Airlines have been frequent visitors to the bankruptcy system over the past 20 years. Several airlines have made round trips to the bankruptcy courts. These cases are highly publicized. The most recent large airline bankruptcy filing involves American Airlines. Given the large unionized labor force and impact of labor costs on airline profitability, the disposition of collective bargaining agreements is a significant issue in these cases.

The power to reject executory contracts is one of the important tools utilized by the debtor to reorganize or sell its business in bankruptcy. For most contracts, the debtor merely must show that it exercised reasonable business judgment in deciding to reject a contract.

Over the years, Congress has amended the Bankruptcy Code to impose significant additional conditions on a debtor’s ability to reject an executory contract where a labor collective bargaining agreement is involved. Recent opinions issued August 15 and September 5 by U.S. Bankruptcy Court Judge Sean H. Lane of the Southern District of New York in the American Airlines bankruptcy case illustrates the hurdles a debtor must clear to reject a collective bargaining agreement. The fact-intensive nature of the review is demonstrated by the 105-page August 15 opinion.

American Airlines’ Recent Unfriendly Skies

American Airlines filed for bankruptcy and within months sought to reject its collective bargaining agreements with its pilots. American, once the largest passenger airline in the world in terms of revenue and capacity, suffered losses as a result of deregulation of the airline industry, external shocks to the industry such as the terrorist attacks of 9/11, and, ironically, competition resulting from mergers and consolidations of other large airlines in various Chapter 11 bankruptcy cases. According to the court’s opinion in In re AMR, 477 B.R. 384 (Bankr. S.D.N.Y. 2012), American lost approximately $10 billion since 2001, and fell to fifth among passenger carriers worldwide and fourth among U.S. carriers. The opinion also notes that American was more leveraged than other large carriers, and had no unencumbered assets to pledge as collateral for additional financing.

At the time of the opinion, American employed 65,000 workers, approximately 70 percent of whom were represented by one of three labor unions under nine separate collective bargaining agreements. The opinion states that American’s labor costs were 24 percent higher than other large airlines, and 79 percent higher than low-cost carriers. Following American’s bankruptcy filing in November 2011, it unveiled its “Plan for Success,” a business plan for the future. The plan required that American reduce its labor costs. Consequently, American sought to modify each of its CBAs. American proposed to the unions a 20 percent labor cost reduction, which would have saved $1.25 billion annually over a six-year period. According to the opinion, subsequent negotiations with the unions resulted in changes to some terms of the proposal, but did not change the overall savings demand. On March 27, American filed motions to reject the CBAs.

Rejection Under Section 1113

Section 365 of the Bankruptcy Code grants debtors the power to reject or assume contracts with third parties. Section 1113 of the Bankruptcy Code imposes special substantive and procedural requirements on debtors who desire to reject CBAs. Congress enacted Section 1113 following the Supreme Court’s opinion in NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984), which held that a debtor could reject a CBA after showing only that the CBA burdens the estate and a balance of the equities favors rejection. Section 1113 was enacted to require collective bargaining as a means of addressing a debtor’s relationship with its union employees as a prerequisite to rejection of CBAs in bankruptcy.

Section 1113 sets forth a procedure not provided for other executory contracts, and requires the debtor to provide the union with its proposed modifications prior to seeking to reject the CBA. The opinion noted, “the proposed modifications must be (1) based on the most complete and reliable information available at the time of the proposal; (2) necessary to permit the reorganization of the debtor; and (3) assure that all creditors, the debtor and all of the affected parties are treated fairly and equitably.” The opinion also noted that Section 1113 requires the debtor to provide the union with information to evaluate the proposal, bargain in good faith with the union to attempt to reach an agreement, establish the debtor made its proposal in compliance with these provisions and the union refused to accept the proposal without good cause, and, finally, the balance of the equities favors rejection.

American Airlines’ Proposal Largely Approved

American moved to reject the CBAs under Section 1113 and alleged that it satisfied the prerequisites to seek rejection. The Allied Pilots Association (APA) objected to rejection on several grounds. First, the APA argued that American’s proposal was not “necessary.” The opinion states U.S. Court of Appeals for the Second Circuit case law requires that in order to demonstrate rejection of a CBA is necessary, “a debtor must prove its proposal is made in good faith, and that it contains necessary, but not absolutely minimal, changes that will enable the debtor to complete the reorganization process successfully.” The APA argued the proposal was not necessary because (1) American should have considered merger options before seeking to reject the CBA; (2) American’s business plan and valuation assumptions were flawed; and (3) American improperly sought to outsource union flying through the use of codesharing and regional jets.

The court rejected the first two arguments. The court held that the possibility of a future merger did not bar rejection under Section 1113. The opinion states there was no evidence of a merger for the court to consider. While the union had engaged in discussions with U.S. Airways, and in fact had a signed term sheet, the process had not yet been completed. The opinion observed that proposed airline mergers did not always succeed. The court observed Section 1113 does not impose a waiting period on debtors while alternatives are explored, and a waiting period “is at odds with the urgency present elsewhere in the statute, which requires a court to consider a Section 1113 application expeditiously.” Finally, the court held a Section 1113 inquiry is focused on proposals by the debtor, not another party.

The court also rejected the APA’s objections to American’s business plan and valuation assumptions. The APA argued American’s business plan was inappropriate given a potential merger with U.S. Airways. The court reiterated that the possibility of a merger is not a bar to Section 1113 relief, and noted the importance that a debtor develop an alternative to mergers and other business options that could maximize the value of the estate to all stakeholders. The court engaged in a review of the plan — which included reduction in labor costs and the purchase of new aircraft — and found the plan was a reasonable standalone business strategy to serve as a basis for American’s motion to reject the CBAs.

The APA also alleged that American did not change its proposal from its initial position to the proposal in the motion, and the debtors’ failure to compromise was evidence of a lack of good-faith negotiations. The court held that, unlike a nonbankruptcy negotiation where parties stake out positions in anticipation of future compromise, under Section 1113, a debtor is required to propose only what is necessary for reorganization. The court found that although the ultimate amount of concessions had not changed, American had agreed to other modifications. The court held that American and the APA both had negotiated in good faith.

That being said, the court ultimately denied the debtor’s motion to reject the CBAs for two reasons. First, the court found that changes to the parties’ use of codesharing were not necessary. The opinion noted that codesharing occurs when one air carrier is permitted to place its schedule identifier on flights offered by another, thereby allowing one airline to increase the size and depth of its network by reaching locations served by the other. Like most pilot CBAs, American’s agreements imposed restrictions on its ability to outsource flying to low-cost subcontractors or to form nonunionized subsidiaries to take over flying that would otherwise be performed by unionized pilots. The court found the proposed changes would significantly expand American’s codesharing abilities and eliminate the limitation on the number of flights operated in the Hawaiian market American then served. The court found this aspect of the proposal of essentially unlimited codesharing was not necessary to achieve a successful reorganization.

The court also denied the motion because the proposal sought to eliminate all restrictions on American’s ability to furlough pilots. The court found that American had failed to justify this request under its business plan, and also had not identified comparable furlough rights elsewhere in the airline industry. In all other respects, the court approved the proposal made by the debtors, including modifying the maximum number of hours a pilot flies in a month, enforcing American’s sick leave policy, and the cost savings if the proposal were implemented.

The court noted that denial of the motion was without prejudice to the debtor correcting the two defects and submitting a new motion. With this road map for approval, on August 17, the debtors filed a renewed motion to reject the CBAs, which removed the provisions on furloughs and imposed limits on codesharing. The court granted the renewed motion in an order dated September 5.

Applying Section 1113

Few provisions in the Bankruptcy Code provide a more detailed procedure to address a special situation than Section 1113. Clearly, this was intended to balance the collective bargaining process under labor law with the reorganization principles of Chapter 11. As confirmed by these opinions, the ability to modify the rights of thousands of employees in one motion involves special and often complex judicial review under the Bankruptcy Code. The American Airlines decision makes for interesting reading for both bankruptcy and labor specialists, both in the factual analysis performed by the court and how this court reached its conclusions in applying Section 1113. •

Andrew C. Kassner is the chair of the corporate restructuring practice group of Drinker Biddle & Reath, practicing in the firm’s Philadelphia and Wilmington, Del., offices. He can be reached at andrew.kassner@dbr.com or 215-988-2554.

Joseph N. Argentina Jr. is an associate in the firm’s corporate restructuring practice group in the Philadelphia and Wilmington offices. He can be reached at joseph.argentina@dbr.com or 215-988-2541.