adequate assurance of future performance offers valuable guidance to those advising buyers, as assignees of executory contracts, in a distressed M&A transaction, particularly in a bankruptcy context:
1) A potential buyer’s due diligence review should include careful analysis of whether and to what extent the acquisition of a seller’s rights under specific executory contracts is intrinsic to the value of the acquired entity as a going concern.
2) A potential buyer should consider whether it has the capability and the wherewithal to perform fully and satisfactorily the obligations under an assigned executory contract and should factor any additional costs of assuming the material and economically significant terms of such contract into its economic analysis.
3) Often, seemingly insignificant or secondary terms may prove to be pivotal in obtaining court approval for the assumption and assignment of an executory contract. Accordingly, a buyer should seek the opinion of qualified and experienced counsel regarding the advisability of entering into any such transaction in light of the specific terms of the governing agreement. As the Court of Appeals for the Third Circuit observed, transactions of this nature must be scrutinized through a looking glass of practicality and pragmatism.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
