Diamond Sports Group swings for the fences (and strikes out)
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Texas Bankruptcy Court rejects debtors’ efforts to reduce executory contract payment terms pending assumption or rejection.
During a U.S. bankruptcy case, can a debtor pay something less than the full contract rate provided for in a contract entered into prior to the bankruptcy while still requiring the counterparty to fully perform its obligations pending assumption or rejection of that contract? Recent litigation involving telecast fees payable by the Diamond Sports Group debtors (“DSG”) to certain Major League Baseball (“MLB”) teams confirms the prevailing view that in the period between a bankruptcy filing and assumption or rejection of a prepetition - that is, pre-bankruptcy - contract, a debtor must generally pay the rates provided for in the contract. However, the case also highlights the sometimes fraught dynamic between debtors and non-debtor counterparties with respect to postpetition and pre-assumption/rejection performance and the risk to counterparties that the payment of contract rates is not guaranteed.
Treatment of executory contracts under the bankruptcy code
Subject to certain exceptions, contracts that contemplate material ongoing or future performance by each party to the contract either may be “assumed” (i.e., adopted) or “rejected” (i.e., disavowed) by a debtor. Such contracts are referred to as “executory contracts.” To assume an executory contract, the debtor must cure outstanding defaults and provide “adequate assurance” that it will perform its obligations under the contract following assumption. If a debtor rejects an executory contract, it is relieved of any ongoing performance obligations and the rejection is treated as a material breach of the contract as of immediately prior to the bankruptcy filing. The counterparty may then file a proof of claim against the debtor in the bankruptcy case asserting the amount of damages resulting from the breach and non-performance. In a chapter 11 case, a debtor generally has until confirmation of its chapter 11 plan to determine whether to assume or reject an executory contract, which can result in a substantial gap period between the bankruptcy filing date and the date that the contract is assumed or rejected.
While the Bankruptcy Code provides varying degrees of clarity for certain types of prepetition agreements, including unexpired leases of nonresidential real property, unexpired leases of personal property and certain aircraft equipment and vessel lease arrangements (see 11 U.S.C. §§ 365(d)(3), 365(d)(5) and 1110), for all other agreements, it is silent as to a debtor’s postpetition and pre-assumption/rejection performance obligations. However, in language that became central to the dispute in the DSG cases, in NLRB v. Bildisco & Bildisco, the US Supreme Court observed that “[i]f the debtor-in-possession elects to continue to receive benefits from the other party to an executory contract pending a decision to reject or assume the contract, the debtor-in-possession is obligated to pay for the reasonable value of those services, which, depending on the circumstances of a particular contract, may be what is specified in the contract.”1
This obligation to pay for the “reasonable value” of postpetition goods and services is part and parcel to the priority status given under the Bankruptcy Code to the “actual and necessary expenses of preserving the bankruptcy estate” during the pendency of a case. Such expenses are treated as “administrative expenses” under section 503(b)(1)(A) of the Bankruptcy Code and must be paid in full, either in the ordinary course of business or in connection with the confirmation of a chapter 11 plan.2 But the Supreme Court’s direction in the Bildisco case begs the question of what is “reasonable” and whether there are circumstances in which the prices for goods and services negotiated at arm’s length between parties prior to a bankruptcy filing may not be reasonable for the purposes of determining the size of an administrative expense claim. Lower courts have consistently concluded that the presumptive “reasonable value” of postpetition goods and services for the purposes of determining the size of a counterparty’s administrative expense claim is the rate for such goods and services provided in the contract, particularly when the contract was negotiated at arm’s length between unrelated parties. In a handful of cases, courts have found the presumption to be rebutted by evidence of shifts in market values for goods and services from the time of contracting to the time of the bankruptcy filing in circumstances where a debtor challenged the size of a creditor’s administrative expense claim after rejecting a contract.3 However, none addressed the question at issue in the DSG cases: could the Supreme Court’s “reasonable value” standard be used to effectively reduce the contract pricing to reflect then-prevailing market conditions prior to a debtor’s decision to assume or reject?
The Diamond Sports Group chapter 11 cases
At the time of its bankruptcy filing DSG operated 19 regional sports networks (the “RSNs”), which are media companies that license rights from professional sports teams to produce game broadcasts. Traditionally, the focus of such regional sports networks was to sell content to “linear broadcasters” (i.e., television, cable, and satellite providers). However, DSG reported that, with the movement of consumers away from the linear broadcasting model to streaming and other digital content, DSG’s revenues dropped precipitously in the period prior to the bankruptcy filing resulting in DSG shifting its focus to digital and streaming content delivered directly to consumers. DSG alleged that the direct to consumer (“DTC”) business was also the focus of MLB and that MLB has ambitions to “nationalize the DTC rights and monetize them for the sole benefit of MLB’s thirty ownership groups.” The RSNs’ telecast rights agreements (“TRAs”) with MLB teams included both rights to sell content to traditional linear broadcasters and, with the consent of MLB, DTC rights. However, since October 2021, MLB had not approved the transfer of DTC rights to broadcast games played by the Arizona Diamondbacks, the Cleveland Guardians, the Texas Rangers, and the Minnesota Twins.
DSG commenced bankruptcy cases under chapter 11 in the US Bankruptcy Court for the Southern District of Texas in March 2023. Following the filing, DSG began withholding payment of telecast fees due under the TRAs with the teams whose DTC rights MLB had not approved for use by the relevant RSN. The unpaid fees amounted to millions of dollars of lost revenue to the MLB teams and an ongoing postpetition breach of the contracts. MLB and the relevant teams made motions in the Bankruptcy Court seeking to enforce the TRAs and to require the debtors to pay all fees due under the contracts or, alternatively, to compel the debtors to assume or reject the contracts. For its part, DSG did not dispute that the ongoing use of telecast rights postpetition gave rise to administrative expense claims payable to the MLB teams under the TRAs. However, DSG took the position that applying the Bildisco “reasonable value” standard to determine the value of the benefit to the debtors from their postpetition use of the telecast rights required a 29% reduction to the contract rates.
DSG presented two primary arguments in support of this position. First, it argued that MLB’s failure to approve the transfer of DTC rights deprived the RSNs of a key element of their bargains, such that the reasonable value to the debtors for the telecast rights under the TRAs must be discounted to account for the fact that those rights were limited to linear rights. Second, DSG urged the court to adopt an approach that would discount the contract rates to the current fair market value of the telecast rights, which DSG contended had become significantly less valuable than when the contracts were negotiated as a result of consumers’ shift away from linear broadcasters.
MLB and the teams responded that the transfer of DTC rights to the debtors had always been subject to MLB’s approval and the failure of that contingency to occur was already “baked in,” such that the RSNs were getting exactly what they bargained for. Further, MLB and the teams contested DSG’s market and valuation evidence, taking the position that the contract rates actually undervalued the telecast rights granted under the TRAs.4 MLB and the teams argued that, in any event, the appropriate measure of “reasonable value” was not the fair market value of rights conferred under a contract or the profitability of a contract to a debtor, as suggested by DSG, but the price for the goods and services agreed between arm’s-length counterparties at the time of contracting (i.e., the contract rate).
The Bankruptcy Court’s decision
In a bench ruling following a two-day trial that focused heavily on the parties’ competing expert valuation evidence, the Bankruptcy Court rejected DSG’s arguments and granted MLB’s and the teams’ motions to compel payment of the full contract rates pending a decision on assumption or rejection of the agreements. The court also held that the contract rate “is the presumptive rate” for the purposes of valuing an administrative expense claim in the absence of evidence “that the pre-petition contract [rate] is clearly unreasonable” and that the burden is on the debtor to rebut the presumption. The court cautioned, however, that “market forces shouldn’t be the only evidence that something is clearly unreasonable [and it’s not] the role of this Court to determine the fair market value for every contract that comes before this Court.” The court rejected DSG’s argument that evidence that the TRAs were less profitable to the debtors as of the bankruptcy filing than when they were originally entered into compelled the conclusion that the contract rates were “clearly unreasonable.” The Bankruptcy Court placed significant weight on the burden to MLB and the teams as a result of the imposition of the automatic stay, which prevented them from seeking to enter into new agreements in relation to the linear broadcasting rights pending an assumption/rejection decision, as well as the evidence that MLB had made offers to purchase the rights back from DSG, in concluding that the contract rate was the “right answer” under the circumstances. While the Bankruptcy Court did not compel the debtors to decide on rejection or assumption, it clearly suggested that, if the debtors concluded that they could not justify the ongoing costs associated with postpetition performance under the TRAs, the appropriate way forward was to reject the agreements without delay.5
On the one hand, the Bankruptcy Court’s decision confirms the prevailing view that a debtor will normally be required to continue performing under its executory contracts postpetition at the rates provided for in its prepetition agreements. This should give contracting parties some comfort that the risk that contracted for payment terms will be altered while they are forced to perform in the event of a counterparty’s chapter 11 filing may be limited. On the other hand, the Bankruptcy Court carefully considered the valuation evidence and based its decision on a reasoned conclusion that the contract rates were not “clearly unreasonable” in the circumstances. What remains to be seen is under what facts and circumstances a court might conclude contract rates are unreasonable to the point that they should be discounted pending a decision on rejection/assumption. That possibility was not rejected out of hand by the Bankruptcy Court, as urged by MLB and teams, though the Bankruptcy Court was clear that it viewed “market forces alone” as insufficient evidence that such relief is justified.
More generally, the DSG cases provide a window into the dynamic relationship that can develop between debtors and counterparties under certain executory contracts during the period between a bankruptcy filing and assumption or rejection of a particular agreement, and that the mere threat of costly and lengthy litigation of the kind between DSG and MLB may - and often does - serve to convince parties to come to the negotiating table.
3. In re Cont’l Airlines, Inc., 146 B.R. 520, 528-530 (Bankr. D. Del. 1992); Sharon Steel Corp. v. Nat’l Fuel Gas Distrib. Corp., 872 F.2d 36, 42-43 (3d Cir. 1989); Wheeling- Pittsburgh Steel Corp. v. West Penn Power Co. (In re Wheeling-Pittsburgh Steel Corp.), 122 B.R. 29, 32 (Bankr. W.D. Pa. 1990); Boruff v. Cook Inlet Energy LLC (In re Cook Inlet Energy LLC), 583 B.R. 494, 503-6 (B.A.P. 9th Cir. 2018).