A Modified Countryman Test for Multi-party Executory Contracts

In a recent decision, the Court of Appeals for the Fifth Circuit held that an agreement between a debtor, a surety, and third-party beneficiaries was not an executory contract and, thus, was ineligible to pass-through the bankruptcy unaffected. The Fifth Circuit, however, adopted a modified Countryman test for muti-party executory contracts. Matter of Falcon V, L.L.C., 2022 WL 3274174 (5th Cir. 2022).

Background

Falcon V, LLC and its affiliates (collectively, “Falcon V”) -- entities engaged in the oil and gas industry -- entered into an arrangement with Argonaut Insurance Company (“Argonaut”) by which Argonaut posted four irrevocable performance bonds (the “Bonds”) guaranteeing Falcon V’s obligations to certain third-party obligees (the “Surety Bond Program”). As irrevocable performance bonds, the Bonds provided that “regardless of the payment or nonpayment by [Falcon V] of any premiums owing with respect to this Bond, [Argonaut’s] obligations under this Bond are continuing obligations and shall not be affected or discharged by any failure by [Falcon V] to pay any such premiums.” Falcon V, on the other hand, was obligated pay premiums to Argonaut and to indemnify Argonaut for any payments that Argonaut made under the Bonds (the “Indemnity Agreement”).

Falcon V later filed for Chapter 11 bankruptcy, and Argonaut filed a proof of claim for the amount outstanding under the Bonds. Argonaut also asserted that the Surety Bond Program could not be assumed or assigned because it was a “financial accommodation” but reserved its right in case the Bonds and Indemnity Agreement were found to be executory. Subsequently, the bankruptcy court confirmed Falcon V’s Plan of Reorganization (the “Plan”), which provided that each reorganized Falcon V entity was “deemed to have assumed each executory contract . . . to which it is a party.”

Following confirmation of the Plan, Argonaut requested Falcon V provide additional collateral to fully secure the Bonds, citing the terms of the Indemnity Agreement. Relying on the Plan, Falcon V refused, asserting that Argonaut’s claims were discharged. Argonaut proceeded to file a Motion to Interpret and Affirm the Terms of the Confirmed Chapter 11 Plan, arguing that Falcon V assumed the Surety Bond Program per the terms of the Plan, and that even if the Surety Bond Program had not been assumed, it had “passed-through” the bankruptcy unaffected.

The bankruptcy court held that the Surety Bond Program had not been assumed under the Plan, as it was not an executory contract, and ordered that Argonaut’s unsecured claim against Falcon V be disallowed as a co-obligor’s contingent claim for reimbursement of contribution but did not explicitly address Argonaut’s pass-through argument. Argonaut appealed to the district court, which affirmed the bankruptcy court’s decision that the Surety Bond Program was not an executory contract and held that the bankruptcy court did not err by declining to address the pass-through argument because the doctrine applies exclusively to executory contracts. Argonaut appealed to the Fifth Circuit.

Discussion

The Fifth Circuit was faced with two issues -- first, whether the lower courts erred in their determination that the Surety Bond Program was not an executory contract, and second, even if the Surety Bond Program was not executory, whether the Surety Bond Program passed through the bankruptcy unaffected.

In addressing the first issue, the Fifth Circuit relied on the Countryman test for executoriness, under which a contract is executory only if (1) “performance remains due to some extent on both sides” and (2) “the failure of either party to complete performance would constitute a material breach of the contract, thereby excusing the performance of the other party.” The Fifth Circuit went on to highlight the rationale behind the test, which ultimately seeks to “facilitate the debtor’s rehabilitation” by guaranteeing the debtor’s choice to assume or reject contracts. Against this backdrop, the Fifth Circuit agreed with the lower courts that the Surety Bond Program was not an executory contract because Argonaut’s obligations under the Surety Bond Program ended after it issued the Bonds, and as a result, Argonaut did not owe further performance to Falcon V.

Argonaut argued that the lower courts’ interpretation of the Countryman test was inflexible and proposed a modified test for surety contracts, under which “[w]here the surety and the principal continue to owe obligations to the obligee, and the principal has not fulfilled its indemnity obligations to the surety, that is an executory contract.” Thus, according to Argonaut the Surety Bond Program was an executory contract because (1) both it and Falcon V continued to owe obligations to the various third-party obligees, and (2) Falcon V had not satisfied its indemnity obligations to Argonaut.

The Fifth Circuit declined to adopt Argonaut’s proposed modification to the Countryman test but agreed that the test should be applied more flexibly to multi-party contracts in a way that accounts for the various obligations owed to all of the parties and not just the obligations flowing between the debtor and the creditor. The Fifth Circuit conceded that the Surety Bond Program satisfied the first prong of this modified Countryman test because Argonaut maintained certain outstanding obligations to the various third-party obligees under the Bonds. The Fifth Circuit held, however, that the Surety Bond Program did not satisfy the second prong of the modified Countryman test because of the irrevocable nature of the Bonds, which committed Argonaut to pay the obligees even if Falcon V failed to perform. Since it held that the Surety Bond Program was not an executory contract, the Fifth Circuit dismissed Argonaut’s pass-through argument, which can only apply to executory contracts.

Takeaways

The Fifth Circuit’s opinion in Falcon V provides much needed certainty, at least in the Fifth Circuit, to beneficiaries of surety contracts that the surety’s obligations would remain enforceable notwithstanding their direct obligor’s bankruptcy. The modified Countryman test adopted in this case, however, is a new feature in the executory contracts landscape and its scope and impact remain to be seen.