For many businesses that operate in shopping centers, industrial complexes, office buildings or other leased property, nonresidential real property leases are often among the “crown jewels” of the company’s assets. Likewise, of critical importance to the owners and management agents of commercial real estate are the securing and maintaining of profitable, long-term, quality tenants and the shedding of tenants whose financial health has declined or who otherwise no longer fit with the lessor’s current or long-term plans for the real estate in question. It is almost inevitable that in many instances, the goals of the nonresidential real property lessor and the goals of the tenant of that property will diverge either before or immediately upon the tenant commencing a bankruptcy case. When a tenant of nonresidential real property commences a bankruptcy case, many of the general rules on contract law and other state law principles that would typically govern the relationship are substantially modified and/or trumped entirely by the Code. The amendments to the Code brought about by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) altered the landscape for commercial real estate lessors and tenants filing bankruptcy cases even more dramatically than what previously existed. Landlords and tenants of such real property leases (and their professionals) are still struggling with the most appropriate means to deal with these new changes when the tenant needs to avail itself of the bankruptcy process.
In analyzing the issues and possible solutions for nonresidential real property leases in chapter 11 (or even in chapter 7), certain bedrock principles and Code provisions governing the relevant lease-related issues are critical to the equation. Section 365 of the Code has long contained several favorable provisions to the commercial real estate lessor to enable it to (a) protect itself from being an indefinite, involuntary (and possibly gratuitous) storage facility for its tenant in bankruptcy, and (b) preclude the tenant from compelling the lessor to accept a proposed assignment of the lease to a new assignee unless certain very specific (and frequently very onerous) hurdles are overcome with strong evidence presented to the bankruptcy court. The BAPCPA changes to §365 have placed even greater restrictions on the debtor-tenants’ ability to force the lessor of nonresidential real property to accept the tenant’s continued occupancy of the property without complying with the very stringent requirements for assumption of the lease. In addition, BAPCPA made certain changes to §503 of the Code, creating an express two-year future rent damage claim and cap for the lessor to assert as administrative expense against the debtor-tenant in the event that the tenant assumes a lease during the bankruptcy and is later forced to reject the lease due to the inability to find an appropriate assignee timely or otherwise reorganize and exit bankruptcy.
Key protections and tools given to the lessor by §365 include: (1) the ability to seek to compel the debtor-tenant to timely pay all rental obligations arising after the date of the bankruptcy filing (§365(d)(3)) and (2) the ability to seek to block the debtor’s proposed sale/assignment of its leasehold to a third party unless the debtor and/or proposed assignee can demonstrate, among other things, “adequate assurances” of future performance under the lease, and to promptly cure any defaults under the lease and (in the case of shopping center leases) similar or better financial and operating performance by the proposed assignee to that of the debtor at the time the lease was entered into (§365(b)).
Counter-balancing the pro-lessor protections in the Code, the debtor has long been granted the protections of the “automatic stay” in §362 of the Code, which, among other things, precludes the lessor from unilaterally terminating an unexpired lease or seeking to evict the tenant without bankruptcy court approval regardless of whether there have been defaults in rent payments or even if the lease contains the not-uncommon, so-called “ipso facto” clause authorizing termination in the event of a bankruptcy filing (which under §365(e)(1) is deemed to be unenforceable).
Another important protection given to the debtor that leased nonresidential real property involves the ability to obtain essentially indefinite extensions of time to assume or reject a lease in the bankruptcy. Section 365(d)(4) (pre-BAPCPA) set an initial 60-day deadline for the debtor-tenant to elect to assume or reject an unexpired lease of nonresidential real property. This deadline, however, contained no limit on the number or length of extensions that could be granted to the debtor by the bankruptcy court “for cause.” As a result, a tenant that was in default pre-bankruptcy in rent payments or otherwise could nevertheless potentially remain in the space over the objections of the lessor for many months or even years while the tenant struggled in bankruptcy to find a buyer, exit financing or find some other means to reorganize. And of course, at the end of the day, the tenant might ultimately prove unsuccessful on any of those quests, resulting in the lessor’s loss of not only pre-bankruptcy rent, but rental opportunities that might present themselves during the bankruptcy with other prospective, healthy tenants.
BAPCPA dramatically changed these rules, and thus the playing field for chapter 11 practitioners confronting these nonresidential real property lease issues (in large measure, in favor of the lessor), in significant ways, including:
- the imposition of an initial 120-day period after the commencement of the bankruptcy (as opposed to the pre-BAPCPA 60-day initial period) for a debtor-tenant to assume or reject an unexpired lease of nonresidential real property, with the corresponding requirement that any extension of this deadline must be approved by the bankruptcy court prior to the expiration of the deadline.
- the imposition of an outside limitation on the debtor-tenant to assume or reject an unexpired nonresidential real property lease to 210 days (seven months) after the commencement of the bankruptcy case or the lease will be deemed rejected by operation of law and the debtor-tenant specifically required by the terms of the statute to immediately surrender the premises to the lessor without the necessity of the lessor pursuing a state court eviction remedies (§365(b)(4) of the Code).
- the imposition of a two-year cap on the lessor’s rights to recover, as administrative expense obligations of the bankruptcy estate, future rental obligations owed by the debtor-tenant under a lease of nonresidential real property once the lease is assumed in the bankruptcy case if the lease is thereafter rejected in the bankruptcy case (§503(b)(7) of the Code). This two-year administrative claim right would be triggered, for example, if a debtor determined that a lease was too valuable to be lost in the bankruptcy and simply ran out of time and extensions to assume and/or assign the lease to a buyer and/or reorganize and exit bankruptcy.
Debtor’ Duties and Initial Period to Assume or Assign an Unexpired Lease of Nonresidential Real Property
Under the pre-BAPCPA version of §365(d)(4), the debtor-tenant was limited this initial period to 60 days to assume or reject a lease. This short window often required the debtor to file a motion to assume and assign a lease or (more likely) seek an extension of time literally when the case was barely a month old (due in part to conflicting decisions among the courts as to whether §365 required the debtor to actually obtain court approval of an extension request within the 60-day period versus merely file the motion to extend time within the 60-day period). BAPCPA provided the debtor an additional 60-day breathing spell and at the same time resolved the split of authority on whether it was necessary for an order approving an extension of time to assume or reject a lease to be entered prior to the expiration of the period. The BAPCPA version of the statute now expressly requires and had been interpreted to require that the order approving the extension of time must now be granted prior to the expiration of the 120-day period. In re Tubular Technologies LLC, 362 B.R. 243 (Bankr. D. S.C. 2006).
One twist to this change by BAPCPA that may spark future litigation is that at least one court has found that although §365(d)(3) entitles the lessor to receive timely rent from the debtor-tenant at the full contract/lease rate during the first 60 days of the case, for the balance of the 120-day initial period of time, in order to assume or reject such lease under §365(d)(4), the lessor’s right to rent is governed by the general, administrative expense provisions in §503(b) of the Code and thus limited to the actual, reasonable market value of the property. In re JS Marketing and Communications Inc., Case No. 05-65426-7, (Bankr. D. Mont. 2008). While lessors will no doubt continue to argue to the contrary, authority such as this opens the door to efforts by a debtor-tenant with arguably above-market rent terms to seek to reduce the actual rent to be paid after the initial 60-day period to what would be determined by the actual, reasonable current market rent.
Further, in the event that the debtor-tenant actually finds itself in the position of being able to timely assume and assign a nonresidential real property lease, BAPCPA resolved one more conflict for the authorities regarding the physical impossibility of the debtor’s ability to cure historic defaults, such as violations of a lease’s “go dark” prohibition. Obviously, if a debtor was forced to close for some period of time due to lack of funding or otherwise, it cannot unwind the past. Thus, the requirement in §365(b) that a lessor cure defaults as a condition to assumption of the lease was argued in some cases to preclude assumption where a “go dark” lease prohibition had been violated. Section 365(b)(1)(A) was specifically modified by BAPCPA to exclude the curing of defaults of such non-monetary lease obligations as a condition to assumption where curing was impossible, except that in the case of shopping center leases, the statute requires curing of the default from the date of assumption forward and the payment to the landlord of any pecuniary losses resulting from such default.
Limitations on Debtor’s Ability to Obtain Extensions of Time to Assume or Reject Unexpired Leases of Nonresidential Real Property
The initial 120-day period that BAPCPA gives to debtors to elect to assume or reject their unexpired leases is likely viewed by debtors and prospective debtors leasing nonresidential real property as far less than “half a loaf” in light of the sharp limitations added to §365(d)(4)(B), which limit the debtor’s ability to obtain an extension of this 120-day period to an additional 90 days to assume or reject the lease. After that, the debtor is prohibited from obtaining any further extensions “without the prior written consent of the lessor.” §365(d)(4)(B)(ii).
In what is perhaps one of the most significant pitfalls to these new restrictions, the BAPCPA version of §365(d)(4)(b) still contains the relatively unmodified, affirmative obligation on the part of the debtor-tenant to “immediately surrender the property” if the lease is not assumed within the applicable time periods or extended time periods (a “deemed rejection”). This affirmative obligation places the debtor-tenant in a potentially untenable quandary. It has been held that §365(d)(4)’s mandatory surrender provisions obviate the need for the lessor to seek to resort to state court eviction remedies upon a deemed rejection and entitles the lessor to an order from the bankruptcy court compelling prompt surrender (see In re U.S. Fax Inc., 114 B.R. 70 (E.D. Pa. 1990); In re James, 198 B.R. 885 (Bankr. W.D. Pa. 1996); In re Damianopoulos, 93 B.R. 3 (Bankr. N.D.N.Y 1988); and Salzer, 52 F.3d 708 (7th Cir. 1995). This obligation to immediately surrender the premises is arguably tempered, however, by the contrary authority that, with regard to personal property of the debtor that remains on the premises after a deemed rejection, such property is not automatically deemed abandoned, and thus the debtor retains a protectable interest in the property that the lessor may not unilaterally obstruct or eliminate. In re Arista Devices Corp. v. Deam Assoc., 94 B.R. 26 (E.D.N.Y. 1988). Likewise, it has been recognized that a rejection of a lease is not equivalent to a termination of the lease. In re Miller, 282 F.3d 874 (6th Cir. 2002).
The tenant of a lease that has been deemed rejected may well have conflicting rights and goals to those of the lessor who is likely seeking to expeditiously re-lease and/or build out the space for a different tenant. Following a deemed rejection, the debtor-tenant that still has valuable personal property located in the premises, would typically seek to hold over in possession for a period of time to enable it to find the means to remove, sell and/or otherwise dispose of the personal property. In light of the shortened time periods for assumption or rejection, coupled with the mandatory nature of §365(d)(4)’s “immediately surrender” provisions regarding the tenant’s obligation to immediately surrender upon a deemed rejection, prudent tenants and their advisors must take greater care in planning for the necessity of removal of their personal property or obtaining forbearance from the lessor, or face possibly harsh consequences.
The shortened time limitations for assumption or rejection of nonresidential real property leases may create significant challenges to the tenant’s practical ability to retain a lease, even if it believes from the beginning of the bankruptcy that it is necessary to the reorganization, or is a “crown jewel” that can be sold for significant value. If there are pre-petition lease defaults, §365(b) and (f) of the Code requires such defaults to be promptly cured (or adequate assurances of the debtor’s ability to promptly cure) by the debtor as a condition to assumption of the lease. And the tenant may simply have insufficient cash flow to satisfy such cures. In such circumstances, negotiations and/or concessions/waivers from the lessor with respect to cures, rent reductions or other lease accommodations may be necessary to seek and obtain, giving the lessor the opportunity to elect whether to continue to retain the tenant or possibly seek its own concessions, or whether the property would be better served by filling the space with an alternative tenant.
These issues can become even more complex and time-sensitive when the tenant has secured a prospective buyer/assignee for its lease, due to the requirements under §365(b) and (f) that adequate assurance of not only the ability to promptly cure defaults be provided, but also of the ability of the proposed assignee to perform the lease obligations into the future (and in the case of shopping center leases, that the proposed assignee has a similar or better financial and operating performance to that of the tenant and any guarantors of the tenant at the time the lease was originally entered into, among other things). The ability of a prospective buyer of the debtor’s assets, including leaseholds, to place contingencies on its obligation to purchase upon obtaining lease concessions, and/or the finite amount of the purchase offer that which may not be adequate to satisfy cure costs, secured claims or other necessary fees or expenses, also provide much bargaining power to the lessors, and even more so in light of the BAPCPA changes.
Limitations on Lessor’s Rights to Payment and Damages
As discussed earlier, prior to assumption of an unexpired lease of nonresidential real property, the debtor is obligated by §365(d)(3) to timely pay/perform all lease obligations. Following assumption of such a lease, the debtor becomes obligated to timely pay all lease obligations going forward as priority administrative expense claims. However, in the event that the debtor ultimately is forced to reject a lease that it was obliged to assume earlier in the bankruptcy, §503(b)(7) of the Code (as amended by BAPCPA) now expressly provides that the lessor is entitled to:
A sum equal to all monetary obligations due, excluding those arising from or relating to a failure to operate or a penalty provisions, for the period of 2 years after the rejection date. . .
In light of the limited seven-month outer window of time imposed by BAPCPA in §365(d)(4) to assume or reject such a lease, and the understandable importance to the debtor of not abandoning a lease with potential value, either in a reorganization or sale, the hazards to the debtor (and estate) being saddled with one or more of these new §503(b)(7) administrative expense claims arising from a lease that is ultimately rejected after it was assumed has been amplified. Even more diligent, careful (and early) planning on financing issues and realistic appraisals of the likelihood of sustaining the leased location or ultimately being able to assign to a third-party may be critical.
BAPCPA left unmodified the lessor’s rights under §502(b)(6) of the Code to assert an unsecured claim in the bankruptcy case for any unpaid, pre-petition amounts owed under the lease. It also addresses claims for damages arising as a result of the termination of the lease that do not exceed the rent reserved by the lease, without acceleration for the greater of one year or 15 percent, not to exceed three years of the remaining term of the lease.
The changes BAPCPA made to §§365 and 503(b) of the Code create myriad new issues for the lessors and tenants of nonresidential real property to navigate and anticipate both prior to and during the bankruptcy case. With the much-shortened cushions of time to make decisions on leases and the potential adverse consequences now to a decision that turns out to be improvident on assumption or rejection of a lease, advisors to the debtor and the lessor would be well served to review all aspects of the BAPCPA changes to any decision contemplated.