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Wednesday, January 2, 2008
Bankruptcy Update for Commercial Landlords and Tenants
 Recent
years have seen a myriad of changes in bankruptcy law that affect leases of
commercial real estate. These
changes began with the bankruptcy reform legislation enacted by Congress, which
took effect in late 2005. As with
many other aspects of the Bankruptcy Abuse and Consumer Protection Act of 2005
(“BAPCPA”), the changes that affect commercial leases were an
attempt by Congress to correct perceived abuses by debtors and the bankruptcy
courts. Of course, Congress also
took away some of the protections non-debtor landlords had come to expect from
the Bankruptcy Code.
Traditionally,
Section 365 of the Code was one of the most potent weapons a debtor had at his
disposal. Pursuant to Section 365, the debtor is given the power to
“accept or reject” an executory contract or unexpired lease. In general, acceptance means that the
debtor assumes the benefits and burdens of the contract or lease, which will
continue largely as if the bankruptcy had not occurred (the debtor must cure
defaults in order to assume).
Rejection, on the other hand, means that the debtor is walking away from
the contract or lease. Upon rejection,
the debtor is deemed to have breached the lease immediately prior to the filing
of bankruptcy. And the non-debtor
party has a pre-petition claim for damages against the debtor (the rent owed
from the date of the filing of the petition through the date of rejection is
treated as an administrative expense of the estate). The Code caps the amount of that
claim. The debtor is also given the
right to assign the lease to a third party. Thus, the pre-BAPCPA Code appeared to
give the debtor a nearly unfettered right to analyze its leases, consider their
economic benefit, incorporate that benefit into its plan of reorganization, and
discard those that did not fit the plan.
BAPCPA
changed that understanding. Under
the prior law, the debtor had sixty days to assume or reject a commercial lease
of real property. The Code
permitted the bankruptcy courts to grant multiple extensions of this
deadline. The courts regularly
granted such extensions, often until confirmation. This was clearly of great benefit to
debtor lessees. Very often,
particularly in retail bankruptcies, below-market leases are a significant
asset of the estate. But having to
assume those leases early on in the case (and cure the defaults that have
occurred) can limit the debtor’s flexibility as it reorganizes.
That
is precisely the situation under BAPCPA.
A debtor now has 120 days to assume or reject a lease of nonresidential
real property with only a single extension of not more than 90 days (and the
motion must be made within the 120-day period) being available. Thus, the debtor must make the decision
to assume or reject within 210 days.
Extensions beyond 210 days are only possible if the landlord consents in
writing.
Congress appears
to have recognized that there will now be an increase in cases where the debtor
assumes a lease only to later reject it.
Under the prior law, the landlord would have had an
administrative-expense claim for the entire balance due. Under BAPCPA, the administrative-expense
claim is limited to two years of rent.
The assumption or
rejection of leases is not the only area in which Congress amended the Code to
change the balance of power between commercial landlords and their
tenants. Section 365 was also
amended to make clear that a lease may not be assigned to a third-party whose
use of the property would be a violation of the lease. Many courts had deemed such limits on
assignment void under the prior law.
Those decisions have now been legislatively overruled.
As
previously mentioned, the curing of defaults is often a major problem for a
debtor who wishes to assume a lease.
Curing monetary defaults (e.g. unpaid rent) may require
substantial cash payments. But
under prior law such cash-flow problems were not the biggest that faced a
debtor who wished to assume a lease.
The curing of non-monetary defaults was a source of much greater concern. Some courts disregarded all non-monetary
defaults and focused solely on those that the debtor could cure via
payment. Others held that the lease
could not be assumed unless all defaults were cured, even those where such cure
was impossible. Section 365 now
provides that the debtor must cure all defaults save for those nonmonetary
defaults, if it would be impossible for the debtor to cure them at the time of
assumption. The revision also
provides that, with respect to nonmonetary defaults, the debtor is obligated to
provide compensation for those nonmonetary defaults. How the courts will implement this
provision remains unclear.
Landlords would be wise to include language in their post-BAPCPA leases
that assign a monetary penalty for such non-monetary defaults. Absent such language in a lease, the
landlord may find the bankruptcy courts rather hostile to such claims.
BAPCPA is not the
only source of changes in this area of the law. In Saddleback Valley
Community Church v. Eltoro Materials Co. (Eltoro Materials
Co.), 504 F.3d 978 (9th Cir. 2001), the Ninth Circuit Court of
Appeals handed down a significant decision for commercial leases. The case concerned the cap on
“damages resulting from the termination of a lease of real
property” found in Section 502 (b)(6) of the Code. This provision applies to, inter alia, limit the damages a party
may claim when the debtor rejects a lease.
In this case, the lessor asserted a claim for damages resulting from the
debtor “leaving one million tons of its wet clay ‘goo,’
mining equipment, and other property” on the property after it rejected
the lease. The debtor sought to
disallow the claim based on the aforementioned cap. The question for the court was whether
the cap limited the claim of a lessor regardless of the nature of the claim or
whether the cap only applied to a claim for lost future rental income.
Judge Kozinski,
writing for the court, concluded that the cap only applied to lost rents.
The structure of the cap-measured as a fraction of the
remaining term-suggests that damages other than those based on a loss of future
rental income are not subject to the cap. It makes sense to cap damages for
lost rental income based on the amount of expected rent: Landlords may have the
ability to mitigate their damages by re-leasing or selling the premises, but
will suffer injury in proportion to the value of their lost rent in the
meantime. In contrast, collateral damages are likely to bear only a weak
correlation to the amount of rent: A tenant may cause a lot of damage to a
premises leased cheaply, or cause little damage to premises underlying an
expensive leasehold.
The court found this result to be
consistent with the statutory language because the collateral damages were not
triggered by termination of the lease (though it may have triggered the right
to sue): “[t]he million-ton
heap of dirt was not put there by rejection of the lease.”
The
facts of the Eltoro case demonstrate
the significance of this decision.
The lessor claimed damage to the property of $23 million, while the
monthly rent was only $28,000. Had
the cap applied, the claim would have been limited to an amount between
$336,000 and $1,008,000, depending on the length of time remaining on the
lease. This is an important
decision for landlords as it is the first appellate decision that addressed the
applicability of the cap to tort claims for damaged to leased property. The decision is only controlling in the
Ninth Circuit, but its solid reasoning (and the fact that its author is the
widely respected Judge Kozinski) should persuade other courts to follow its
holding.
For more
information, please contact Michael D. Rubenstein at mdrubenstein@liskow.com or go to www.liskow.com.
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