Property Leases Adequate Protection Payments and the Debtors Statutory Duty to Perform Lease Obligations

In 1994 Congress amended the Bankruptcy Code to provide greater protection for
personal property lessors. The Bankruptcy Reform Act of 1994 added
§365(d)(10) to the Code. This section requires the trustee or
debtor-in-possession to timely perform all of the obligations of the debtor first
arising from or after 60 days after the order for relief in a chapter 11 case.

</p><p>In theory, §365(d)(10) grants the debtor 60 days to determine whether to
assume or reject a lease of personal property. If the debtor is unwilling or unable
to make this determination within the first 60 days of the case, the debtor must
perform under the lease until the determination to reject or assume is made, thus
granting additional protections to the personal property lessor. The obligation to perform
includes, if provided for in the lease, maintaining and insuring the property, and
most importantly, paying to the lessor the contractual lease payment.

</p><p>Section 365(d)(10) represented a major shift from the law that existed prior
to the enactment of the 1994 amendments. Under the prior law, the burden of proof
was on the lessor of personal property to establish that some post-petition,
pre-assumption benefit had been conferred upon the debtor in order to support an
administrative expense. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… Corp v. Grigsby (In re White Motor Corp.),</i>
831 F.2d 106,110 (6th Cir. 1987)</a>. By shifting the burden of proof
from the lessor to the debtor, §365(d)(10) makes such a showing by the lessor
unnecessary. After the expiration of the initial 60-day period, a personal property
lessor's right to administrative rent is automatic. <i>In re The Elder-Berman Stores
Crop., et al.,</i> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… B.R. 759 (Bankr. S.D. Ohio 1996)</a>.

</p><h3>Non-compliance by the Debtor</h3>

<p>But what happens if the debtor cannot pay the contractual lease claims or seeks
to assert that a lease is not a "true lease" but rather a secured transaction simply
labeled a lease, and ignores the provisions of §365(d)(10)?

</p><p>There are no provisions within §365(d) (10) addressing the consequences of
non-compliance. Unlike §365(d)(3), which relates to leases of real property,
§365(d)(10) contains no provision terminating the lease and granting the lessor
the right to possession of the property. The rights of the lessor and the remedies
for non-compliance have been left to the courts to determine.

</p><p>One option is for the lessor to simply request an administrative expense. If the
debtor does not timely object, or fails to object until after the obligation has been
incurred pursuant to §365(d)(10), the claim will be allowed as an administrative
expense and paid at the administrative expense level. <i>See</i> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=…; 201
B.R. at 762</a>.

</p><p>The down side to simply awaiting payment as an administrative expense claimant in
a chapter 11 case is that the estate may become administratively insolvent and unable
to pay administrative claims in full, or may be converted to a chapter 7 such that
chapter 7 administrative claims prime chapter 11 administrative claims.

</p><p>A better option for the lessor is to move the court to order the debtor to pay
the lease payments and to comply with §365(d)(10). Such a motion under
§365(d)(10) should be accompanied by a motion to compel the debtor to assume
or reject the lease, or set a time by which the debtor must assume or reject the
lease and demand that the debtor provide adequate protection pursuant to §363(e),
or alternatively that the stay be lifted.

</p><h3>Adequate Protection for Lessor</h3>

<p>Section 363(e) was amended in 1994 as part of the statutory scheme to
provide greater protection to lessors of personal property. Before the 1994
amendments, §363(e) provided:

</p><blockquote>
Notwithstanding any other provision of this section, at any time, on the
request of an entity that has an interest in property used, sold or leased,
or proposed to be used, sold or leased by the trustee, the court, with or
without a hearing, shall prohibit or condition such use, sale or lease as is
necessary to provide adequate protection of such interest.
</blockquote>

<p>The following language was added as part of the 1994 amendments:

</p><blockquote>
This subsection applies to property that is subject to any unexpired lease of
personal property (to the exclusion of such property being subject to an order
to grant relief from the stay under §362).
</blockquote>

<p>The additional language makes clear that Congress intended to insure that
personal-property lessors have the right to seek adequate protection for their interest
in property that is the subject of an unexpired lease, modifying the general rule that
existed prior to the enactment of the changes.

</p><h3>The Debtor's Response</h3>

<p>The debtor may respond to these motions in a number of ways. The debtor may seek
to modify the payment schedule in a counter-motion that the "equities of the case"
favor a different result. Section 365(d)(10) gives the court the authority to
modify the payment schedule pursuant to its equitable powers, but if it does so it
must consider the lessor's right to adequate protection under the circumstances. As the
burden of proof is now on the debtor to show the need for equitable relief, and as
the pre-petition payment schedule most likely resulted from arm's-length negotiations
between the lessor and the lessee, it is hard to imagine many circumstances where the
court will grant the debtor the equitable relief it seeks.

</p><p>The debtor may contend that the lease is not a lease at all, but rather a
secured transaction. If the lease is not a "true lease" but rather a financing
device, then the lessor is not entitled to payments under §365(d)(10).

</p><p>The question of what constitutes a lease is a mixed question of fact and state
law. <i><a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… re Homeplace Stores Inc.,</a></i><a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=…; 228 B.R. 88, 92 (Bankr. D.
Del. 1998)</a>. Further, the method to determine whether a lease should be
recharacterized is an adversary proceeding. Fed.R.Bankr.P. 7001.

</p><p>While the debtor bears a substantial burden of proof to overcome the strong
presumption that a document-denominated lease is not a true lease, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=… re Edison
Bros. Stores Inc.,</i> 207 B.R. 801, 812 (Bankr. D. Del.
1997)</a>, the time it takes to resolve this issue may be quite lengthy. The debtor
should not be permitted to avoid the lease obligations during this dispute. At least
one court has held that the debtor must, at a minimum, escrow the contractual payment
pending a resolution of the controversy. <i>See</i> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&amp;vr=1.0&amp;cite=…; 201 B.R. at 764</a>.

</p><h3>Conclusion</h3>

<p>Congress's modifications to §§365 and 363, and the increased protections
afforded lessors of personal property, substantially increase the options available to
lessors of personal property, and the debtor should not be permitted to avoid the
obligations contemplated by Congress if the lessor's counsel acts with diligence and
with resolve.