Law Review (Note): Caraballo, Samantha- Rejection of an Executory Contract Does Not Invalidate Rights Exercised or Performance Rendered Prior to Rejection

Available at:   https://scholarship.law.stjohns.edu/bankruptcy_research_library/370/

Abstract:

Under section 365 of Title 11 of the United States Code (the "Bankruptcy Code"), a trustee or a debtor in possession may "reject" an executory contract. Rejection results in a breach of contract. Courts consider non-bankruptcy contract law to determine the impact of the breach on the executory contract. In general, rejection does not undo a party’s past performance or exercise of rights under the contract. Instead, it relieves a debtor from its future obligation to perform.

Part I of this Article explains the different approaches to defining "executory contract." Part II of this Article elaborates on a trustee and debtor in possession’s power to reject an executory contract in a bankruptcy case. Part III of this Article discusses the consequence of rejection. Part IV of this Article addresses rejection’s impact on past performance and exercise of rights under the contract

Commentary:

This note makes clear that under Mission Prod. Holdings v. Tempnology and its progeny, rejection under § 365 is a breach, not a rescission, and does not unwind rights already granted or exercised prior to rejection. That distinction is critical when considering whether contractual provisions—particularly those mandating arbitration—survive rejection.

Considering,  for example, whether an arbitration clause is  an “executory contract” depends first on whether it is part of a broader agreement with continuing obligations on both sides at the petition date. Under the Countryman test (favored by the Fourth Circuit), an arbitration agreement standing alone may be executory if, at filing, each party still had material unperformed obligations—such as the debtor’s obligation to arbitrate disputes and the counterparty’s obligation to participate in and be bound by arbitration. Under the functional approach, an arbitration clause could be treated as executory even if the creditor’s only duty is to arbitrate, if rejecting it would confer a tangible benefit on the estate.

If the arbitration provision is embedded in a broader executory contract (e.g., a consumer loan agreement or service contract), and that contract is rejected (or deemed rejected if not timely assumed), rejection constitutes a breach of the arbitration clause as well. Under Mission Products, however, breach does not necessarily erase rights that survive outside bankruptcy law. This raises the thorny question: is the right to compel arbitration a “vested” right that survives breach, or merely a future performance obligation?

Some courts have held that arbitration clauses are procedural mechanisms for resolving disputes—not substantive rights that “vest” pre-breach—and thus can be rendered unenforceable if the executory contract containing them is rejected and not assumed. Others treat arbitration as a stand-alone enforceable right, analogizing it to a forum-selection clause, which generally survives breach. In consumer bankruptcy, this analysis has practical importance: if arbitration is rejected, debtors may keep disputes in bankruptcy court without having to meet the McMahon/Epic Systems pro-arbitration federal policy head-on.

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