FOR THE NORTHERN DISTRICT OF CALIFORNIA
RUSSELL and SUSAN LUGLI, No. 1-89-00934
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
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.
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
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 _______________________