Memorandum of Decision Re: Executory Contract, Specific Performance

FOR THE NORTHERN DISTRICT OF CALIFORNIA In re RUSSELL and SUSAN LUGLI,                                       No. 1-89-00934        Debtors. ___________________________/
Memorandum of Decision
     The debtors in possession in this Chapter 11 case have brought a motion to be allowed to reject an executory contract which requires them to convey an apartment building to The Profile Group. Profile objects, on grounds that the contract is not executory.      The relevant facts are not especially complicated. In 1984, some five years prior to this Chapter 11, the debtors agreed to exchange their apartment building in Modesto for Profile's interests in two properties in Southern California. Because government approval was required before the debtors could transfer their apartment building, they agreed with Profile that the debtors would get the Southern California property interests from Profile immediately and Profile would get the apartment building when Profile obtained government approval. The agreement provided that if Profile did not obtain such approval within six months, it would get substitute property acceptable to it or $1.5 million in cash. The agreement also provided that the apartment building would be conveyed subject to only $1.3 million in encumbrances.      The debtors never performed under the contract, and further encumbered the apartment building for almost $2 million. Profile brought suit, seeking specific performance and, alternatively, damages. The debtors countersued for rescission. Profile then recorded a lis pendens clouding title to one of the Southern California properties still owned by the debtors. The state court allowed the debtors to convey this property upon the posting of a $500,000.00 bond. The lawsuit was still pending when the bankruptcy was filed.      The debtors argue that the contract was still executory because Profile had not obtained government approval and had not completed an exchange called for in escrow instructions. Profile contests the motion, arguing that it has fully performed and the contract is therefore not an executory contract subject to section 365 of the Bankruptcy Code. The Court believes that both sides have missed the true issues, and that Profile does not appreciate the ramifications of its own position.      Ordinarily, all prepetition unsecured creditors must be treated alike in bankruptcy proceedings, and none may receive payment in preference of others. In re Air Beds, Inc. (9th Cir.BAP 1988) 92 B.R. 419, 422. However, section 365 affords an exception to the rule. If a contract is executory, and if the court authorizes the debtor or trustee to assume it, then the estate may pay prepetition obligations under the contract even though this results in the other party to the assumed contract being preferred over other creditors. However, if the contract is not executory, such payment is not permitted and the creditor has nothing more than a claim against the estate for breach of contract. See, e.g, In re Pacific Express, Inc. (9th Cir.1986) 780 F.2d 1482, 1487; In re FCX, Inc. (E.D.N.C.1986) 60 B.R. 405, 411; In re J.M. Fields (Bkrtcy.S.D.N.Y.1982) 22 B.R. 861, 865. Where the debtor has already received all of the contractual consideration from the other side, the estate cannot possibly benefit from assumption of the contract. To avoid allowing the estate to perform on contracts where no benefit results to the estate, most courts apply the "Countryman" test and hold that such contracts are not executory and therefore not subject to section 365. See, e.g., In re Alexander (9th Cir.1982) 670 F.2d 885, 887. As Professor Countryman noted:
       The trustee's obligation to assume or reject should        not be extended to [contracts where the nondebtor par-        ty has fully performed]. The estate has whatever benefit        it can obtain from the other party's performance and        the trustee's rejection would neither add to nor detract        from the creditor's claim or the estate's liability.        His assumption, on the other hand,wouldinnoway        benefit the estate and would only have the effect of        converting the claim to a first priority expense of        administration and thus of preferring it over all        claims not assumed--a prerogative which the Bankruptcy        Act has never supposed to have vested in either the        trustee or the court.
     Countryman, "Executory Contracts in Bankruptcy: Part I," 37 Minn.L.Rev. 439, 451-52 (1973).      The Countryman test benefits only the debtor estate, by prohibiting its depletion where the benefits under the contract have already been obtained. It makes no sense for the nondebtor who wants the debtor to perform to argue that the contract is not executory, because a finding that the contract is not executory means that the debtor may not perform even if it wants to. Except in rare cases under circumstances not present here, a specific performance action is usually a dead letter once a bankruptcy is filed because equitable remedies are not available if the result is inequitable. See generally Cherkis, Collier Real Estate Transactions and the Bankruptcy Code, section 4.01. Specific performance is provided for under the Code only when the vendee is in possession. 11 U.S.C. section 365(i).      In opposing the debtors' motion, Profile incorrecly assumes that if the debtors cannot reject the contract, they must assume it and transfer the apartment building to Profile. However, the true result if the contract is deemed non-executory is that Profile is nothing more than an unsecured creditor with a breach of contract claim. If Profile has effectively clouded title to the apartment building by recording a lis pendens against it prior to bankruptcy, the the court might impose a constructive trust in Profile's favor, if it could do so without undermining the Bankruptcy Code's policy in favorof ratable distribution. If title was not effectively clouded, the court cannot even do that. In re Tleel (9th Cir.1989) 876 F.2d 769, 773-74.      The irony of this situation is that if Profile is sustained in its argument that the contract is not executory, then its interests in the apartment building are reduced to tenuous equities. However, if the court finds that the contract is in fact executory, then Profile has a statutory lien for whatever it has paid pursuant to section 365(j) of the Code. The court accordingly will save Profile's bacon by finding the contract to be executory.      A contract is not executory if, as of the date of the bankruptcy, one party has fully performed so that the other side has received the full benefit of the contract. In re W. & L. Assoc., Inc. (Bkrtcy.E.D.Pa.1987) 71 B.R. 962, 965. Here, Profile at first gave the debtors the full benefit of the contract but then, when it appeared that the debtors would not perform, Profile in essence took back part of what it had transferred by recording a lis pendens against one of the Southern California properties it had given to the debtors. On the date of the filing, the debtors did not have the full benefit of the contract because they did not have free and unrestricted use of both Southern California properties. In order to complete the contract, the debtors would have to transfer the apartment building and Profile would have to release its interest in the bond posted by the debtors to free up the property acquired from Profile. Since performance requirements existed on both sides on the date of bankruptcy, the contract was executory. Stated as simply as possible, a contract is executory if one party performed fully and then, prior to bankruptcy, took back part of its performance.      For the foregoing reasons, the court finds that the contract is executory and that it is appropriate for the debtor to reject it. The court will hold a hearing on October 6, 1989, at 2:00 P.M. to fix the amount of Profile's lien pursuant to section 365(j). If the equity in the apartment building is insufficient to fully secure the lien, the court will hear argument at that time as to whether a constructive trust should be imposed on the Southern California property (for which the bond stands) and/or the rents from the apartment building to the extent of the shortfall. Testimony will be taken at the hearing. All appraisal testimony shall be in the form of declarations filed and served no later than September 29, 1989; declarants shall be available in court for cross-examination.      The court notes that it will be necessary to establish values for the Southern California properties when they were transferred and for the apartment building at the present time. The court further notes that the contract itself creates at least a rebuttable presumption that the value of the Southern California properties when transferred was $1.5 million; the burden will be on the debtors if they seek to establish some other value.      Counsel for the debtors shall submit an appropriate form of order which counsel for Profile has approved as to form.
Dated: August 21, 1989                                                                              _______________________                                                                                                                      Alan Jaroslovsky                                                                                                                      U.S. Bankruptcy