By Roger Cox *
What are the relative rights, obligations, and remedies of parties to a retail, restaurant, or office lease upon the filing of a Chapter 11 bankruptcy?
1.Section 365 Governs Leases in Effect as of Bankruptcy Filing – the Basics and the Buzzwords.[i]
Section 365 of the Bankruptcy Code governs treatment of “unexpired leases” – leases that are in effect as of a bankruptcy filing.[ii] Generally, a Chapter 11 debtor, known as the Debtor in Possession or “DIP,” may assume or reject an unexpired lease. The decision to assume or reject an unexpired lease is essentially a business decision by the debtor, although in certain situations, rejection may occur from the passage of time (see below).[iii]
-Assumption of a lease is effectively a decision by the “Debtor in Possession” to retain and continue performance under the lease. On the other hand, rejection is a decision to breach the lease, which in the case of a tenant debtor leads to termination of that lease and a resulting unsecured claim by the landlord for the breach of that lease. [iv]
-To assume a lease that is in default, the debtor must [i] cure all past defaults, and [ii] provide adequate assurance of future performance. In other words, the debtor must generally bring its performance under the lease current (including pre- and post-bankruptcy defaults, if any), and must further prove to the court’s satisfaction that there is a go-forward ability to perform under the assumed lease.[v]
–Rejection of a lease is effectively a decision by the debtor to end (to the extent possible) its performance under the lease and rid itself of most or all go-forward obligations because the burdens of the lease outweigh the benefit to the estate – or in more simple terms, the retailer / debtor may simply want to close certain locations, which in a bankruptcy context will likely involve rejection of that lease. Generally, rejection results in a material breach of the lease by the rejecting debtor, excusing the affected counter-party from performance and allowing the counter-party an unsecured claim for damages (Section 365 may limit the extent of these damages – another reason why bankruptcy may be attractive to a multi-location retailer looking to downsize). If the debtor is a tenant, it should vacate the property upon rejection, and the affected landlord should no longer have any go-forward obligations to the debtor.
-Assumption of a lease by a debtor can be complicated because the debtor may be able to assume and assign the assumed lease to a third party. For example, many Chapter 11 bankruptcies now feature sales of substantially all a debtor’s assets, and the buyer of those assets is often afforded the ability to pick and choose what leases should be assumed or rejected. Assumption would effectively include an assignment of the unexpired lease to this buyer (or perhaps to another third party). Generally, this right to assume and assign controls over any anti-assignment provision in the lease (there are certain protections for shopping center landlords – see below).
-Existing (“Unexpired”) Leases Only. Section 365 applies only to “unexpired leases,” so a lease that is already expired or been terminated under state law before the bankruptcy filing is generally not subject to Section 365.[vi]
2.Commercial Leases – Debtor (Debtor in Possession) as Tenant – Chapter 11 and Related Deadlines and Deemed Rejection if not Assumed.[vii]
-120 Day(+) Rule. Generally, a debtor who is a tenant occupying non-residential (i.e., commercial) property has 120 days after the bankruptcy filing within which to assume a lease. Otherwise, the lease is deemed rejected. This 120-day period can be extended for another 90 days, with leave of court. Future extensions may be granted, but only with the consent of the landlord.[viii]
For the period between the bankruptcy filing (often called the “petition date”) and any deadline for assumption or rejection, landlords have some protection. Generally, under Section 365(d)(3), the tenant is required to pay rent post-petition. Arguably, this can continue without any special orders or permission from the bankruptcy court. The tenant simply pays rent in the ordinary course of its business under the terms of the lease.[ix] In many Chapter 11s, payment of rent is addressed in cash collateral orders or DIP financing arrangements.
A court may extend, for cause, the time for a debtor to pay rental obligations that arise within 60 days of the bankruptcy filing.[x] Otherwise, if the debtor/tenant fails or refuses to pay post-petition rent, the landlord may seek relief from the automatic stay under Section 362 of the Bankruptcy Code to exercise its remedies under applicable state law. Similarly, landlords may seek to compel an early assumption or rejection. In any event, in such a situation, the landlord will need to be proactive. There is not, however, a separate, codified mechanism to compel payment of rent.[xi]
-Cure of Past Defaults. In the context of assumption, the cure of past defaults can sometimes be a source of conflict. What is included in a cure of a past default? Does this include costs incurred by the landlord? What about attorneys’ fees? Generally, the written lease (and applicable state law) will govern, and when there has actually been a default by the debtor/tenant, the landlord is typically awarded its reasonable attorneys’ fees as part of the cure.[xii] On the other hand, if the debtor/tenant has been in compliance with the lease, then outside costs such as attorneys’ fees might not be included in the cure amount. (By the way, cure amounts are often negotiated between the parties.)
-Shopping Center Leases. Shopping center owner/lessors have some additional protection in the context of adequate assurance of future performance. Generally, the reorganized debtor (or assignee) must have the same ability to pay rent as the initial tenant; any “percentage rent” should not decline substantially; assumption should be subject to specific requirements in the lease regarding use of the premises, exclusivity provisions, radius, use, etc. Assumption and assignment must not disrupt the tenant mix. Again, these special provisions only apply to so-called shopping center leases.[xiii]
3.Commercial Leases – Debtor as Landlord/Lessor.
Although in retail or restaurant cases, Section 365 issues arise with the debtor as a tenant, it is not uncommon, especially in real estate-driven cases, for a debtor to be the landlord/lessor of commercial real property. This situation reinforces the concept that rejection is effectively treated as a breach, and not necessarily a termination. When the debtor is the landlord, Section 365(h) provides some limits to the effect of rejection, and it grants the non-debtor tenant some special protections, including continued right to occupancy.[xiv]
Generally, the non-debtor tenant has two options: (i) treat the lease as terminated, vacate the property, and assert a general unsecured claim based upon lease rejection damages; or (ii) (if the lease term has already started) retain its rights to occupy the real property for the remainder of the lease term, which would include continuing to pay rent. The non-Debtor tenant may be able to offset against the rent due under the lease its post-rejection damages resulting from the debtor/landlord’s failure to perform its contractual obligations (such as maintenance, paying utilities and taxes, etc.), but under this latter scenario the non-debtor tenant will generally have no rejection damages claim.
The debtor landlord may, however, rid itself of certain burdens by rejecting the lease, notwithstanding the non-debtor tenant’s right to maintain occupancy. Generally, the debtor landlord, in the event of rejection, is provided some relief from providing certain services to a tenant. To oversimplify, the non-debtor tenant can retain the right to occupancy, but not much more.[xv]
4.Breach By Rejection – Unsecured Claim for Damages.
A debtor’s rejection of an unexpired lease gives rise to a general unsecured claim against the estate. Sometimes called a “rejection damages claim,” this typically consists of lost rent, additional rent (pass-throughs under the typical commercial lease), and other damages under applicable state law.
The rejection damages claim is subject to a formulaic cap, which is calculated as follows:
-The rent reserved by such lease, without acceleration, for the greater of one year or fifteen percent, not to exceed three years, of the remaining term of such lease, following the earlier of –
1.The petition date; and
2.The date on which the lessor repossessed, or the lessee surrendered, the lease property; plus -Any unpaid rent due under the lease, without acceleration, on the earlier of the above dates.[xvi]
5.Administrative Claim for Unpaid Post-Petition Rent?
Although Section 365 generally requires payment of post-petition rent, in some cases, a period of time might pass post-petition where no rent has been paid, often followed by a rejection of the lease. The issue there is whether such post-petition unpaid rent is entitled to any sort of priority treatment.
Section 365(d)(3) of the Bankruptcy Code appears to provide for its own administrative claim, given its mandate of post-petition rent. Additionally, under Sections 507(a)(2) and 503(b), unpaid expenses incurred by a DIP post-petition, especially those that benefit the estate, should be entitled to priority treatment. So, in a situation where a tenant (a DIP or even a trustee) has continued to occupy the premises after the bankruptcy filing, but before lease rejection, the affected landlord should be entitled to an administrative priority claim.
When a lease is assumed, the post-petition rent issue is moot, because of the requirement of curing past defaults and providing adequate assurance of future performance – i.e., the rent must be paid as part of the assumption process. So as a practical matter, any controversy regarding post-petition rent on an assumed lease should be fully addressed by the lease assumption/cure of past defaults process.
What about rent after rejection? Although unpaid post-rejection rent will generally not form the basis of an administrative claim, there are well established exceptions – typically arising where there has been continuing post-rejection use (e.g., continued use or occupancy even after actual or deemed rejection) benefiting the estate.[xvii]
As is the case with other components of Sections 365 and 507, there are other nuances. One controversial issue, for example, is whether so-called stub rent (rent payable for a partial month, accruing before the due date for the next month’s rent) is entitled to priority treatment.[xviii] A similar issue may arise when a lease has expired by its own terms (either pre- or post-petition), yet the debtor/tenant remains in possession and occupies and utilizes the premises post-petition. Arguably, this could also give rise to an administrative claim for the rental value of the leased premises.
6.The Section 363 Sale – Unexpired Leases.
In modern Chapter 11 practice, a debtor often moves to sell all or a substantial portion of its assets under Section 363 of the Bankruptcy Code (which authorizes sales of estate property outside the ordinary course of business), often in a surprisingly short time frame (some courts and practitioners refer to the “melting ice cube” to justify a quick sale to preserve any going-concern value). [xix] This can often implicate multiple income producing properties under which the debtor is a tenant. In the case of a national debtor/tenant, this can involve numerous properties, some of which are desirable for the debtor or purchaser, while others may be burdensome and of little benefit.
Generally, the debtor (as DIP) moves for Bankruptcy Court approval to conduct a sale outside the ordinary course of business. A so-called “363 sale” typically involves an auction-style procedure, under which a lead bidder or “stalking horse” submits an opening bid, often with a template contract. A bidding process will occur, under which the assets are typically sold free and clear of liens and encumbrances to the highest and best bidder. The DIP usually conducts the auction, through counsel, often with the assistance of a so-called financial advisor or investment banker. This is all subject to court approval.
But what about landlords who are affected by a tenant’s 363 sale? Typically (but not always),[xx] a debtor will seek authority to assume and assign its rights under the more viable leases as part of the sale process. As the phrase implies, the lease assumption issues under Section 365 come into play. Additionally, under a proposed assignment, the proposed assignee (typically – but not always – the 363-sale purchaser) must provide adequate assurance of future performance.[xxi]
A frustrating part of the process for affected landlords is the practice of allowing a successful bidder additional time after the auction within which to select what leases will be assumed (and assigned) or rejected. Thus, an affected landlord must track the 363 sale process carefully (especially the so called “melting ice cube” case in which may traditional statutory time frames are shortened by court orders).[xxii] Courts should clearly delineate deadlines for objecting to issues such as proposed cure amounts and other Section 363 issues related to assumption. But the simple question of whether a particular lease is actually being assumed by the 363-sale buyer can linger. If not addressed directly in a sale order, this deadline might be found in the model asset purchase agreement (APA), a plan, a separate notice, or a separate order.
7.Summary – Back to Basics and Buzzwords
The key lease related concepts encountered in Chapter 11 can be summarized as follows:
-Unexpired leases are governed by Section 365 of the Bankruptcy Code
-Generally, a trustee or Debtor in Possession has the right to assume or reject an unexpired lease.
-Assumption requires the cure of past defaults and adequate assurance of future performance.
-Rejection results in a breach of the lease – the practical effects are different depending on whether the rejecting debtor/trustee is the landlord or the tenant.
-Generally, non-debtor landlords are entitled to be paid post-petition rent. Section 365 provides some guidance; however, Section 362’s Automatic Stay may prevent enforcement actions without court approval.
-The non-debtor party might be able to compel assumption or rejection by way of a motion filed in the bankruptcy case.
-So-called “363 sales” often involve assumption or rejection of leases and executory contracts.
-It bears repeating: The Automatic Stay of Section 362 of the Bankruptcy Code still applies so when in doubt about what enforcement remedies can be invoked, the affected counter party should consider seeking relief from the Automatic Stay before taking any action.
*Roger Cox is the author of Cox’s Texas Creditors Rights Laws Annotated (Thomson Reuters 2018-20), and a former contributor to the SMU Law Review. He is Board Certified in Business Bankruptcy Law, Commercial Real Estate Law, and Farm & Ranch Real Estate Law by the Texas Board of Legal Specialization. Underwood has offices in Amarillo, Austin, Fort Worth, Lubbock, and Pampa. This article is for general and academic information only and is not intended as legal advice or as a specific position asserted on behalf of any existing or future client of the firm.
[i] This article addresses only commercial leases, or what Section 365 calls non-residential leases, in the context of a Chapter 11 case. Section 365 contains provisions that deal specifically with residential leases. Residential leases are beyond the scope of this article. Section 365 also addresses “executory contracts” – the broad concepts are similar, but different deadlines apply and there is special treatment for certain contractual scenarios. This is likewise outside of the reach of this article, as is any analysis of Section 365 deadlines in the context of a Chapter 7 (liquidation) case.
[ii] 11 U.S.C. § 365.
[iii] For purposes of this article, the reader should assume that there is no trustee, but rather a Debtor in Possession, which has many of the powers of a trustee. Id. § 1107. Section 365 uses the term “Trustee,” but in a typical Chapter 11 case, assumption/rejection issues are addressed by the Debtor in Possession. A Debtor in Possession is sometimes called, informally, the DIP. A chapter 11 trustee may be appointed in cases of fraud, mismanagement or other issues. Id. § 1104. In a “small business” case, there is a special provision for removal of a small business debtor as debtor in possession. Id. § 1185.
[iv] Generally, a rejection may not literally terminate a lease. Rather, rejection sets up a material breach of the lease. This distinction is especially important for situations where the debtor is a landlord / lessor, and the non-debtor counter party may want to remain in possession of the affected property.
[v] Id. § 365(b).
[vii] As mentioned above, in a Chapter 11 case, the debtor is typically considered a “Debtor in Possession.” In the context of Section 365 and this article, “trustee” and “Debtor in Possession” overlap, but in a larger sense, they are not literally synonymous. And other than the newly created Subchapter V trustee in a small business case, if a trustee is appointed, there is no longer a Debtor in Possession.
[viii] 11 U.S.C. § 365(d)(4).
[x] Id. § 365(d)(3).
[xi] In re Circuit City Stores, Inc., 447 B.R. at 511.
[xii] In re Senior Care Center, LLC, 607 B.R. 580 (Bankr. N.D. Tex. 2019) (Jernigan, J.) (cure amounts for a lease that had been in default included late charges and landlord’s attorneys’ fees). This opinion provides a useful analysis of this component of the “cure” process.
[xiii] 11 U.S.C. § 365(b)(3).
[xiv] Id. § 365(h)(1).
[xv] See generally, 2 Norton Bankr. L. & Prac. 3d § 46:35 (unexpired leases in which debtor is a lessor).
[xvi] Id. § 502(b)(6). There are many nuances to the rejection damage claim and calculation of the cap. For example, there is a split among courts regarding whether the fifteen percent reference refers to the remaining time under the lease or the remaining rent that would have become due.
[xvii] See generally, In re Davenport Beverage Corp., 505 B.R. 374 (Bankr. D. Mass. 2014) (debtor’s continued occupancy to operate business post-petition). See also, In re Energy Resources Co., Inc., 47 B.R. 337 (Bankr. D. Mass. 1985).
[xviii] In re Imperial Beverage Group, LLC, 457 B.R. 490 (Bankr. N.D. Tex. 2011) (Houser, J.).
[xix] See In re Lehman Brothers Holdings, Inc., 445 B.R. 143 (Bankr.S.D.N.Y. 2011)(“Thus, a sale should be approved when the court is faced with the situation of a so-called “melting ice cube,” a sale that would prevent ‘further, unnecessary losses,’ the failure of other potential buyers to appear despite ‘well-publicized efforts,’ and where the only alternative ‘is an immediate liquidation that would yield far less for the estate’ and creditors.”).
[xx] See generally, A. Acebedo, The Sale of Real Property Free and Clear of a Lease: Making Sense of Sections 363(f) and 365(h) of the Bankruptcy Code, 24 Am. Bankr. Inst. L. Rev. 279 (2016).
[xxi] The sale motion should include a motion or request to approve assumption and assignment. See generally, In re 365 Franklin, LLC, 2017 WL 6371342 (Bankr. D.D.C. 2017), citing In re Mirant Corp., 440 F.3d 238 (5th Cir. 2006).
[xxii] One commentator’s take on 363 sales from a few years ago: A. Raykin, Section 363 Sales: Mooting Due Process?, 21 Emory Bankr. Dev. J. 91 (2012).