Commercial Landlords Tilt the Playing Field Against Tenants under New Bankruptcy Law

The current Bankruptcy Code provides that a lease of commercial real estate must be assumed or rejected by a debtor within 60 days after filing of bankruptcy, or it is deemed rejected. Courts may grant unlimited extensions of time to assume or reject such leases. These extensions are routinely granted, especially in larger cases, so long as debtors are paying rent and otherwise generally honoring the provisions of the lease.

The assumption function is an important one for debtors on several levels. One effect of assumption is that the rent (including pre-petition arrearages) under an assumed lease becomes “administrative” rent for the remaining term of the lease. In other words, assumption of a lease elevates the past due rent and future rent, as it accrues, to the highest payment priority. This is fine so long as the Chapter 11 is successful and the debtor continues to operate. However, an improvidently assumed lease can cripple a failed Chapter 11 because the rent due for the remaining term of an assumed lease can, as a practical matter, swamp the unpaid claims of other creditors (including the professionals appointed by the court to represent the debtor and others).

Under the new law, a debtor will have 120 days after the bankruptcy, or the date of confirmation of a plan, whichever is earlier, to assume or reject a commercial lease. The court may extend this period for an additional 90 days upon a showing of good cause. Any subsequent extension will require the prior written consent of the landlord. Conse-quently, the new law takes away the court's discretion to extend the assumption period beyond 210 days after bankruptcy (unless the landlord consents in writing). At the same time, however, the new law “caps” the administrative rent on an assumed lease to 2 years following rejection or actual turnover of the premises. Any remaining claim due and owing from the balance of the lease becomes an unsecured claim subject to the Bankruptcy Code's cap thereof. As a result, the penalty is softened for assuming a lease in a Chapter 11 that goes awry.

This timing change is a major coup for landlords, as it puts significant pressure on tenants to evaluate their leases early in Chapter 11 cases. This evaluation can be difficult, particularly in large retail cases, such as those of Ames, K-Mart and Caldor. Typically, a particular store's performance will reflect seasonal highs and lows, which will be less susceptible of examination over a period of 210 days. Some debtors may be forced into making premature decisions on lease assumption/rejection, and may forfeit the value of rejected leases in the face of inadequate time to make a careful analysis or properly market the leases for sale. A debtor who assumes a lease improvidently at least can take advantage of the new 2-year cap on post-petition administrative rent (with the balance of any landlord claims becoming a pre-petition, unsecured claim subject to the same cap that currently cuts off liability to landlords).

Tenants having sufficient leverage can be expected to seek to soften this time limitation by obtaining the landlord's written waiver of the lease assumption deadline at the time of lease execution. Landlords might respond with some request for consideration for extensions. The change in the law will almost certainly cause parties at least to consider their bankruptcy strategies more carefully before they sign a lease.

Ability to Assume and Assign Leases That Are in Non-Curable, Nonmonetary Default

Section 365(b) of the Bankruptcy Code requires that a debtor cure any defaults prior to assumption of an unexpired lease (or provide adequate assurance of prompt cure). Under the new law, Congress clarified that a debtor may assume a lease that has gone into incurable nonmonetary default so long as compliance with the lease is resumed at the time of assumption and assignment. However, a landlord is entitled to recover pecuniary loss arising from the nonmonetary breach at assumption. This change may be intended to respond to the effect of cases such as In re Claremont Acquisition Corp., 113 F.3d 1029 (9th Cir. 1997) which held that certain historical defaults, such as the business being shuttered, were not susceptible of cure and, therefore, the lease could not be assumed.

The practical effect of this change is not entirely clear. On the one hand, the new legislation clarifies that debtors may assume and assign leases that had fallen into nonmonetary, incurable default. On the other hand, some read the new law to require that the assignment of a lease must occur before the close of the 210-day window to assume and assign leases. In addition, when shopping center leases with continuous operation provisions are assigned, the assignee apparently needs to be in full compliance with the continuous operation provision immediately upon assignment (at least under a literal reading of the new law). The new law is a significant change from the old practice of allowing assignees a reasonable time after assignment to fit out the space and begin operations. It is certainly not immediately apparent how this will work in practice as the typical purchaser of a lease from a bankrupt entity expects to take time to re-fit the property before it opens. At minimum, the change may chill the bidding for sales of leases until the courts give some guidance as to how assignments will work.

Restrictive Use Or Anti-Assignment Provisions

Under the current law, the courts have tried to balance the shopping center landlord's right to control the tenant mix with the Bankruptcy Code's desire to allow debtors to sell their leases despite anti-assignment clauses contained in the leases. The battle was centered over two code provisions that were at odds:

1) Section 365(b)(3) which conditions assignment to a third party on the debtor's adequate assurance to a landlord that an assignee will be able to perform. Section 365(b)(3) requires that adequate assurances include assurances that the assignment will not upset lease provisions preserving mix and balance and use of the property; and

2) Section 365(f)(1) which states, “except as provided by in subsection (c) of this Section” a debtor may assign a lease notwithstanding a provision that restricts or conditions assignment. Courts have read Section 365(f)(1) as the prohibition on anti-assignment clauses to trump Section 365(b)(3)'s protection given to shopping center landlords. Contrast In re Rickel Home Centers, 240 B.R. 826 (D. Del. 1998), with In re Trak Auto Corporation, 367 F.3d 237 (4th Cir. 2004).

The new law seemingly quiets the conflict by adding one phrase to Section 365(f)(1), “except as provided in subsections (b) and (c).” The new law makes clear that a debtor must take into account and respect a landlord's right to control the use, mix and balance of its shopping center property when giving the landlord adequate assurances that the assignee will be able to perform under the lease.

Period for Filing Plan under Chapter 11

Section 1121 of the Bankruptcy Code provides that a Chapter 11 debtor has the exclusive right to file a plan of reorganization and obtain the requisite votes for the plan's acceptance during the first 120 days of the case. On request, the court may increase the debtor's 120-day exclusivity period. At the expiration of the exclusive period, any creditor can file its own plan.

When the new law becomes effective, the right of a debtor to obtain extensions of the exclusivity period for filing of a plan is limited to 18 months after the filing. The right to extend for “cause” beyond the initial time limitation has been eliminated.

Particularly in large or complex cases, it often is impossible for debtors to formulate a viable reorganization plan quickly enough to meet the relevant time limits. In all cases, fixed time limits without the ability to extend for “cause” may reduce the incentive for creditors to cooperate with debtors to negotiate the terms of a reorganization plan. Instead, the new law may increase the incentive for certain creditors to wait until the end of a debtor's exclusive period, and then to propose their own plan.

Conclusion

After Oct. 17, 2005, the leverage certainly shifts noticeably toward landlords in real estate reorganizations. The law poses certain significant questions that will need to be answered by the courts.

The changes in the coming bankruptcy law (effective Oct. 17, 2005) are certain to be welcomed by commercial landlords who are given new advantages when tenants file for bankruptcy. Landlords will have new ammunition to control the disposition of premises and to ensure prompt performance of lease obligations. The new law already has landlords and tenants rethinking their strategies, both in the leasing stage and post-bankruptcy. Because the law is subject to significant uncertainty in its interpretation and function, however, only time will tell how the changes play out.

Perhaps the most significant commercial leasing changes in the law involve timing of actions, the ability to assume leases that are in nonmonetary default, and the application of restrictive use clauses, or what are often called anti-assignment provisions.

Timing Changes

The current Bankruptcy Code provides that a lease of commercial real estate must be assumed or rejected by a debtor within 60 days after filing of bankruptcy, or it is deemed rejected. Courts may grant unlimited extensions of time to assume or reject such leases. These extensions are routinely granted, especially in larger cases, so long as debtors are paying rent and otherwise generally honoring the provisions of the lease.

The assumption function is an important one for debtors on several levels. One effect of assumption is that the rent (including pre-petition arrearages) under an assumed lease becomes “administrative” rent for the remaining term of the lease. In other words, assumption of a lease elevates the past due rent and future rent, as it accrues, to the highest payment priority. This is fine so long as the Chapter 11 is successful and the debtor continues to operate. However, an improvidently assumed lease can cripple a failed Chapter 11 because the rent due for the remaining term of an assumed lease can, as a practical matter, swamp the unpaid claims of other creditors (including the professionals appointed by the court to represent the debtor and others).

Under the new law, a debtor will have 120 days after the bankruptcy, or the date of confirmation of a plan, whichever is earlier, to assume or reject a commercial lease. The court may extend this period for an additional 90 days upon a showing of good cause. Any subsequent extension will require the prior written consent of the landlord. Conse-quently, the new law takes away the court's discretion to extend the assumption period beyond 210 days after bankruptcy (unless the landlord consents in writing). At the same time, however, the new law “caps” the administrative rent on an assumed lease to 2 years following rejection or actual turnover of the premises. Any remaining claim due and owing from the balance of the lease becomes an unsecured claim subject to the Bankruptcy Code's cap thereof. As a result, the penalty is softened for assuming a lease in a Chapter 11 that goes awry.

This timing change is a major coup for landlords, as it puts significant pressure on tenants to evaluate their leases early in Chapter 11 cases. This evaluation can be difficult, particularly in large retail cases, such as those of Ames, K-Mart and Caldor. Typically, a particular store's performance will reflect seasonal highs and lows, which will be less susceptible of examination over a period of 210 days. Some debtors may be forced into making premature decisions on lease assumption/rejection, and may forfeit the value of rejected leases in the face of inadequate time to make a careful analysis or properly market the leases for sale. A debtor who assumes a lease improvidently at least can take advantage of the new 2-year cap on post-petition administrative rent (with the balance of any landlord claims becoming a pre-petition, unsecured claim subject to the same cap that currently cuts off liability to landlords).

Tenants having sufficient leverage can be expected to seek to soften this time limitation by obtaining the landlord's written waiver of the lease assumption deadline at the time of lease execution. Landlords might respond with some request for consideration for extensions. The change in the law will almost certainly cause parties at least to consider their bankruptcy strategies more carefully before they sign a lease.

Ability to Assume and Assign Leases That Are in Non-Curable, Nonmonetary Default

Section 365(b) of the Bankruptcy Code requires that a debtor cure any defaults prior to assumption of an unexpired lease (or provide adequate assurance of prompt cure). Under the new law, Congress clarified that a debtor may assume a lease that has gone into incurable nonmonetary default so long as compliance with the lease is resumed at the time of assumption and assignment. However, a landlord is entitled to recover pecuniary loss arising from the nonmonetary breach at assumption. This change may be intended to respond to the effect of cases such as In re Claremont Acquisition Corp., 113 F.3d 1029 (9th Cir. 1997) which held that certain historical defaults, such as the business being shuttered, were not susceptible of cure and, therefore, the lease could not be assumed.

The practical effect of this change is not entirely clear. On the one hand, the new legislation clarifies that debtors may assume and assign leases that had fallen into nonmonetary, incurable default. On the other hand, some read the new law to require that the assignment of a lease must occur before the close of the 210-day window to assume and assign leases. In addition, when shopping center leases with continuous operation provisions are assigned, the assignee apparently needs to be in full compliance with the continuous operation provision immediately upon assignment (at least under a literal reading of the new law). The new law is a significant change from the old practice of allowing assignees a reasonable time after assignment to fit out the space and begin operations. It is certainly not immediately apparent how this will work in practice as the typical purchaser of a lease from a bankrupt entity expects to take time to re-fit the property before it opens. At minimum, the change may chill the bidding for sales of leases until the courts give some guidance as to how assignments will work.

Restrictive Use Or Anti-Assignment Provisions

Under the current law, the courts have tried to balance the shopping center landlord's right to control the tenant mix with the Bankruptcy Code's desire to allow debtors to sell their leases despite anti-assignment clauses contained in the leases. The battle was centered over two code provisions that were at odds:

1) Section 365(b)(3) which conditions assignment to a third party on the debtor's adequate assurance to a landlord that an assignee will be able to perform. Section 365(b)(3) requires that adequate assurances include assurances that the assignment will not upset lease provisions preserving mix and balance and use of the property; and

2) Section 365(f)(1) which states, “except as provided by in subsection (c) of this Section” a debtor may assign a lease notwithstanding a provision that restricts or conditions assignment. Courts have read Section 365(f)(1) as the prohibition on anti-assignment clauses to trump Section 365(b)(3)'s protection given to shopping center landlords. Contrast In re Rickel Home Centers, 240 B.R. 826 (D. Del. 1998), with In re Trak Auto Corporation, 367 F.3d 237 (4th Cir. 2004).

The new law seemingly quiets the conflict by adding one phrase to Section 365(f)(1), “except as provided in subsections (b) and (c).” The new law makes clear that a debtor must take into account and respect a landlord's right to control the use, mix and balance of its shopping center property when giving the landlord adequate assurances that the assignee will be able to perform under the lease.

Period for Filing Plan under Chapter 11

Section 1121 of the Bankruptcy Code provides that a Chapter 11 debtor has the exclusive right to file a plan of reorganization and obtain the requisite votes for the plan's acceptance during the first 120 days of the case. On request, the court may increase the debtor's 120-day exclusivity period. At the expiration of the exclusive period, any creditor can file its own plan.

When the new law becomes effective, the right of a debtor to obtain extensions of the exclusivity period for filing of a plan is limited to 18 months after the filing. The right to extend for “cause” beyond the initial time limitation has been eliminated.

Particularly in large or complex cases, it often is impossible for debtors to formulate a viable reorganization plan quickly enough to meet the relevant time limits. In all cases, fixed time limits without the ability to extend for “cause” may reduce the incentive for creditors to cooperate with debtors to negotiate the terms of a reorganization plan. Instead, the new law may increase the incentive for certain creditors to wait until the end of a debtor's exclusive period, and then to propose their own plan.

Conclusion

After Oct. 17, 2005, the leverage certainly shifts noticeably toward landlords in real estate reorganizations. The law poses certain significant questions that will need to be answered by the courts.