Leases and Executory Contracts in Chapter 11

Abstract

This paper offers the first empirical analysis of the timing and disposition decisions large Chapter 11 debtors make with respect to their leases and other bilateral (“executory”) contracts in bankruptcy, with an emphasis on commercial real estate leases. Section 365 of the Bankruptcy Code, which governs these contracts, provides debtors with a rich set of strategic options that can be analyzed from a real options framework. The debtor can choose to keep (“assume”), abandon (“reject”), or transfer (“assign”) their contracts, with time limits provided by the Bankruptcy Code. I analyze the effect of a change to the Code in 2005 (BAPCPA) that shortens the time to expiration of a debtor’s option to reject, requiring tenant-debtors to make decisions on their real estate leases within seven months unless a landlord grants an extension.

This paper offers several new findings. The distribution of leases and executory contracts across firms is highly skewed; for debtors at the tails, leases are quite important. At the 90th percentile, leases comprise 46.4% of the firm’s assets and over 70% of its financial liabilities. The main use of assignment in bankruptcy is to facilitate sales, rather than restructurings: over 90% of contract assignments occur in the context of sales of business units or the whole firm. I find that the seven month limit strongly accelerated real estate lease disposition decisions, suggesting that bankruptcy bargaining is far from a frictionless, Coasean world. Further, I find that BAPCPA is associated with a significantly lower probability of reorganization for the most lease-intensive firms.

While debtors’ behavior is in some ways consistent with a simple real options theory, I find important deviations. In particular, some executory contracts are assumed before expiration. I present suggestive evidence of implicit contracting motives: debtors often assume early in order to secure performance from their counterparties that cannot be guaranteed by the contract alone.

Keywords: bankruptcy, Chapter 11, leases, executory contracts, real options

JEL Classification: G33