©2019

Commercial Leases in Bankruptcy,
A Landlord's Guide

I. Overall Strategy - - maximizing recovery, expediting recovery, or getting possession?

a. Does Lease have value? If not, no one wants it anyways. If yes, Trustee will want to sell it by assuming and assigning it - - thus retaining value of lower than market rentals until lease ends (including options!).

b. If prove that lease terminated pre-petition, and no longer subject to relief from forfeiture, stop trustee from assuming and assigning to a third party. But, this impacts right to be paid immediately under 11 USC 365(d)(3).

c. Did lease terminate pre-petition? Is it an “Unexpired Lease”?

i. In re Windmill Farms

1. Lease expires by time that U/D filed, even after three days’ notice passes.

2. But subject to relief from forfeiture.

ii. “An application for relief against forfeiture may be made at any time prior to restoration of the premises to the landlord.” Cal Code Civ. Pro. 1179.

1. Thus, critical to obtain premises pre-petition.

iii. “For the reasons set forth below, the court determines that Debtor contractually waived its right to relief from forfeiture of the Lease under both California Code of Civil Procedure § 1179 and California Civil Code § 3275 and therefore it may not assume the Lease after its termination. Accordingly, Debtor's request for relief from forfeiture and motion to assume the Lease should be denied.”

In re Art and Architecture Books of the 21st Century 518 B.R. 43, 45 (Bankr. C.D. Cal. 2014)

- - Potentially distinguishing factors in Art and Architecture Books case:

1. Commercial Lease

2. Each party had sophisticated real estate counsel, and lease was heavily negotiated, including the waiver of the relief from forfeiture provision.

iv.. Landlord in Art and Architecture sought immediate payment of post-petition rent. Obtained at bankruptcy court level but reversed on appeal to District Court :

“… the Landlord's Motions for immediate payment under 11 U.S.C. § 365(d)(3) should be denied. See 11 U.S.C. § 365(d)(3) (stating “[t]he trustee shall timely perform all the obligations of the debtor ... arising from and after the order for relief under any unexpired lease of nonresidential real property”) (emphasis added);”

 

In re Art and Architecture Books of the 21st Century (Bankr. C.D. Cal., Mar. 21, 2016, No. 2:13-BK-14135-RK) 2016 WL 1169116, at *2

d. Back to obtaining premises pre-petition:

i. What about an agreement to terminate the lease pre-petition? Can this be reversed as a fraudulent transfer?

In re Great Lakes Quick Lube LP (7th Cir., 3/11/2016). Yes!

But, section 365(c)(3) says you can’t assume and assign if lease terminated pre-petition. J. Posner pointed out this was not a problem, because Trustee only sought value of lease, not actual recovery of lease (given the option in Section 550).

ii. What about an agreement to vacate the premises in exchange for funds after obtaining an unlawful detainer judgment, or after U/D action filed?

a. Argument is that the lease already terminated.

b. By obtaining possession, cuts off right to seek relief from forfeiture.

c. Could termination of relief from forfeiture rights itself be a fraudulent transfer?

 

II. Timing Issues

a. In Chapter 7, leases expire after 120 days, unless a motion is filed.

Start counting from “order for relief,” a distinction that matters in an Involuntary filing.

b. In Chapter 11, If a debtor does not assume the lease within 120 days when the case is filed (or after 210 days if an extension was obtained), the lease is rejected as a matter of law.

c. Effect of Deemed Rejection.

i. The Bankruptcy Code requires the debtor or trustee to immediately surrender the property to the lessor and this is something that bankruptcy courts are willing to compel. § 365(d )(4) In re Elm Inn, Inc., 942 F.2d 630, 634 (9th Cir. 1991)

ii. However, some courts have ruled that if a landlord accepts rent after the deemed rejection, they waive the automatic rejection and cannot compel surrender. Other courts have ruled that no such waiver occurs.

 

New York/Second Circuit Cases:

In Re T.F.P Resources Inc., 56 Bankr. 112 (Bankr. S.D.N.Y. 1985) - - waived right to enforce rejection by accepting rent thereafter.

California/Ninth Circuit Cases:

“Bankruptcy courts from this circuit have disagreed over whether waiver is an option under Section 365(d)(4). Compare In re VMS Nat'l Properties, 148 B.R. 942, 944 (Bankr.C.D.Cal.1992) (finding that the lessor waived its rights under Section 365(d)(4) by accepting pre-petition rents) with In re Chandel Enters., Inc., 64 B.R. 607, 610 (Bankr.C.D.Cal.1986) (“If either waiver or estoppel were applicable, the Congressional intent in enacting the 1984 amendments, eliminating uncertainty regarding the status of nonresidential leases and requiring the debtor-in-possession to take affirmative action to assume the lease, would be circumvented.”) (citation omitted).”

In re George 177 F.3d 885, 889 (9th Cir. 1999)

 

III. Rejection/Assumption

A. Business Judgment Rule

U.S. Supreme Court: Profitable lease may be rejected for a more profitable one. Standard is the business judgment rule.

Group of Institutional Investors v. Chicago, M., St. P. & P.R.R., 318 U.S. 523 (1943)

B. Good Faith

1. Case filed solely to reject contract may not be allowed.

2. In re Southern Cal. Sound Sys., Inc., 69 B.R. 893 (Bankr. C.D. Cal. 1987)

 

C. Contractual Restriction on Assignment:

1. Except as provided in subsections (b) and (c), “notwithstanding a provision in an unexpired lease of the debtor, or in applicable law, that prohibits, restricts or conditions the assignment of such lease, the debtor may assign such lease.”

11 U.S.C. § 365(f)(1).

Lease provision requiring payment in event of assignment not enforceable. In re Standor Jewelers West, Inc., 129 B.R. 200, 201-02 (BAP 9th Cir. 1991)

Purpose of carving out (b) and (c) relates to protections for landlords re adequate assurance of future performance and shopping center protections.

2. Can only assign an unexpired lease if:

-the debtor assumes the lease per § 365 and

-adequate assurance of future performance by assignee is provided whether or not there has been a default.

See 11 U.S.C. § 365(f)(2).

3. Use restriction in lease:

Unenforceable except for shopping center leases?

What if assignee is a chemical co and you, the landlord, don’t want the risk of environmental spills?

Argue no adequate assurance of future performance related to contractual obligation to keep property in good condition.

4. In order to assume a lease, must cure defaults – e.g., pay or provide adequate assurance that past-due rent will be paid.

a. Ipso Facto Clauses - - an exception to requirement that lease defaults be cured.

“(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—

(A) cures, or provides adequate assurance that the trustee will promptly cure …”

Section 365(b)(2):

Paragraph 1 of this subsection does not apply to a default that is a breach of a provision relating to--

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title; or

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

11 U.S.C. § 365(b)(2).

5. Adequate Assurance of Future Performance:

To assume, must provide adequate assurance of future performance if the lease is in default. So, in order to assume (but not assign) need not provide adequate assurance of future performance if lease is not in default (pre or post-petition). After all, the landlord accepted this tenant, so stuck with him if not in default. 365(b)(1).

But, to assign to a 3rd party, adequate assurance of future performance must be provided. 365(f)(2). This is because all claims against Debtor are given up:

“(k) Assignment by the trustee to an entity of a contract or lease assumed under this section relieves the trustee and the estate from any liability for any breach of such contract or lease occurring after such assignment.”

 

D. Other Timing Issues:

New tenant only liable for debts under the lease arising after the closing date (i.e. after their purchase). But there are frequently year-end reconciliations, fourth quarter CAM charges and property taxes due.

If there were an unknown injury at the property which occurred before the lease assignment, but was not asserted until after, who would be liable? Would the new tenant be liable under the indemnification provisions of the lease?

6. Can Lease be rejected retroactively?

Duty to pay rent only until Lease is rejected.365(d)(3).

1. Retroactive Rejection? E.g., in Fresh N Easy case.

In re Federated Dep't Stores, Inc., 131 B.R. 808 (S.D. Ohio 1991) , not allowed.

Newer cases: allow rejection retroactive to date of motion, IF keys turned over before motion filed.

Ninth Cir: Pacific Shores Dev., LLC v. At Home Corp. (In re At

Home Corp.), 392 F.3d 1064, 1071 (9th Cir. 2004)

Second Cir: Adelphia Business Solutions, Inc., v. Abnos (In re Adelphia Business Solutions, Inc.), 482 F.3d 602 (2d Cir. 2007).

 

IV. Lease Assumption Re Shopping Centers.

a. What is a Shopping Center?

(1) combination of leases held by a single landlord;

(2) tenants engaged in the commercial retail distribution of goods;

(3) a common parking area;

(4) The development of the premises as a shopping center;

(5) A master lease;

(6) Fixed hours during which all stores are open;

(7) Joint advertising;

(8) Leases depend upon each other via restrictive use provisions;

(9) percentage rent provisions in the leases;

(10) The ability of tenants to terminate leases if anchor tenant terminates its lease;

(11) Joint trash removal;

(12) a tenant mix; and

(13) contiguity of the stores.

In re Joshua Slocum Ltd., 922 F.2d 1081 (3rd Cir. 1990)

7th Cir. - - does it resemble a shopping center? In re Goldblatt Bros. Inc., 766 F.2d 1136, 1140-41 (7th Cir. 1985).

b. Strategies/Additional Rights When Representing Shopping Center Owners

1. Adequate Assurance of Future Performance

The Bankruptcy Code contains special protections for landlords of shopping centers.

Specifically shopping center landlords are (if they assert their rights) protected from lease assignments:

a) to those less financially sound than was the debtor was at the time the lease was entered into;

b) that would substantially reduce percentage rents collected (e.g., because the assignee has a lower revenue than the Debtor),

c) that would result in a breach of the landlord=s obligation to its other tenants in the same shopping center,

d) that would result in a breach of the landlord=s obligations owed to its own lenders, or

e) that would disrupt the tenant mix or balance in the shopping center.

2. Enforcing these rights in an active Chapter 11 case takes constant vigilance because frequently it is not known who the successful bidder will be until an in-court auction takes place. Normal deposition notice periods (e.g., 10 days in California and 5 days in Delaware) may not be sufficient to allow discovery of all bidders= finances.

So, it is critical to object to the Motion to Approve Bidding Procedures early on in a case to obtain access to financial information re prospective Bidders.

In the larger Chapter 11 cases Debtors will typically obtain a >bidding procedures order= prior to auctioning off the leases at issue. Some methods of protecting a landlord=s interests under these circumstances include objecting in order to

a) obtain access to prospective bidders= financial information at the time it is provided to the Debtor, and seeking expedited discovery procedures applicable to all bidders;

b) obtaining permission to share such financial information with the landlord=s own lender. Necessary in order to insure that the assignment did not result in a breach of the landlord=s obligations owed to its own lender;

c) seeking language in the final assignment/sale order indicating that all assignments remain subject to all provisions of the lease including those concerning use, radius, exclusivity, tenant mix and balance. This is needed to ensure that a landlord - - by consenting to the assignment - - is not violating its obligation owed to other tenants at the same shopping center;

“(3) For the purposes of paragraph (1) of this subsection and paragraph (2)(B) of subsection (f), adequate assurance of future performance of a lease of real property in a shopping center includes adequate assurance--

(A) of the source of rent and other consideration due under such lease, and in the case of an assignment, that the financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time the debtor became the lessee under the lease;

(B) that any percentage rent due under such lease will not decline substantially;

(C) that assumption or assignment of such lease is subject to all the provisions thereof, including (but not limited to) provisions such as a radius, location, use, or exclusivity provision, and will not breach any such provision contained in any other lease, financing agreement, or master agreement relating to such shopping center; and

(D) that assumption or assignment of such lease will not disrupt any tenant mix or balance in such shopping center.”

11 U.S.C.A. § 365(b)(3)

V. Security Deposits, Guarantees, and Collateral Upon Lease Assumption

If lease is being assigned to a third party, section 365(l) of the Bankruptcy Code provides that all landlords (not just shopping center owners) may require a deposit or other security for performance of the debtor's obligations under the lease, and that the deposit or security be substantially the same as would have been required upon the initial leasing to a similar tenant. Specifically it provides:

"If an unexpired lease under which the debtor is the lessee is assigned pursuant to this section, the lessor of the property may require a deposit or other security for the performance of the debtor's obligations under the lease substantially the same as would have been required by the landlord upon the initial leasing to a similar tenant."

Typically the landlord will still be in possession of the initial deposit, and there will be no proper reason to increase the amount. However, in the case of very old leases the deposit may be inadequate in light of today's higher rent.

Further, if the initial lease was secured by personal or other guarantees, there is an argument that the new tenant must provide similar guarantees, as that is “other security for the performance of the debtor’s obligations … substantially the same as would have been required by the landlord upon the initial leasing to a similar tenant.” 365(l) In the case of a shopping center owner the financial condition of the new guarantor also must be comparable to that of the original guarantor. 365(b)(3)(A).

If lease is rejected, security deposit applies to 15% cap. So does Line of Credit.

VI. Appealing An Adverse Lease Assumption Ruling

Whenever there is a sale of assets in bankruptcy court, good faith buyers are protected from appeals of the orders challenging their purchase. That is a provision contained in Section 363 of the Bankruptcy Code.

“(m) The reversal or modification on appeal of an authorization under subsection (b) or (c) of this section of a sale or lease of property does not affect the validity of a sale or lease under such authorization to an entity that purchased or leased such property in good faith, whether or not such entity knew of the pendency of the appeal, unless such authorization and such sale or lease were stayed pending appeal.”

11 U.S.C.A. § 363

There is no such provision in Section 365 of the Bankruptcy Code which governs the assumption and assignment of leases.

The Third Circuit Court of Appeals has ruled that the protection for good faith buyers contained in Section 363 of the Bankruptcy Code applies to those to whom leases are assigned under 11 USC 365. The Third Circuit equated this to the sale of an asset.

Without a stay pending appeal, the appeal may become moot in any event. Still, will a buyer be willing to rely upon this legal principle? See In re Victoria Station Inc. 88 B.R. 231, 232, aff'd (9th Cir. 1989) 875 F.2d 1380 (B.A.P. 9th Cir. 1988).

VII. Payment of Rent Post-Petition

A. Section 503 – Administrative Claims

Administrative expenses have priority status.

1. Section 503(b)(7): when a lease is assumed and then rejected, admin claim is limited to 2 years.

Statutory background

Section 503(b)(1)(A)

Section 503(b)(1)(A) of the Bankruptcy Code provides:

(b) After notice and a hearing, there shall be allowed administrative expenses, other than claims allowed under

section 502(f) of this title, including --

(1)(A) the actual, necessary costs and expenses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case…

Section 365(d)(3)

“The trustee shall timely perform all the obligations of the debtor, except those specified in § 365(b)(2), arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title. The court may extend, for cause, the time for performance of any such obligation that arises within 60 days after the date of the order for relief, but the time for performance shall not be extended beyond such 60-day period. … . Acceptance of any such performance does not constitute waiver or relinquishment of the lessor’s rights under such lease or under this title.”

 

B. Post-Petition Rent Obligations During first 10-20 days of case

If no rent is due for month in which case is filed, Debtor gets significant breathing room.

Example: today is July 19th. If case filed today, and rent due July 1st was not paid, does 365(d)(3) apply?

“The trustee shall timely perform all the obligations of the debtor, except those specified in section 365(b)(2), arising from and after the order for relief…”

11 U.S.C.A. § 365

August rent definitely arises after the order for relief.

What about rent for period from July 19-July 31? Called Stub Rent.

Two views: Billing Date v. Accrual Date approach

Delaware view: Based on when the obligation to pay arises. (Look at Billing Date- - August 1, so Stub Rent need not be paid under this view ). But if lease is assumed, it must be. And, since property may provide benefit to estate, can still be an administrative claim under 503(b)(1) (although these claims are not always paid in full, and may be paid years later). Contractual rental rate is the presumption.

3rd Circuit: In re Goody’s Family Clothing Inc.,

610 F.3d 812 (3d Cir. 2010).

Ninth Circuit and Second Circuit: Accrual Date Approach

In re Treesource Indus., Inc., 363 F.3d 994, 998 (9th Cir. 2004)

In re Stone Barn Manhattan LLC 398 B.R. 359 (Bankr. S.D.N.Y. 2008)

a. Distinction carries over to Property Taxes - - pro-rated or all or nothing approach.

Only post-petition pro-rated amount is due

In re Child World, Inc., 161 B.R. 571, 577 (S.D.N.Y. 1993 - - only pay property taxes accruing post-petition.

Must be Paid in Full:

In re Montgomery Ward Holding Corp., 268 F.3d 205, 212 (3d Cir. 2001)

 

C. Requirement of ‘timely’ payment

a. Payment now or years later with other admins?

i. Court decides:

In re HQ Global Holdings, Inc., 282 B.R. 169, 173 (Bankr. D.

Del. 2002

ii. Must be paid asap

In re Leisure Time Sports, Inc., 189 B.R. 511 (Bankr. S.D.

Cal. 1995)

iii. Landlord is paid at end, possibly not in full

New York: In re Pudgie’s Dev. of NY, Inc., 239 B.R. 688

(S.D.N.Y. 1999)

No consequence specified in statute for non-compliance.

In re Southwest Aircraft Services Inc., 831 F.2d 848, 854 (9th Cir. 1987),

failure to make payments under subsection (d)(3) is only a factor to be considered in determining whether cause exists under subsection (d)(4) to extend the 60 day period for assumption or rejection.

 

VIII. Claims

i. Attach lease

ii. Admin (post-petition like stub rent) is a separate motion, but include in claim also.

iii. Claim components:

1. Pre-petition defaults/arrearages. - - not subject to limitation. Ties in to whether accrual or “date due” jurisdiction.

2. Damage from rejection of lease. 502(b)(6) - - 12 mos or 15% up to 3 years. 15% of total rent due or just the number of months? And must apply deposit (or LOC) towards this amount. Just a claim - - no guar of payment.

# of months:

Ninth Cir: In re Connectix Corp. 372 B.R. 488

(Bankr. N.D. Cal. 2007)

Amt of rent:

New York: In re Andover Togs, Inc., 231 B.R. 521,

547 (Bankr. S.D.N.Y. 1999)

3. Other damages?

In 9th Circuit 502(b)(6) does not act as a limit on tort claims - - e.g., for waste and cost of remediation.

In re El Toro Materials Co., Inc., 504 F.3d 978, (9th Cir. 2007) (Debtor rejected lease, and left 1 million tons of wet clay glue, as well as equipment).

Environmental claims - - need for remediation discovered after premises are turned over. May be an administrative claim to extent “spill” occurred post-petition. See the following cases:

In re Teleglobe Communications Corp., 304 B.R. 79 (D. Del. 2004).

In re Treesource Indus., Inc. 363 F.3d 994 (9th Cir. 2004),

502(b)(6) caps the claim of a landlord resulting from the termination of a lease.

Cap does not apply to post-petition use of property. This is why retroactive rejection is so important to Debtors.

In re Financial News Network, Inc., 149 B.R. 348, (Bankr. S.D. N.Y. 1993), In re First Alliance Corp., 140 B.R. 531 (B.A.P. 9th Cir. 1992).

b. Cap might not apply if the Debtor can pay all claims, including uncapped claims, in full - - a good faith challenge

In re Liberate Technologies, 314 B.R. 206, 213–24, (Bankr. N.D. Cal. 2004);

502(b)(6) Allow claim except to extent that:

“(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds—

(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease, following the earlier of—

(i) the date of the filing of the petition; and

(ii) the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus

(B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates;”

What is “rent reserved”?

Kuske v. McSheridan (In re McSheridan), 184 B.R. 91 (BAP 9th Cir. 1995).

1) must be designated as rent or additional rent in the lease or be an obligation of the tenant;

2) The charge must be related to the value of the property or the lease; and

3) Must be a fixed, regular or periodic charge.

McSheridan: future rent claims cannot include anything other than “rent”.

Real estate taxes, insurance, and common area charges are rent.

What is not rent: liquidated damages, broker fees, attorney's fees, and late charges.

Can Landlord affect claim by acts taken subsequently?

After lease was rejected, landlord sold property. Court ruled that damages were satisfied. In re Fly I, Inc., 377 B.R. 140 (Bankr. D.Del 2007).

What if LL re-leases property?

Letters of Credit

If held as security deposit and applied to rejection damages, claim should be reduced by amount drawn after it has already been reduced by 502(b)(6). In re AB Liquidating Corp. 416 F.3d 961, 965 (9th Cir. 2005). 3rd Circuit also, In re PPI Enterprises Inc. 324 F.3d 197, 210.

Not all courts agree. Musika v. Arbutus Shopping Center, LP 257 Bankr 770 (Bankr. D. Md. 2001).

In re Stonebridge Technologies, 430 F.3d 260, 270 (5th Cir., 2005), damages cap can limit beneficiary’s ability to draw on LOC IF claim is filed.

Do Not File A Claim At All If Letter of credit amount exceeds 15% cap?

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