By: Sarika Angulo, Senior Associate at CAB and invited blog contributor.
It is widely known that Puerto Rico is presently in the midst of a major financial quandary. The Commonwealth has amassed over $73 billion dollars in government-debt alone. This economic downturn has led to many sources of financial distress, which has inevitably had a significant negative ripple effect on the private sector as a result of the brain drain to the mainland, the rise in unemployment, mortgage and foreclosure crises, and the tightening of consumer credit. In an effort to assist Puerto Rico put its fiscal house in order, Congress appointed a “Financial Oversight & Management Board for Puerto Rico” pursuant to “The Puerto Rico Oversight, Management, and Economic Stability Act.” See Public Law 114-187 of June 30, 2016, tit. 1, Art. 101(b)(2) (colloquially known as “PROMESA”).
While the abstract policies behind PROMESA are laudable as they are aimed at reducing costs drastically, increase revenues, and expand economic growth, a comprehensive and concrete plan to abate the crisis is yet to be outlined. Until then, this financial uncertainty may continue to have dire consequences for the private sector. Local businesses bearing the brunt of a sluggish economy may have no other option but to turn to the last resort of filing for bankruptcy to obtain a respite and perhaps start anew. But, if the local business that files for bankruptcy is a party to an ongoing distribution agreement, what happens to the agreement as of the time of the filing of the bankruptcy petition? Does the agreement remain in full force and effect, thereby becoming property of the debtor’s (distributor) bankruptcy estate or is it automatically terminated? If the latter, does such “termination” constitute a breach of the distribution agreement by the debtor/distributor? If so, can such breach by the debtor/distributor be considered “just cause” to terminate the distributorship under Puerto Rico’s Dealer and Franchise Statute (commonly known as “Act 75”)? See P.R. Laws Ann. tit. 10, §§278 et seq.
A thorough research on these issues has yielded only one case from the District of Puerto Rico. In American Healthcare Corp. v. Beiersdorf, Inc., 2006 WL 753001 (D.P.R. March 23, 2006), the Court addressed this particular controversy, but in the context of a Chapter 11 reorganization. There, the court held that there was no valid basis for a Law 75 claim after the dealer’s contract had been rejected and did not become part of the estate in a Chapter 11 proceeding. So, Plaintiff was not the “owner” of any dealer’s contract or had no valid basis to assert a subsequent judicial claim under Law 75 against the principal because it breached the contract by rejecting it.
Accordingly, based on controlling case law, here I address what could be expected to occur to an ongoing distribution agreement at the time of the filing of a bankruptcy petition by the debtor/distributor as seen through the prism of Chapter 11. Under the U.S. Bankruptcy Code (the “Code”), Chapter 11 is ordinarily used by businesses to reorganize their debts and continue operating. When a debtor files for relief under this chapter, an estate in bankruptcy is created. See 11 U.S.C §541(a).This estate may include contracts, such as executory contracts. While the Code has an expansive provision addressing “executory contracts” (see 11 U.S.C. §365), as well as an elaborate section defining the terms contained therein, it does not describe the term “executory contracts.” For this reason, courts and practitioners alike have adopted the definition coined by Professor Vern Countryman of Harvard Law School in a 1973 article in the Minnesota Law Review where he defined such contracts as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.” See Vern Countryman, Executory Contracts in Bankruptcy: Part I, 57 Minn. L. Rev. 439, 460 (1974). Under this definition, an ongoing distribution agreement under Act 75 falls squarely within the meaning of “executory contract.” See American Healthcare Corp. v. Beiersdorf, Inc., 2006 WL 753001, at *2.
Despite the cult status enjoyed by Countryman’s test, some courts have departed from it as they believe the test is too static and rigid, creating a higher threshold for the definition of an executory contract than Congress intended. See, e.g., In re Riodizio, Inc., 204 B.R. 417 (Bankr. S.D.N.Y. 1997) (citing Mitchell v. Streets (In re Streets & Beard Farm P’ship), 882 F.2d 233 (7th Cir. 1989)); In re Spectrum Info. Tech., Inc., 190 B.R. 741 (Bankr. E.D.N.Y. 1996). Instead, these courts have replaced Countryman’s test with a more functional approach under which the focus is on whether or not the estate will benefit from the assumption or rejection of the contract. See In re Gen. Dev. Corp., 84 F.3d 1364 (11th Cir. 1996); see also In re Cardinal Indus., 146 B.R. 720 (Bankr. S.D. Ohio 1992). The U.S. Bankruptcy Court for the District of Puerto Rico is one of these courts. See American Healthcare Corp., 2006 WL 753001, supra.
Under this functional approach —which Puerto Rico follows— if the debtor wishes to continue with an executory contract because it considers it to be a valuable asset of the bankruptcy estate, it may request leave of Court to assume the contract. See 11 U.S.C. §365(a). On the other hand, if it deems the contract to be too onerous and cumbersome, the debtor may likewise request the Court to reject it. Id. Although the debtor may, under the Code, select which executory contract to assume or reject, the debtor cannot cherry pick particular clauses to assume or reject. The executory contract must be entirely assumed or entirely rejected. See American Healthcare Corp., 2006 WL 753001, at *3.
Now, the rejection of a distribution agreement by a Chapter 11 debtor entails certain critical consequences, particularly where an interplay exists between the rejection and Act 75. This is so because for Chapter 11 purposes a rejection of an executory contract (in this case the distribution agreement) constitutes a breach of contract. See 11 U.S.C. §365(g)(1) and 502(g). Under Act 75, an entire breach of the contract by the distributor constitutes “just cause” for the termination of the distributorship by the principal. See P.R. Laws Ann. Tit. 10 §§278(d), 278a, 278a-1. In other words, the principal can walk away from the distribution agreement without any liability. That means that the principal will not be liable to the debtor/distributor for damages, which pursuant to Act 75 encompass the amount of the profits obtained in the distribution of the merchandise or in the rendering of the services, as the case may be, during the last five (5) years, or if less than five (5), five (5) times the average of the annual profit obtained during the last years, whatever they may be (see P.R. Laws Ann. Tit. 10 §278(b)) and, should the debtor/distributor be the prevailing party, attorneys’ fees. See P.R. Laws Ann. Tit. 10 §278e.
As history has shown, a dire financial environment is a breeding ground for bankruptcies. In a distributorship context, trends have proven that bankruptcy filings seldom occur without warning as they are generally reasonably foreseeable based on signs of financial distress shown by the distributor. Nevertheless, many of these signs are not readily identified until it is too late for the principal to intervene. For that reason, principals should be keenly alert to an inclination by the debtor to repeatedly incur in financial delinquencies and/or request debt restructuring. In such circumstances, legal counsel should always be consulted to ensure proper analysis to devise the most appropriate course of action in order to reach a favorable outcome for all parties involved.