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The use and abuse of executory contracts in bankruptcy

Bankruptcy can be a difficult journey for a financially troubled business, but the risks for customers of the debtor can also be both significant and unexpected. One of the greatest hazards faced by customers of companies in commercial bankruptcy is the chance of having a once stable and ongoing business relationship turned on its head if the trustee should decide that one or more of the debtor's contracts is not necessary to the health or recovery of the business. Such contracts are referred to as "executory contracts." Any business that has a business relationship with a bankrupt or nearly bankrupt firm should be aware of what may happen to such contracts.

Without providing an explicit definition of an executory contract, the bankruptcy code gives the trustee the power to either reject or assume an executory contract. Generally speaking, an executory contract is a contract that has been partially performed by the parties but one or both parties is under a continuing duty to perform.

One of the most important examples of an executory contract is a partially performed real estate lease. Even if many months remain on the original term of the lease, the trustee can choose to reject the lease and thereby terminate the debtor's legal obligation to occupy the space and pay rent. In short, the trustee can declare the lease null and void.

While the bankruptcy code contains several provisions designed to protect the creditors of the debtor, abuse of the power to reject executory contracts is not uncommon. For example, a debtor in possession under Chapter 11 can reject a real estate lease after paying rent for several months and then renegotiate the lease and obtain more favorable terms.

The power to reject executory contracts is an important feature of bankruptcy law, and it is often used to improve the debtor's financial situation. Nevertheless, any business that has an ongoing relationship with a firm in or on the verge of bankruptcy may wish to consult an experienced bankruptcy attorney for advice on how best to anticipate the possibility that the contract will be rejected.

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