Executory Contracts and Leases: Section 365

Introduction

Section 365 of the Bankruptcy Code is one of the most powerful tools available to a Chapter 11 debtor and one of the most consequential provisions for distressed M&A buyers. The section gives the debtor (or, in a sale context, the debtor and buyer) the ability to assume favorable contracts and leases (preserving the economics on the debtor's side), reject unfavorable contracts and leases (cutting off future obligations and capping the resulting damages), and assign assumed contracts notwithstanding contractual anti-assignment provisions. The mechanics drive significant value creation in restructurings: rejecting above-market leases can save the debtor tens of millions of dollars per year, assuming favorable customer contracts can preserve the operating-business economics that justify a going-concern emergence, and the ability to assign contracts over a counterparty's objection is what makes Section 363 sale economics work for buyers.

This article walks through Section 365 mechanics in detail: the assumption requirements (cure of monetary defaults, compensation for pecuniary loss, adequate assurance of future performance), the rejection mechanics (deemed pre-petition breach, capped damages under Section 502(b)(6)), the assignment framework (Section 365(f) override of anti-assignment provisions, Section 365(c) limits on personal-services and financial-accommodation contracts), the timing deadlines (Section 365(d)(4)'s 210-day non-residential lease cap, Section 365(d)(2)'s flexibility for executory contracts), the IP license carve-out (Section 365(n)), and the cumulative effect on plan structure and distressed M&A pricing.

The Bankruptcy Code does not define "executory contract", and the definition has been left to case law. The dominant test, articulated by Professor Vern Countryman in 1973, is that a contract is executory if both parties have material unperformed obligations such that a failure by either to perform would constitute a material breach excusing the other's performance. The test is not perfect (it produces edge cases for contracts with one-side-heavy remaining performance), but it remains the workhorse standard across most U.S. bankruptcy courts.

Executory Contract (Countryman Test)

A contract is executory if both parties have material unperformed obligations such that a failure by either to perform would constitute a material breach excusing the other's performance. The test was articulated by Professor Vern Countryman in 1973 and remains the dominant standard in U.S. bankruptcy practice. Common examples of executory contracts: real estate leases (landlord must continue providing premises; tenant must continue paying rent), supply agreements with continuing performance obligations, software licenses with ongoing support obligations, employment agreements with future services, IP licenses with ongoing royalty and use obligations, and franchise agreements. Common examples of non-executory contracts: fully performed contracts where only payment remains owed (a contract that has become a debt obligation), unilateral contracts, and contracts that have terminated or expired pre-petition.

Unexpired leases are treated as a sub-category of executory contracts under Section 365 but with several specific provisions (most notably the 210-day deadline under Section 365(d)(4) for non-residential leases). The lease/contract distinction matters because the deadlines, damages-cap calculations, and assumption requirements differ.

To assume a contract under Section 365(b)(1), the debtor must (1) cure or provide adequate assurance of prompt cure of any default, (2) compensate or provide adequate assurance of prompt compensation for any actual pecuniary loss resulting from the default, and (3) provide adequate assurance of future performance under the contract. The three requirements (cure, compensation, future performance assurance) are cumulative; failure on any prong blocks assumption.

The "ipso facto" override is one of the most consequential features of Section 365. Section 365(e) provides that contractual provisions terminating or modifying a contract upon the debtor's bankruptcy or insolvency are unenforceable in a bankruptcy context. The provision protects the debtor from contract counterparties using bankruptcy-trigger clauses to walk away from valuable contracts at the moment the debtor is most vulnerable.

Rejection under Section 365(g)(1) is treated as a breach of the contract immediately before the petition date. The counterparty has a pre-petition claim for damages resulting from the breach. The economic effect is significant: the debtor's future obligations under the contract are eliminated, and the counterparty's damages claim is treated as a general unsecured claim (typically recovering at unsecured-class recovery rates of 5-30% depending on the case).

For leases, Section 502(b)(6) caps the damages claim at the greater of one year of rent or 15% of the remaining lease term's rent (capped at 3 years), plus any accrued unpaid pre-petition rent.

Section 502(b)(6) Lease Rejection Damages Cap

The statutory cap on a landlord's rejection damages claim under Section 502(b)(6). The formula: damages are capped at the greater of (1) the rent reserved by the lease for the one year following the petition date or the date of surrender of the leased property, whichever first occurs, or (2) the rent reserved by the lease for 15%, not to exceed three years, of the remaining lease term. Plus any accrued pre-petition rent that has not yet been paid. The "Time Approach" (majority view) interprets the 15% prong as meaning the rent for the first 15% of the remaining lease term, capped at 3 years; the "Rent Approach" (minority view) interprets it as 15% of total remaining rent. Section 502(b)(6) applies only to "true leases"; the Second Circuit's 2025 ruling confirmed that synthetic leases and equipment financings disguised as leases do not qualify.

The cap is one of the most consequential features of Chapter 11 for any tenant with above-market lease obligations. A debtor with a 20-year remaining lease at $5 million annual rent has a face-value future obligation of $100 million. Rejection caps the landlord's claim at the greater of $5 million (one year) or $15 million (3 years × $5M = 15% × 20 = 3 years), so the cap is $15 million. The unsecured-class recovery on the $15 million capped claim might be $3 million (at a 20% recovery), versus the $100 million of future rent obligations the debtor would otherwise face. The economic delta (avoiding $97 million of future rent) drives substantial Chapter 11 value creation in real-estate-heavy cases.

Section 365(f) lets the debtor assume and assign a contract or lease notwithstanding contractual provisions that prohibit, restrict, or condition assignment. The override is a powerful structural feature of Chapter 11: contracts that say "this agreement may not be assigned without the counterparty's consent" can be assigned to a Section 363 buyer over the counterparty's objection, subject to "adequate assurance of future performance" by the assignee.

The Section 365(f) override is the structural foundation of distressed M&A. A buyer of operating assets in a Section 363 sale gets the cherry-picking economics: assume favorable contracts (long-term customer agreements at favorable pricing, exclusive distribution rights, IP licenses, below-market real estate leases) and assign them over anti-assignment objections, while leaving unfavorable contracts (above-market leases, money-losing supply agreements, restrictive franchise agreements) for rejection and capped pre-petition damages.

Section 365(c) limits

Section 365(c) creates exceptions to the assumption-and-assignment override. The two most significant:

The 365(c) limits explain why a Chapter 11 debtor cannot force a lender to "assume" a prepetition revolving credit facility on its existing terms.

Section 365(d)(4) imposes a hard deadline on non-residential lease assumption. The debtor must assume a non-residential real estate lease within 120 days after the petition date or be deemed to have rejected it. The court can extend the deadline by up to 90 additional days on motion of the debtor for cause shown, but cannot extend further without the lessor's consent. The maximum non-consent period is therefore 210 days (120 + 90).

For executory contracts that are not unexpired leases, Section 365(d)(2) provides more flexibility: the debtor can assume or reject at any time before plan confirmation, with the court able to compel a decision on motion of the counterparty for cause shown. The executory-contract flexibility differs sharply from the lease 210-day rule, with the difference reflecting the balance between debtor flexibility and counterparty protection.

Section 365(n) provides specific protection for licensees of intellectual property when the debtor licensor rejects an IP license. The licensee can elect to: (1) treat the rejection as a termination and have a damages claim; or (2) retain its rights under the license for the remainder of the original license term, including any extensions, even though the licensor has rejected. Election (2) is the more common choice because it preserves the licensee's ability to continue using the IP without renegotiation.

Section 365(n) applies to specifically defined "intellectual property" under the Bankruptcy Code (Section 101(35A)): patents, copyrights, trade secrets, mask works, and plant variety protections. Notably, the statutory definition does NOT include trademarks, which created a long-running circuit split before the Supreme Court's 2019 ruling in Mission Product Holdings v. Tempnology held that rejection of a trademark license does not extinguish the licensee's rights under non-bankruptcy law. The decision effectively extended Section 365(n)-equivalent protection to trademark licensees through trademark law's non-bankruptcy rules.

The cure-amount question is one of the most commonly litigated issues in Section 365 motions. The debtor proposes a cure amount in the assumption motion; the counterparty has the right to object and assert a higher amount. Disputes typically center on (1) which pre-petition charges are properly part of the cure (rent, late fees, attorney's fees, interest, common-area-maintenance reconciliations), (2) whether post-petition stub-period amounts are part of the cure, and (3) the contract-or-applicable-law basis for any disputed components.

For shopping-center leases, Section 365(b)(3) imposes specific adequate-assurance requirements: assurance of the source of rent and other consideration (often via reserve account or credit support), assurance that the use restrictions and tenant-mix provisions will be respected, and assurance that the financial condition and operating performance of the proposed assignee will be similar to the debtor's at the time the lease was executed. The shopping-center carve-out reflects landlord lobbying success in 1984 and continues to give shopping-center landlords meaningfully stronger objection rights than landlords of standalone properties.

The economic significance of Section 365 is most visible in retail and restaurant Chapter 11 cases, where lease portfolios often run hundreds or thousands of locations. A typical large retail Chapter 11 case involves a lease-rationalization program that progresses through several phases.

Phase 1: Initial portfolio diagnostic (pre-petition or first 30 days post-petition)

The debtor's real estate advisor (Hilco Real Estate, A&G Real Estate Partners, RCS Real Estate) reviews the lease portfolio across multiple dimensions: rent versus market, store profitability, lease term remaining, landlord identity (sophisticated REIT versus mom-and-pop), use restrictions, and termination rights. The diagnostic produces a tier-by-tier classification: "core keep" leases (favorable economics, profitable stores), "negotiate" leases (above-market but stores profitable enough to justify a rent reduction), and "reject" leases (above-market and either unprofitable stores or non-strategic locations).

Phase 2: Landlord negotiation (days 30-150)

The debtor opens negotiations with landlords across the "negotiate" tier, typically seeking 20-40% rent reductions, lease term extensions, or other concessions. Landlords' bargaining position varies: a sophisticated REIT with diversified tenant exposure may accept significant concessions to preserve a credit tenant; a mom-and-pop landlord with single-tenant exposure may resist concessions but face the threat of rejection.

Phase 3: Section 365 assumption-and-assignment or rejection (days 150-210)

Within the 210-day Section 365(d)(4) deadline, the debtor files motions to assume the "core keep" leases (with cure of any pre-petition defaults) and assume-and-assign or reject the rest. The Rite Aid 2025 case, the Joann 2025 case, and the Forever 21 2025 case all followed this pattern, with hundreds of leases moving through assumption-rejection motions in the months leading up to confirmation or sale closing.

The economic delta

A retailer with 300 stores at average rent of $300,000 annually has $90 million of annual rent obligation. Rejecting 100 stores (the unprofitable tail) saves $30 million annually, with the rejected leases producing capped 502(b)(6) damages claims that the unsecured class recovers at typical 5-30% rates. Negotiating 20-30% rent reductions across the "negotiate" tier of 100 stores saves another $5-9 million annually. The cumulative annual savings of $35-39 million transforms the operating model and is one of the central value-creation mechanics in retail Chapter 11.

Section 365 mechanics are one of the primary reasons distressed M&A multiples diverge from healthy-deal multiples. A buyer of distressed assets through a Section 363 sale gets:

1. The ability to assume favorable contracts and assign them notwithstanding anti-assignment provisions, capturing the going-concern economics of those contracts 2. The ability to leave unfavorable contracts behind for rejection and capped damages 3. Free-and-clear protection under Section 363(f) that eliminates pre-petition successor liability

The combination is structurally unavailable in any out-of-court M&A transaction and produces a meaningful premium that buyers are willing to pay.

The cumulative effect of Section 365 on plan-of-reorganization economics is similarly significant. A debtor with above-market leases, money-losing supply contracts, or unfavorable franchise agreements can use the rejection mechanic to cut off future obligations and reset the operating cost structure. The 502(b)(6) cap converts what would otherwise be uncapped future obligations (face value of remaining rent could be hundreds of millions) into bounded pre-petition unsecured claims that recover at unsecured-class rates. This conversion is one of the central value-creation mechanics of Chapter 11 for operationally distressed but financially capable businesses.

Section 365 is foundational restructuring vocabulary. Any banker working on Chapter 11 mandates needs the assumption-rejection-assignment framework, the timing rules, the damages cap, the cherry-picking economics, and the legal limits internalized at a level that allows fluent application across operational diligence, plan structure, and sale process work.