Bankruptcy Decision’s Analysis of Surety’s Rights in Bankruptcy and of Bonds as Executory Contracts Raises Concerns

At a time of unprecedented energy sector bankruptcy filings and the urgent need for clarity concerning the interplay between bankruptcy and surety law, the U.S. Bankruptcy Court for the Middle District of Louisiana on September 22, 2020, issued In Re Falcon U, LLC, 2020 WL 5648733, a decision that erroneously concludes that a surety bond is not an executory contract in Chapter 11. While the decision is facially appealing, it is fundamentally flawed and misguided. Sureties should be aware of its flaws and the need for diligent, active bankruptcy representation at the very outset of a principal’s Chapter 11 Reorganization, as this decision might be one which sureties will have to confront and expose as mistaken in its analysis so as to avoid disallowance of the surety’s claims and preservation of its rights to adequate protection with respect to outstanding surety credit (bonds).

The Facts: The Surety in Falcon issued four bonds to secure its Principal’s obligations to several obligees for the plugging and abandonment of wells, for environmental liabilities and to satisfy local licensing requirements. At the time of the bankruptcy filing, the aggregate penal sum of the bonds was approximately $10.5 million; of which approximately $3.2 was secured by cash collateral. It appears likely that the Surety was assured that its rights would be unimpaired by the bankruptcy filing, as the Surety first appeared in the bankruptcy only months after a Plan of Reorganization had been confirmed. While the Plan retained the Surety’s rights in its cash collateral, it discharged the remaining $7.3 million consisting of the Surety’s unsecured bond exposure. The Plan made no reference to the assumption of the surety bond program or to the interim and final surety bond program which had been approved by interim and final Court orders that governed the surety relationship during the Chapter 11. The decision makes no reference to whether the Surety had informally or otherwise negotiated the terms of those surety bond program orders.

The Court’s Decision: The Court’s analysis was applied both to the surety bond program evidenced by the two court orders and the pre-petition terms of the bonds and general indemnity agreements. The decision is based upon an erroneous finding that a surety bond is not an executory contract under Section 365 of the Bankruptcy Code because, again erroneously, the Court found that the Surety had no on-going performance obligations to the Principal under the bonds or indemnity agreements, even though the Court clearly had construed those agreements as a single contract to be read as one agreement. The Court’s simplistic discussion of whether the Surety owed a continuing obligation “to the Principal” ignores the nature of the tripartite relationship in the bond in which the consideration continuing to be provided by the Surety is a performance obligation for the benefit of the Principal which is being provided at its request, even if rendered to the third party Obligee. From this erroneous point of departure, the Court concluded as a matter of law that the bonds could not be assumed in bankruptcy, even as an integral part of the surety bond program approved twice by the court and even with the Surety’s consent. Contrary to the Court’s conclusion, the Surety had several on-going performance obligations. While the obligations were owed to the bond Obligees, the named beneficiaries of the bonds, they were put in place for the benefit of the Principal which continued to derive the value of the Surety’s bonds. By virtue of such bonds, the Principal was able to comply with its permit and regulatory obligations and, as a result, could extract gas from wells it could not operate in the absence of the continuing surety credit being provided through maintenance of the subject bonds. Moreover, while the Principal had paid the bond premiums, that did not end its performance obligation (as the Falcon decision clearly acknowledges) and, by extension, the Surety’s on-going performance obligations (which the Falcon decision fatally fails to understand). Rather, the Court seemed to overlook the indisputable factual and legal concept that the bonds remained executory as to the Principal as the Principal remained the primary obligor under the bonds, but the Surety held exactly the same performance obligations as the Principal but as a secondary, not primary, obligation of performance. That secondary obligation is indisputably an on-going performance obligation of the Surety. Further, the Principal clearly owed to the Surety the duty of exoneration, a duty that further creates ongoing performance obligations. The Court’s error was compounded by its speculation that, even if bonds were executory contracts, they were incapable of being assumed because they constitute contracts of financial accommodation which the Bankruptcy Code excepted from assumption or assignment to, for example, a third party purchaser. While that is true absent consent by the party extending the surety credit, here it appears that consent was given to the post-petition extension of such surety credit by virtue of the Surety’s decision not to oppose the surety bond program orders which contemplated continued extension of surety credit through maintenance of the existing bonds and continued payment of premiums. To close its misguided analysis, the Court declared the Surety, as a matter of law, could not consent to an assumption of the bonds even if both parties clearly intended that result by the negotiated arrangement to keep its bonds in place during and after the bankruptcy, with both time periods being governed by the pre-petition, ordinary course of dealing among the parties. This ruling was rendered despite the predominant view of other Bankruptcy Courts that a surety bond is executory, but cannot be assumed or assigned as a contract of financial accommodation absent the consent of the surety. The Judge ruled that the Surety’s unsecured $7,361,209.45 claim was contingent and unliquidated because the Surety had incurred no loss as of the confirmation date and, therefore, the claim was discharged. This ruling would seem to fly in the face of a surety’s right to be placed in funds, a right which expressly exists in most general indemnity agreements and which, when breached, results in an immediate right to payment, i.e., a fixed claim for damages that is neither contingent nor unliquidated.

The Takeaway for Sureties: Sureties from the outset of a Chapter 11 should consider the need to educate the Court and other parties, regarding the unique nature of the tripartite surety relationship, and the intersection of ongoing contractual obligations and performance required of the various parties, particularly those of both the principal as the primary obligor under the bond and the surety as secondary obligor entitled to exoneration. Participation in the negotiation and court approval of a surety bond program order at the outset of a case is usually needed; and, perhaps more importantly, the surety should ensure that the Plan of Reorganization treats the surety as a voluntary provider of credit entitled to protections similar to those afforded secured lenders. Those protections should survive confirmation of the Plan and the Plan should leave no ambiguity about the surety’s rights following the debtor’s emergence from bankruptcy. It appears, however, from the Court’s discussion of the facts in the Falcon case that the surety may have been lulled into inaction by assurances that its position would be protected and it would ride through the bankruptcy process with its rights unimpaired. But that assurance appears to have been for naught.

This case might simply and correctly be viewed as a warning regarding the danger of being lulled into inaction by the assurances of a debtor regarding lack of impairment of the surety’s rights as part of a bankruptcy plan. In re Falcon is, however, more pernicious in its analysis. It is a bad decision. Sureties therefore must be mindful of its existence, particularly because the analysis has some superficial appeal; and to avoid a similar result, sureties must be prepared to point out why the court’s analysis was incorrect and why a bond is executory, as explained above. Finally, even if a court in a subsequent case were to be convinced that the Falcon Court was correct in its statement that the surety bond is not executory and therefore non-assumable, then it could not properly enter a surety bond program order as was done in the Falcon case as there would be no ongoing obligation to be maintained and no reason for the debtor to continue to pay premiums to maintain bonds that were not executory. In that case, the debtor, assuming that it needs to keep bonds in place, would have to find a surety that would be willing to post new bonds with all the protections available under sections 363 and 364 of the Bankruptcy Code. And the existing surety might consider issuing such bonds to replace its pre-petition bonds, with the beneficial effect of its obligations thereunder now being clearly post-petition and non-dischargeable. Thus, if a subsequent court were to be convinced erroneously that the Falcon Court was right, as long as that issue is addressed up front at the time of a surety bond program motion, the surety’s position can only be strengthened. So the ultimate moral is beware of false assurances and make sure that the surety’s interests are protected at the outset and in the final confirmed Plan. Of course, the surety in Falcon can hardly be criticized for its reliance upon the assurances it apparently was given. But when courts do not understand the rights of the parties, bad decisions inevitably follow.