Last year, in a post entitled "What Makes a CEO Perk Executory and the Circuits’ Split Over the Definition of an Executory Contract," I reported on an interesting sideshow to the Conseco bankruptcy involving the rights of Conseco’s exhigh flying ex-CEO Stephen Hilbert (and his enterprising wife, Tomisue Tomlinson) to four self-dealt "split-dollar" life insurance policies worth $87 million in the aggregate.  As noted in my prior post, Chicago’s Judge Robert W. Gettleman ruled that Chicago’s Bankruptcy Judge Carol W. Doyle was right in concluding that the policies were not "executory contracts" and were automatically terminated when Conseco filed for bankruptcy in December 2002.  He also agreed with Judge Doyle’s conclusion that "because Conseco was not attempting to enforce a contract, its material breach of the Agreements in December 2001, when it stopped making premium payments, was of no consequence."

Last Friday, the 7th Circuit affirmed Judge Gettleman’s decision, with Indiana’s own Judge Michael S. Kanne authoring the opinion on behalf of a unanimous panel.  Dick ex rel. Amended Hilbert Residence Maintenance Trust v. Conseco, Inc. (In re Conseco, Inc.), 2006 WL 2328635 (7th Cir. 8/11/06) (pdf). 

In affirming the lower courts’ rulings, the 7th Circuit made two important general statements regarding executory contracts in bankruptcy.  First, regarding when a contract is executory, the 7th Circuit stated:

Recognizing that the literal definition would render nearly all agreements executory, we determined that in order to effectuate Congress’s intent, § 365 should be applied only ‘to contracts where significant unperformed obligations remain on both sides.’  In other words, a contract is executory if each party is burdened with obligations which if not performed would amount to a material breach.  (Citation omitted.)

Second, as to what law applies in determining whether "the remaining obligations are significant," the 7th Circuit stated that the court should look to state law (and in this case, Indiana law) for answers.

Applying these general principles to the case, the 7th Circuit concluded on de novo review that the split-dollar policy agreements were not executory, reasoning as follows: 

We need only to consider Hilbert’s contractual duties to conclude that the Agreements were not executory contracts when Conseco filed its petition for bankruptcy. Hilbert’s primary obligation under the Agreements was to continue working for Conseco.  In each of the Agreements, Hilbert was referred to as the "Employee" who "is also an officer and director of the Corporation and has contributed significantly to its success." Conseco recited that it "desires to continue to retain the services of the Employee, and accordingly, the Corporation is willing to pay a portion of the premiums due on the Policy as an additional employment benefit." However, by the time Conseco filed for bankruptcy, Hilbert was no longer in Conseco’s employ. Hilbert’s only remaining obligation under the Agreements was to remit timely his share of the life insurance premiums to Conseco, and it is the significance of this duty we evaluate.

If Hilbert stopped paying his life insurance premiums (and the Trusts likewise failed to make payments in Hilbert’s stead), there would have been no discernible detriment to Conseco. The Agreements did not impose a duty upon Conseco to continue to make payments in full while covering Hilbert’s shortfalls. In fact, Hilbert’s nonpayment was the other termination event under the Agreements, and in that event, Conseco would have had the option to discontinue its own performance. Moreover, Conseco’s security interest was effective regardless of whether the policies were prematurely surrendered for cash or ultimately a death benefit was paid.

Therefore, if Hilbert had ceased performance of the Agreements, Conseco’s contractual remedies gave it the choice of seeking immediate reimbursement or remitting the full premium amounts and be repaid upon Hilbert’s death. Although both options–particularly early termination–posed a likelihood that the payout would have been insufficient to make Conseco whole for premiums it did pay, the Agreements did not entitle Conseco to any other source of recovery.  Because Conseco would have suffered no actionable damages should Hilbert fail to perform, it would not have been entitled to sue him for material breach.

Therefore, Hilbert could not have materially breached the Agreements by discontinuing his performance. It follows that the Agreements were not executory contracts when Conseco filed for bankruptcy. Because there would be not even a scintilla of injury to another contracting party, the issue whether Hilbert had any interests subject to forfeiture is irrelevant. We conclude that § 365 does not impede the operation of the Agreements’ termination clauses, which were invoked by Conseco’s petition for bankruptcy.

Finally, in rejecting the Hilbert Trust’s arguments that (i) Conseco waived its termination rights by failing to timely exercise them and (ii) Conseco could not exercise its early termination rights because it had breached the agreements by stopping paying the policy premiums a year before the bankruptcy filing, the 7th Circuit showed how facts can develop during the course of the bankruptcy case that can be as significant as those that occur before the bankruptcy case begins.  Judge Kanne wrote:

First, the Trusts claim that Conseco waived its rights upon termination by failing to exercise them in a reasonable time. The Trusts claim Conseco’s notice in September 2004 of its intent to exercise its termination rights amounted to a two-year period of silence, giving rise to a factual issue of reasonableness.

Because the Agreements did not impose a deadline upon Conseco to exercise its termination rights, Indiana law requires Conseco to have acted within a reasonable time, which is determined by considering "the subject matter of the contract, the circumstances attending performance of the contract, and the situation of the parties to the contract." Harrison v. Thomas, 761 N.E.2d 816, 819 (Ind.2002) (citing Epperly v. Johnson, 734 N.E. 2d 1066, 1072 (Ind. Ct. App. 2000)).

The contracts terminated on December 17, 2002, the date Conseco filed for bankruptcy. Under the Agreements, Hilbert or the Trusts first had 60 days to exercise their option to buy out Conseco’s security interest before Conseco’s termination rights accrued on February 17, 2003. However, neither Hilbert nor the Trusts pursued this remedy. Rather, the Trusts initiated this litigation against Conseco on February 19, 2003, a mere two days after Conseco’s termination rights had ripened. The Trusts have continuously asserted that the Agreements did not terminate, i.e., that Conseco had no termination rights at all.

Conseco’s inactivity during the litigation was reasonable. The existence of Conseco’s termination rights was the focus of this litigation and exercising them likely would have resulted in more claims filed by the Trusts. In addition, the Trusts do not point to any harm they have suffered in the interim. Rather than two years, the only time which conceivably could count against Conseco is the two-day period preceding this litigation, and we must take into account that the Agreements did not state or imply that time was of the essence. With no basis to conclude otherwise, Conseco did not waive its termination rights.

Second, the Trusts maintain that Conseco could not exercise its early termination rights because it had breached the Agreements by discontinuing the insurance payments a year before filing for bankruptcy. The Trusts argue this alleged breach reduced the paid balances of the insurance policies from what they would have been had Conseco continued making payments. But the Agreements contain no terms which would negate Conseco’s security interests in the policies in the event of a material breach by Conseco. Indeed, the security agreements explicitly state that Conseco’s rights in the collateral could only be extinguished if the Trusts fully repaid all their liabilities to Conseco. 

There is no indication in the record, nor do the Trusts assert, that the cash surrender value of the policies was sufficient to reimburse Conseco for the payments it had made. So whatever impact Conseco’s nonpayment had upon the policies, Conseco’s reimbursement rights were not disturbed, nor could they have been satisfied. Therefore, even if Conseco breached the Agreements by discontinuing the payments, the Trusts have not shown they would be entitled to any damages as a result.

© Steve Jakubowski 2006