In Diamond Z Trailer, Inc. v. JZ, LLC (In re JZ, LLC), No. 07-1011 (9th Cir. B.A.P., June 18, 2007), the Ninth Circuit Bankruptcy Appellate Panel affirmed a Bankruptcy Court decision holding that an unscheduled executory contract rides through the bankruptcy if not assumed or rejected during the bankruptcy.  Further, a debtor has standing to sue for a breach of that executory contract when the breach occurred after the closure of the bankruptcy case.

The Diamond Z Trailer case involved a 1998 licensing agreement executed by the debtor JZ, LLC (the "Debtor"), which licensed Diamond Z Trailer, Inc. ("Diamond Z") to manufacture, promote and sell a horizontal grinder on an exclusive basis for five years, with two nonexclusive five-year extensions.  The Debtor filed a chapter 11 case in November 2001, but failed to disclose the license as either an asset or executory contract in its bankruptcy schedules, disclosure statement or plan of reorganization.  Before, during and after the chapter 11 case, Diamond Z negotiated with the Debtor to acquire the Debtor’s technology and inventory.  Neither the Debtor nor Diamond Z disclosed these negotiations to the bankruptcy court or estate creditors.

The Debtor’s plan of reorganization, which did not contain a provision assuming or rejecting all executory contracts, provided for the Debtor to retain property of the estate and maintain its legal form.  The January 2003 order confirming the plan provided for 100% payment to creditors through the Debtor’s future operations.  A few months after the closure of the Debtor’s chapter 11 case in April 2003, the license became nonexclusive.  Because no agreement had been reached to purchase the technology, the Debtor sued Diamond Z in October 2004 in state court seeking declaratory judgment that the license agreement was still in effect and that Diamond Z manufactured grinders in breach of the agreement.

The bankruptcy court reopened the case to hear the Debtor’s motion for an order confirming the ride through of the licensing agreement.  Diamond Z argued that the Debtor lacked standing to sue in the state court and, in any event, should be judicially estopped from enforcing the license agreement since it failed to disclose it in bankruptcy.  Of note, the bankruptcy court held that: (1) the Debtor had standing to bring the state court action for breach of the undisclosed license agreement; and (2) the license agreement "rode through" the bankruptcy despite the lack of disclosure.  On appeal, the Bankruptcy Appellate Panel for the Ninth Circuit ("Ninth Circuit BAP") affirmed.

As to the failure to disclose the license agreement, the Ninth Circuit BAP was not persuaded by the Debtor’s argument that it was not required to disclose the agreement because the law is unsettled regarding whether an executory contract becomes property of the estate.  The court stated that a "debtor who lists only those items that the debtor believes are property of the estate improperly truncates the creditor/trustee review process and usurps the role of the court."  A Debtor is required to list all contracts, executory or otherwise, on its schedules.  Nonetheless, the Ninth Circuit BAP found that when creditors were paid in full in the Debtor’s chapter 11 case it was difficult to identify a party that suffered harm as a result of the Debtor’s omission.  Furthermore, the party making the argument, Diamond Z, also failed to disclose the license to the bankruptcy court, and thus, did not have the "clean hands" necessary to make such an argument.

As to the issue of standing, the Ninth Circuit BAP held that the Debtor had standing to sue for breach of the unscheduled license agreement in state court because the Debtor was revested with all scheduled and unscheduled property of the estate upon plan confirmation pursuant to Bankruptcy Code section 1141(b).  The Ninth Circuit BAP held that this ruling is consistent with Bankruptcy Code section 554(d), which states that all unscheduled property of the estate remains property of the estate even after the case is closed.  Once a chapter 11 plan is confirmed, Section 1141(b) vests all estate property in the debtor, which includes any unscheduled property.  Thus, the Debtor in Diamond Z Trailer had standing to sue on for breach of the license agreement because it controlled all property of the estate after its chapter 11 case closed.

The vesting rule of Section 1141(b) does not give unlimited control over unscheduled assets to a debtor, however.  The Ninth Circuit BAP held that Ninth Circuit Court of Appeal decisions Cusano v. Klein, 264 F.3d 936 (9th Cir. 2001) and Hay v. First Interstate Bank of Kalispell, N.A., 978 F.2d 555 (9th Cir. 1992) impose equitable constraints on the Debtor’s entitlement to unscheduled property.  Neither case held that undisclosed assets did not vest in the debtor pursuant to Section 1141(b).  Yet, in both Cusano and Hay, judicial estoppel was imposed on a debtor in the same chapter 11 unscheduled property situation (i.e., the debtor was not permitted to file an action for its own advantage as to property that was not disclosed to creditors in bankruptcy).  In sum, the Ninth Circuit BAP reasoned that property of the estate vested in the debtor by virtue of Section 1141(b) may, in appropriate circumstances, be subjected to equitable constraints with respect to such property.  Each situation must be evaluated on its own facts with remedies fashioned based on the particular situation.  In Diamond Z, the Court determined that equitable constraints were not required because no creditors were harmed, having been paid in full pursuant to the Debtor’s plan, and Diamond Z also failed to disclose the license agreement to the bankruptcy court, and thus, did not have the clean hands necessary to seek an equitable remedy.

As to the effectiveness of the license agreement, the Ninth Circuit BAP held that the "ride through" doctrine developed under the Bankruptcy Act of 1898 survives and applies to executory contracts that are neither assumed nor rejected under Section 365(a) during the course of a chapter 11 case in which a plan is confirmed.  Based on an analysis of Bankruptcy Code sections 365(a), 365(d)(1), 365(d)(2) and 1123(b)(2), the Ninth Circuit BAP held that in a chapter 11 there are three alternatives with respect to executory contracts: assumption, rejection or no action.  Assumption and rejection under Section 365(a) and 365(d)(2) is permissive.  Similarly, assumption and rejection of an executory contract through a chapter 11 plan are permissive.  11 U.S.C. 1123(b)(2).  The fact that these actions are permissive means that neither action must occur, and that a different option exists.  The alternative to assumption or rejection is that the contract rides through the bankruptcy and remains effective between the parties.  Shedding further light on this issue, Section 365(d)(1) states that if the trustee does not assume an executory contract in a chapter 7 case, it is deemed rejected.  The Ninth Circuit BAP noted that chapters 9, 11, 12 and 13 are expressly left out of this provision, presumably to provide flexibility to deal with executory contracts in these cases and permitting ride through as an option.

According to the Ninth Circuit BAP, the ride through doctrine was well established in the Bankruptcy Act.  As a corollary to the general ability to assume and assign all contracts under the Bankruptcy Act, the debtor’s failure to assume a contract did not result in rejection, allowing the contract to "ride through" the bankruptcy and remain in effect.  The question is whether this "ride through" doctrine survives in the Bankruptcy Code.  The Ninth Circuit BAP held that as a matter of statutory construction, the ride through doctrine did survive and was carried forward into the 1878 Bankruptcy Code at Section 365.  A key rule of construction of the 1978 Bankruptcy Code is that doctrines under the Act continue unless Congress expressed a contrary intent.  Nothing in the Bankruptcy Code or its legislative history suggests that Congress intended to alter the basic approach of assumption, rejection and ride through as alternatives.  The First, Second and Fifth circuits have all recognized the ride through alternative.  The Ninth Circuit BAP also noted that the absence of a bright-line rule regarding executory and non-executory contracts creates a "zone of uncertainty" that would be a trap for the unwary if the ride through doctrine did not exist.  Accordingly, the Ninth Circuit BAP determined that the ride through doctrine does in fact exist under the Bankruptcy Code, and based on that doctrine, the Debtor’s licensing agreement rode through bankruptcy and remained effective between the parties.

While Diamond Z Trailer is an example of the Ninth Circuit BAP’s acknowledgement of the ride-through doctrine, the facts are relatively narrow.  The Ninth Circuit BAP focuses heavily on the Debtor’s failure to schedule the license agreement, and whether equitable concerns require a result other than ride through.  Assuming the case has broader applicability, Diamond Z Trailer does not specifically address whether a contract may ride through the bankruptcy in the face of objections by parties in interest.  However, the Ninth Circuit BAP clearly states that assumption or rejection of an executory contract is permissive under Bankruptcy Code sections 365(a) and 1123(b)(2).  Moreover, the court notes that, in all chapters except chapter 7, where assumption or rejection may occur at any time before plan confirmation, a court is not required to grant a non-debtor’s request to fix an earlier date for determination under Bankruptcy Code section 365(d)(2).  According to the Ninth Circuit BAP, these provisions highlight the "flexibility preserved for chapters 9, 11, 12 and 13."  The court further states that that a debtor’s general ability to assume and assign contracts without a counterparty’s permission facilitates reorganizations and was carried into the Bankruptcy Code at Section 365.  Thus, while the court does not address the issue, the Diamond Z Trailer opinion certainly leaves open the possibility that a court may permit ride through of an executory contract notwithstanding objections.

In a similar vein, the case does not appear to foreclose ride through as a viable option for unassumable licenses in certain circumstances.  See Perlman v. Catapult Entertainment, Inc. (In re Catapult Entertainment, Inc.), 165 F.3d 747 (9th Cir. 1999).  For a further discussion on the topic of the availability of ride through for unassumable contracts post-Catapult, see Ohlgren and Kurth article entitled "Ride Through Revisited (Again): The Strategic Use of the Ride-Through Doctrine in the Post-Catapult Era", ABI Journal, Vol. XXIV, No. 5, June 2005.

Authored by:

Theresa Bangert

(213) 617-5596