Lead Article: Does Assuming a Contract in Bankruptcy Waive Later Attacks on the Contract?

I. Introduction

In Astria Health v. Cerner Corp., Quinn Emanual’s client Astria Health defeated a summary judgment motion that presented a complex question at the intersection of state law and the Bankruptcy Code: Can a debtor assume an executory contract under 11 U.S.C. § 365 and still pursue state-law claims that the contract was fraudulently induced or amounted to a fraudulent transfer? 640 B.R. 758, 2022 Bankr. LEXIS 1544 (Bankr. E.D. Wash. 2022) (Holt, J.). The answer, in this case, was yes. In deciding this question, Judge Holt observed that the issues “carries the potential for complexity and confusion nearly unrivaled in the Bankruptcy Code.” Id. at *11. And the Court’s analysis makes clear that there are a number of factors that must be considered in this context. See id. at *23–­­30.

II. The Assumption or Rejection of Executory Contracts Under 11 U.S.C. § 365

A debtor in bankruptcy has the option under 11 U.S.C. § 365 to assume or reject “executory” contracts (which are contracts where both parties have future obligations). The debtor is required to make this determination using its business judgment about whether the continuance of a given contract is in the best interests of the debtor. Astria, 2022 Bankr. LEXIS 1544 at *21. The bankruptcy court must review and approve the debtor’s determination, but this is typically done in a summary proceeding in which the court applies a very deferential standard to the debtor’s exercise of business judgment. Id. Because of the summary nature of the proceeding, it is not considered a ruling on the merits of any contractual issues and carries no collateral estoppel effects. Id. at *29, n.58 (citing In re 611 Sixth Ave. Corp., 191 B.R. 295, 300 (Bankr. S.D.N.Y. 1996)).

The rejection of a contract relieves the debtor of its future performance obligations, but it is not a magic wand that makes the contract disappear. Rather, the debtor’s decision to reject a contract operates as a breach as of the date of the bankruptcy filing, allowing the counterparty to make claims against the debtor for that breach, albeit in the form of a claim in the bankruptcy. A decision to assume the contract, on the other hand, continues both parties’ obligations, and provides priority for the counter-party with regard to the future obligations owed by the debtor to ensure that it fair to compel the counter-party to continue under the contract notwithstanding the bankruptcy.

Section 365 of the Bankruptcy Code spells out this process and the immediate effects for the bankruptcy proceeding but does not address the consequences, if any, that this election may have on state-law claims and defenses that could arise in an adversarial proceeding between the debtor and the counterparty. Such proceedings are not uncommon. Debtors often litigate with contractual counterparties, which raises the possibility that a debtor’s decision to assume a contract might preclude the debtor from later attacking the contract as fraudulently induced, unenforceable, void, or otherwise damaging to the debtor. At first glance, the debtor’s decision to assume, rather than reject, a contract, appears to be a validation of the contract. After all, one may wonder, if the contract was so problematic or damaging, then why would the debtor decline an opportunity to reject it? That view, however, is misaligned with the nature and purpose of a contract assumption.

III. State-Law Ratification Theories Can Bar Attempts to Rescind a Contract.

State law governs most contractual relationships. When a debtor files for bankruptcy protection, there are often potential claims arising from the debtor’s existing contracts that could, if successful, generate money for the creditors. For executory contracts, this presents a potential tension if a debtor wishes to assume a contract, on the one hand, while preserving the right to claim the counterparty has breached the contract or committed fraud in connection with it, on the other hand.

One particularly important type of claim is that a contract was procured by fraud on the part of the counterparty. A debtor (or other plaintiff) that proves fraudulent inducement of a contract can obtain significant forms of relief that are typically not available for “mere” breach of contract, including voiding the contract; recovering punitive damages for the tort of fraud; and vitiating damage limitation provisions that are found in many contracts and which limit the nature or amount of recovery that can be obtained in the event of a breach.

In the Astria bankruptcy, the debtor elected to assume one of the key contracts with its software vendor, Cerner, reasoning that its hospitals’ ability to operate going forward would be destroyed if it lost access to the software system Cerner installed, even though it had many complaints about the system. The assumption decision was made through the normal summary procedure during the bankruptcy and was then effectuated in a confirmed plan of reorganization. The problems with the Cerner software were known throughout the bankruptcy process and all parties contemplated that an adversary action would be filed against Cerner after confirmation with any recovery distributed according to the plan. In contemplation of that litigation, the plan provided that Astria and Cerner each reserved all “claims, obligations, causes of action or other rights” against one another, which “shall be included and determined in the Adversary Proceeding.” Astria, 2022 Bankr. LEXIS 1544 at *15–16. As anticipated, Astria then filed an adversary proceeding against Cerner alleging breach of contract, fraudulent inducement, fraudulent transfer, and other claims. On summary judgment, Cerner argued that Astria’s claim for fraudulent inducement was barred—and Astria was precluded from attempting to void the contract—because it had elected in the bankruptcy to assume the contract.

Cerner argued that the bankruptcy assumption amounted to a “ratification” under Washington state law, which provides that a party who has “affirmed and acted in furtherance of the contract” has ratified and become bound by it. Poweroil Mfg. Co. v. Carstensen, 69 Wash. 2d 673, 678, 419 P.2d 793, 796 (1966) (decided in the context of a corporate ratification of the acts of its directors). The right to rescind a voidable contract may be lost where there has been a waiver or ratification. Id. The same concept is sometimes framed as waiver or estoppel rather than ratification, as in Owen v. Matz, 413 P.2d 368, 369 (1966). In Owen, the Washington Supreme Court found that a party had waived any claim for contract rescission or fraudulent inducement by executing a supplemental agreement with the counterparty after becoming aware of the facts it now pointed to as fraud. Id. But importantly, under Washington law a ratification cannot be found unless the ratifying party intended to ratify the contract in spite of the alleged fraud. See, e.g., Wickre v. Allen, 58 Wash. 2d 770, 776, 778 (1961). And that intent must be “unequivocal.” Id. The element of intent is common in other states’ ratification law as well. See, e.g., Robinson v. Day, 2013 NY Slip op 1321, ¶ 2, 103 A.D.3d 584, 586, 960 N.Y.S.2d 397, 401 (App. Div.) (New York); Fergus v. Songer, 150 Cal. App. 4th 552, 571, 59 Cal. Rptr. 3d 273, 290 (2007) (California); Neese v. Lyon, 479 S.W.3d 368, 384 (Tex. App. – Dallas 2015, no pet.) (Texas).

One final subtlety in the analysis is that the legal standard for ratification in Washington contemplates the negotiation of favorable changes or amendments to a contract as part of the ratification. In other words, for a party to claim its counterparty ratified an alleged fraud, the counterparty must obtain some modifications to the contract in return. See Owen, 68 Wash. 2d 374, 376-77 (1966) (“[W]hen a party claiming to have been defrauded, enters after discovery of the fraud into new arrangements or engagements concerning the subject matter of the contract claimed to have been procured by fraud, he is deemed to have waived any claim for rescission and under certain circumstances for damages.”); Weitzman v. Bergstrom, 75 Wash. 2d 693, 700-01 (1969) (distinguishing Owen on the ground that appellee did not waive fraud claim because his entry into a subsequent agreement did not demonstrate intent to waive fraud claim, and applying Owen’s rule would produce a “gross miscarriage of justice”). In practical effect, the later modifications, made “after the discovery of fraud,” act as a settlement of the prior fraud claim, though the cases discuss the concept as waiver or ratification.

IV. Does the Assumption of a Contract in Bankruptcy Amount to Ratification?

In Astria, the Court was tasked with determining whether Astria’s bankruptcy decision to assume the contract in question amounted to a ratification under Washington law. A finding of ratification would likely have precluded Astria’s cause of action for fraudulent inducement, which, in turn, would have blocked at least one route to avoid or vitiate the damage limitation provisions in the Cerner contract. The Court, however, declined to find ratification—at least in the summary judgment context in which it was raised. While the opinion leaves open the possibility that the fact-finder could find a ratification at trial, the Court’s view of the record reflects a fair degree of skepticism about the application of ratification principles in this case even under a preponderance of the evidence standard.

In concluding that ratification did not bar Astria’s claims, the Court first addressed Cerner’s argument that Astria could not, under any circumstances, avoid the damage limitation provision because assumption of the contract was cum onere, meaning that Astria’s assumption of the contract was an assumption of all terms therein. It is certainly true that debtors cannot pick and choose among contract provisions and assume only those provisions it finds favorable. But, as the Court found, while the cum onere principle prevents a debtor from rewriting an assumed contract, it does not have a “broader effect that ossifies an agreement against a latent defect or an attack otherwise available under applicable non-bankruptcy law.” In other words, any contract assumed by the debtor under section 365 is cum onere, but that principle does not preclude or override non-bankruptcy law that can vitiate certain types of provisions.

Next, the Court found that even if a contract assumption under section 365 could, in some circumstances, constitute a state-law ratification or waiver, the record at hand did not support such a finding, at least on summary judgment. Here the Court found that the explicit reservation of rights in the Plan created, at the very least, equivocation on the question of whether Astria “unequivocally” intended to ratify the contract. Wickre, 58 Wash. 2d at 776, 778. In contrast to the Court’s cum onere analysis, this aspect of the opinion is specific to both Washington ratification law and the facts of the case at hand.

Third, the Court found that Astria’s additional claim that the assumed contract constituted a fraudulent transfer also survived summary judgment because of the Plan’s reservation-of-rights language. The Court acknowledged that courts typically reason that contract assumption under section 365 precludes avoidance actions under 11 U.S.C. § 547 and that several bankruptcy courts have concluded that assumption also precludes a fraudulent transfer claim. Astria, 2022 Bankr. LEXIS 1544 at *28–30. But the strong reservation-of-rights language in the plan meant that Astria had preserved its ability to litigate all potential claims, including fraudulent transfer.

In reaching its holding, the Astria court addressed the sole prior case that had addressed the issue and concluded that assumption did constitute a ratification under New York state law: In re New York Skyline, Inc., 432 B.R. 66, 77 (Bankr. S.D.N.Y. 2010). In that case, the Southern District of New York bankruptcy court determined that a party who assumed a contract under 11 U.S.C. § 365 could not later selectively seek to rescind the contract or avoid any of its obligations under the assumed contract. “When the debtor assumes the lease or the contract under § 365, it must assume both the benefits and the burdens of the contract. Neither the debtor nor the bankruptcy court may excise material obligations owing to the non-debtor contracting party.” New York Skyline, 432 B.R. at 77. In essence, this is the same cum onere principle distinguished by the court in Astria.

Astria distinguished New York Skyline on the basis of the Plan’s reservation-of-rights and the elements of ratification under Washington law (notably, the requirement that the allegedly ratifying party express an unequivocal intent to forsake its ability to void a problematic contract). Notably, New York Skyline did not address the substantive elements of ratification under New York law. The Astria court also expressed “deep concerns” about the conclusion reached in New York Skyline in part because of its failure to address a “serious argument that state law should be preempted or negated if it would interfere with or create nonuniform consequences from a chapter 11 debtor utilizing the federal tool of contract assumption.” Astria, 2022 Bankr. LEXIS 1544 at *26, n.50. The court did not reach the preemption question because it did not need to, but future courts may well be forced to grapple directly with this theory.

While there are fact-bound aspects of this new authority, it does provide a strong basis for debtors to assume contracts in bankruptcy while preserving the ability to challenge those contracts in adversary proceedings so long as the debtor is careful to express its intent to preserve those rights.

V. Considerations for Practitioners

Although Astria does not fully resolve the tension between assumption under 11 U.S.C. § 365 and state-law ratification or waiver law, it does clarify how parties should position themselves in situations where a debtor may want to assume an executory contract and still seek to attack it in an adversary proceeding. Debtors should be mindful of the following:

• Ensure that you clearly express your intent to preserve arguments about whether the counterparty has breached, fraudulently induced, or otherwise acted improperly in connection with the contract (even though you wish to assume the contract under section 365).
• Ensure that you make clear that your desire to assume the contract is because the ongoing performance is necessary at the time of the section 365 election. In other words, emphasize that the assumption/rejection decision is based on the business interests of the debtor at the time of the decision and is not addressed to the question of whether the debtor would have been better off never entering the contract in the first place. These are two different time periods and that has significant implications.

Carefully research applicable state law and ensure that your actions steer clear of the elements of ratification, waiver, estoppel, and similar legal concepts.
Contractual counterparties in such situations should, of course, also research these state-law concepts. Moreover, they should consider the following if there is a possibility of claims from the debtor in an adversary proceeding:

• Press for statements and agreements from the debtor that characterize the contract as a whole as beneficial or in the best interests of the debtor. Create a record that would make a later claim of fraudulent inducement or malfeasance inconsistent with the record in the bankruptcy.
  Consider, if feasible, offering some minor amendments to or modifications of the agreement to the debtor as part of the assumption process. You could then leverage those benefits into a settlement or release of prior claims as consideration for the favorable modifications for the debtor. And even without a formal release, the modification and assumption has a higher likelihood of qualifying as a ratification or waiver. A minor “give” on the contract terms could return a lot of protections from potential future claims.
• Press for statements or agreements from the debtor during the assumption process not to later sue you. Strictly speaking, you may not be entitled to this, but the process provides an opportunity for the debtor to offer some sort of reassurance that would bolster a later claim of ratification or waiver.