In bankruptcy proceedings, the rejection of an executory contract by a trustee under section 365 of the Bankruptcy Code constitutes a prepetition breach of contract, which gives rise to a general unsecured claim. The rejection damages claim, which is governed by state common law, will generally not be paid in full in bankruptcy.
The Bankruptcy Code will impliedly preempt state statutes that impose additional statutory damages, as these statutes impose damages for economic benefit of the counterparty and “‘frustrate section 365’s purpose of giving a debtor the power to decide which contracts it will assume and assign or reject . . . .’” For example, certain states have attempted to impose additional rejection damages in the context of automobile dealer-manufacturer relationships through state dealer statutes. These dealer statutes pose penalties to a debtor who breaches an executory contract it has with an automobile dealership. A court will likely hold that a state statute is implicitly preempted by section 365 of the Bankruptcy Code under the Supremacy Clause, if there is a conflict between the state statute and section 365.
Recently, dealerships attempt to claim statutory damages on top of the common law breach of contract damages after debtors reject executory contract with the dealerships. Bankruptcy courts in the Central District of California and in the Southern District of New York have held that these state dealer statutes’ additional remedies for rejection of executory contracts frustrates the purpose of section 365 of the Bankruptcy Code and are thus preempted by the Bankruptcy Code. In so holding, the two courts opined that the economic nature of the dealer statues were clearly opposed to section 365’s purpose of receiving the economic benefits from rejection that are necessary for the ultimate benefit of the estate and its creditors.
This Article is separated into four parts. Part I discusses a basic background of section 365 of the Bankruptcy Code and its purpose. Part II discusses more broadly state dealer statutes and the legislative purpose for them. Part III discusses the current status of the law on whether section 365 of the Bankruptcy Code preempts the state dealer statutes. Part IV discusses the practical effects of such preemption.