The effects of the epic real estate collapse that have occurred over the last five years are well known. The subprime mortgage crisis has caused residential (as well as commercial) real estate property values to drop significantly, which was has not been seen since the Great Depression. Millions of foreclosure sales across the nation have left banks and mortgagees holding the undesired title of “largest landowners in the United States.” As the economy and residential real estate market attempt to recover, homeowner’s or condominium associations continue to suffer. These nonprofit entities are responsible, in many cases, for the upkeep, maintenance and insurance of the common areas of the development or community for the benefit of its members: the homeowners. An association’s main source of revenue is the association members’ assessments or dues that are collected pursuant to most homeowner’s declarations and enforced under applicable state law.[1]
As a direct result of the numerous foreclosures and bankruptcies, associations’ revenue streams are taking a significant hit. The associations’ boards of directors face monthly budget deficits and are forced to consider bankruptcy as a method to cut expenses and costs. In many of these associations, the boards and their management companies review all expenses, contracts, leases and other expenditures in order to effectively “circle the wagons” or in anticipation of filing their petitions for relief under chapter 11. As a result of their due-diligence, many associations that are no longer developer controlled have discovered that the previous developer-controlled association entered into largely self-serving leases with the developer entity for the use of common areas that are still developer owned. Many associations are now using the bankruptcy courts and chapter 11 to reject these leases and cap their damages and allowed claim amounts in an attempt to reorganize.
Rejection of Unexpired Leases under § 365
Generally, under 11 U.S.C. § 365, a debtor in possession (DIP) or trustee may reject certain executory contracts or unexpired leases of the debtor.[2] In determining whether an unexpired contract should be assumed or rejected, a court applies the business-judgment test, which is whether, under the debtor’s business judgment, rejection of the unexpired lease would be beneficial to the debtor’s estate.[3] The Court of Appeals for the Eleventh Circuit has noted that a debtor’s decision to reject an executory contract or unexpired lease is primarily administrative and should be given great deference by a court, subject only to the business-judgment test.[4] Any scrutiny by a court beyond a debtor’s business judgment would only slow the administration of the debtor’s estate and increase costs.[5] A DIP’s right to reject executory contracts and unexpired leases is a fundamental component of the bankruptcy process, as it provides a debtor with a mechanism to eliminate financial burdens of the estate.[6]
Section 502(b)(6) serves as a statutory cap on the amount of damages that may be claimed by a lessor for damages with respect to termination of a lease of real property. Section 502(b)(6) directs the court to limit such a damage claim to the sum o:f (1) past due rent, determined at the earlier of the petition date or the date the lessee surrendered the property; and (2) rent due for the remainder of the lease, without acceleration, for the greater of either one year or 15 percent, but not to exceed three years, following either the petition date or date of surrender of the property.[7] This statutory cap on such a claim of a lessor for damages resulting from the termination of a lease by a debtor is meant to preserve a portion of the debtor’s estate for unsecured creditors whose claims would otherwise be greatly diluted.[8]
In re Maison Grande Condominium Association Inc.: The Application of the Business-Judgment Rule
The question of whether a homeowner’s association board of directors could use § 365 to reject a lease of non-residential real property was called before the court in In re Maison Grande Condominium Association, Inc.[9] In this case, a condominium association filed for chapter 11 relief in response to financial difficulties caused by substantial unit owner delinquencies and escalating costs of its lease, from a company affiliated with the condominium developer (the lessor), of land on which a swimming pool and certain parking spaces were located.[10] The association later moved to reject the 99-year lease under § 365. The lessor argued, inter alia, that the association’s board of directors failed to exercise its business judgment in rejecting the lease. To further its argument, the lessor argued that rejection of the lease would cause the association to lose its certificate of occupancy and would subject all unit owners to direct payment of all lease obligations.[11]
In granting the debtor’s motion to reject, the court held that the board adequately demonstrated that its “decision to reject the lease was a proper exercise of its business judgment as to how best to restructure the Association’s finances,” citing the fact that the board complied with all condominium declarations, Florida law and the significant savings in rejecting the lease and capping the rejection damages under § 502(b)(6).[12]
Conclusion
Homeowners’ associations and condominium associations’ bankruptcy cases continue to increase all around the country. An association’s board of directors should carefully review their leases, contracts and expenses in determining what action to take to reorganize the association and its debts. In certain situations, § 365 may be a powerful tool if it wants to unload burdensome leases and cap what would otherwise be a significant expense to the association, provided the board of directors believe that such a rejection is in the association’s best interest, within their “business judgment.”
1. See, e.g., Florida Statutes § 720.01, et seq. (2010).
2. See 11 U.S.C. § 365(a).
3. See Orion Pictures Corp. v. Showtime Networks, Inc. (In re Orion Pictures), 4 F.3d 1095, 1099 (2d Cir. 1993).
4. See In re Gardinier, Inc., 831 F.2d 974, 976 n.2 (11th Cir. 1987); see also Sharon Steel Corp. v. Nat’l Fuel Gas Distr. Corp., 872 F.2d 36, 40 (3d Cir. 1989); Sundial Asphalt Co. v. V.P.C. Investors Corp., 147 B.R. 72 (E.D.N.Y. 1992).
5. See Richmond Leasing Company Co. v. Capital Bank, N.A., 726 F.2d 1303, 1311 (5th Cir. 1985). (Emphasis added).
6. See In re Hardie, 100 B.R. 284 (Bankr. E.D.N.C. 1989); see also In re Gunter Hotel Assoc., 96 B.R. 696 (Bankr. W.D.Tx. 1988).
7. See In re Clements, 185 B.R. 895 (Bankr. M.D. Fla. 1995); see also In re: Electrical Acquisition, LLC, 342 B.R. 831 (Bankr. M.D. Fla. 2005).
8. See In re: Southern Cinemas, Inc., 256 B.R. 520 (Bankr. M.D. Fla. 2000).
9. In re Maison Grande Condominium Association Inc., 425 B.R. 684 (Bankr. S.D. Fla. 2010).
10. Id. at 687. See also In re Condo Ass’n of Plaza Towers South Inc., 43 B.R. 18, 22 (Bankr. S.D. Fla. 1984) (approving condominium association’s rejection of 99-year recreation lease under business-judgment rule and explaining that “the Court will not second guess the business judgment of Plaza Towers’ Board of Directors unless there is a showing that their judgment is clearly erroneous.”).
11. Id.
12. Id. at 694.