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Prerequisites to Assigning Commercial Real Estate Leases Addressed by New Bankruptcy Law
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January 7, 2008
(This article first appeared in the November 21, 2007, New York Law Journal.)
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By Jeffrey B. Steiner
Thelen Reid Brown Raysman & Steiner LLP
Among the many amendments to Title 11 of the United States Code implemented by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was the modification of §365(b), which sought to resolve the judicial split regarding a debtor's obligation to cure nonmonetary defaults before assumption and assignment of unexpired leases and other executory contracts in a bankruptcy case.
Before 2005
Under the Bankruptcy Code, a debtor may not assume an unexpired lease or other executory contract unless, at the time of assumption, the debtor cures or provides adequate assurance that it will promptly cure defaults. 1/ The ability to assume an unexpired lease or executory contract is an important tool available to a debtor because it allows the debtor to capitalize on its assets and increase the funds available to either aid in reorganization or liquidation. For example, if a debtor's rent under a lease is below market value, the debtor may capture this value as a liquid asset by assuming and then assigning the lease for consideration in a single transaction or as part of a larger sale of its other assets. In such circumstances, assumption and assignment benefits the entire estate rather than an individual creditor by maximizing the assets and limiting the liabilities of the estate while the non-debtor landlord receives payment in full of all arrears from the estate plus all rental payments post-closing from the assignee (presumably a financially stronger entity).
A judicial split arose in the treatment of nonmonetary defaults when a prior amendment to the Bankruptcy Code, the Bankruptcy Reform Act of 1994, added §365(b)(2)(D), which provided that a debtor is excused from curing a default that was a breach of a provision relating to the "satisfaction of a penalty rate or provision arising from a failure of the debtor to perform nonmonetary obligations under the executory contract." 2/ This section was intended to allow debtors to cure defaults under personal property leases at a nondefault rate. However, read literally it applied to all executory contracts, which created conflicting interpretations of the section's effect on nonmonetary defaults under real and personal property leases. 3/
Some courts interpreted this section broadly to excuse both the payment of a penalty rate and the failure to satisfy nonmonetary obligations contained in the lease while other courts elected a narrower reading, limiting its effect only to excuse the cure of a penalty rate or penalty provisions relating to a default on a nonmonetary provision in the lease. For example, in In re Claremont Acquisition Corp., Inc., 113 F.3d 1029 (9th Cir. 1997), the court interpreted the word "penalty" in former §365(b)(2)(D) as applicable to both the words "rate" and "provision." This reading lead the court to conclude that if either a penalty rate or other penalty payment was made applicable to nonmonetary obligations under the contract, such penalties did not need to be cured, but other nonmonetary defaults must be cured, regardless of whether it is possible to do so. At issue in Claremont was whether the debtor could assume a franchise agreement for a car dealership despite ceasing operations for a period of two weeks in violation of the continuous operation requirement contained in the dealership agreement. The court held that all nonmonetary defaults were to be cured unless such defaults required a payment by the debtor of a monetary penalty. Thus, historical defaults, such as a violation of a "continuous operations" provision of a lease or license, created a situation in which it was impossible for the debtor to assume an unexpired lease or executory contract under §365(b)(2)(D).
In contrast, the U.S. Court of Appeals for the 1st Circuit concluded that a debtor may assume an executory contract or unexpired lease without first curing nonmonetary defaults. In re BankVest Capital Corp., 360 F.3d 291 (1st Cir. 2004). There, the debtor was in the business of originating, securitizing, selling and servicing equipment leases and sought to assume such leases pursuant to a plan of reorganization. Certain lessees objected to the debtor's assumption of their leases, claiming that the debtor had defaulted on the leases by failing to replace certain loaner equipment, a nonmonetary default that was impossible to cure at that point in the case. The 1st Circuit observed that the Claremont ruling produced a harsh result, contrary to the principles of the Bankruptcy Code, and stated that to "prevent a debtor from assuming a contract based on historical events that it cannot remedy undermines Congress' basic purpose in §365: to promote the successful rehabilitation of the business for the benefit of both the debtor and all its creditors." In light of the premise that a worthy debtor's reorganization should be able to survive "unalterable historical facts," the 1st Circuit read the word "penalty" in the original language of subsection (b)(2)(D) as modifying only the word "rate" and not the word "provision." Under this construction, the subsection allowed the debtor to assume and assign the contract without curing the nonmonetary default at issue, namely the debtor's failure to replace certain loaner equipment to the lessee. 4/
The 2005 Amendment
The 2005 amendment appears to have resolved the split among courts by adopting a middle ground approach between the Claremont and BankVest opinions. Section 365(b)(2)(D), in relevant part, now reads:
| (2) | paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to --
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| | (D) | the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform non-monetary obligations under the executory contract or unexpired lease.
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On the one hand, Congress sided with the Claremont court. The revised §365(b)(2)(D) implemented the phrasing inferred by the Claremont court with the word "penalty" modifying both nouns, "rate" and "provision."
Congress, therefore, made clear that §365(b)(2)(D) does not provide a catch-all exception for nonmonetary defaults. Under the current version of the statute, a debtor must cure nonmonetary defaults before assumption unless the nonmonetary default requires some type of penalty payment.
However, in order to reduce the harsh effects highlighted by the BankVest court, Congress added language to §365(b)(1)(A) that specifically exempts certain nonmonetary cure obligations of the debtor. Section 365(b)(1)(A), in relevant part, now reads:
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(b)(1) |
if there has been a default in an executory contract or unexpired lease of the debtor, the trustee may not assume such contract or lease unless, at the time of assumption of such contract or lease, the trustee --
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(A) |
cures, or provides adequate assurance that the trustee will promptly cure, such default other than a default that is a breach of a provision relating to the satisfaction of any provision (other than a penalty rate or penalty provision) relating to a default arising from any failure to perform non-monetary obligations under any unexpired lease of real property, if it is impossible for the trustee to cure such default by performing non-monetary acts at and after the time of assumption, except that if such default arises from a failure to operate in accordance with a non-residential real property lease, then such default shall be cured by performance at and after the time of assumption in accordance with such lease, and pecuniary losses resulting from such default shall be compensated in accordance with the provisions of this paragraph.
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Although additional language of the 2005 amendment specifically excuses certain nonmonetary cure obligations of the debtor, these exceptions only apply to unexpired leases of real property, not personal property. Moreover, only those nonmonetary acts that are "impossible" for the debtor to cure at or after the time of assumption are exempted from cure.
It is also important to note that under the amended §365(b)(1)(A), a debtor is compelled to comply prospectively with all operational terms contained in nonresidential real property leases and to compensate the lessor for losses occasioned by a prior failure to comply with such terms. 5/ For example, if a commercial real property lease contains a "no going dark" provision, the location cannot remain "dark" after assumption and assignment to a new tenant, and losses resulting from the prior "dark" period (such as loss of percentage rent from other tenants) must be compensated. Accordingly, although the 2005 amendment sought to alleviate some of the harsh effects of the Claremont decision, Congress stopped far short of the BankVest court's generous reading of the prior section of the Bankruptcy Code.
Conclusion
The language of §365(b), before and after the 2005 amendment, remains fraught with ambiguity, leaving ample room for disagreement between tenants and landlords in a bankruptcy case when, as is often the case, the most valuable asset of the estate is the debtor's leasehold interest. For example, because of the reference to "such default" in §365(b)(1)(B), which requires compensation, and the directive in §365(b)(1)(A) with respect to compensation in the case of nonresidential leases, it appears that a nonmonetary default under a residential real property lease requires neither cure nor compensation. Similarly, although the amendment undoubtedly excuses a cure of the "unalterable historical facts," the extent of what is "impossible" to cure under §365(b)(1)(A) is not addressed by the 2005 amendment, once again creating an environment ripe for litigation between tenants and landlords.
Accordingly, companies considering filing for protection under the Bankruptcy Code should carefully analyze their leases and other executory contracts, paying particular attention to both monetary and nonmonetary defaults that exist or may exist at the time of a bankruptcy filing to determine whether these assets can in fact be monetized to fund either a liquidation or reorganization and the costs associated with such assumption and assignment under §365(b).
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For more information about the issues covered in this report, please contact Jeffrey B. Steiner in our New York office at 212-603-2260 or at jsteiner@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
ENDNOTES
| 1/ |
See, 11 USC §365(b)(1)(A). The defaults that are excluded from the cure requirements of §365(b)(1)(A) generally are defaults that relate to the filing of a bankruptcy petition or the deteriorating financial state of the debtor. See, 11 USC §365(b)(2)(A) through (C).
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| 2/ |
Former Bankruptcy Code §365(b)(2)(D) provides in relevant part:
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(2) |
paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to - .
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(D) |
the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.
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| 3/ |
See, Thomas M. Ward, Intellectual Property in Commerce §4:80 (2007).
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| 4/ |
According to others, however, the legislative history of the 1994 amendment suggested that Congress intended a much narrower exception to the subsection (b) cure obligation. In light of this background, the word "penalty" in the 1994 amendment was probably meant to define both "rate" and "provision." See, Thomas M. Ward, Intellectual Property in Commerce §4:80 (2007), citing 140 Congressional Record H10769 (daily ed., Oct. 4, 1994) [section-by-section description introduced by Rep. Brooks].
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| 5/ |
Current §365(b)(1)(A), in relevant part, reads:
except that if such default arises from a failure to operate in accordance with a non-residential real property lease, then such default shall be cured by performance at and after the time of assumption in accordance with such lease, and pecuniary losses resulting from such default shall be compensated in accordance with the provisions of this paragraph.
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(Reprinted with permission from the November 21, 2007, edition of the New York Law Journal. © 2007 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited. For information, contact 212.545.6111.)
©2008 Thelen Reid Brown Raysman & Steiner LLP
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