No Proration of Lessors' Payments in Bankruptcy

On March 15, 2007, the U.S. Court of Appeals for the Third Circuit (the 'Third Circuit') issued an important decision regarding the rights of equipment lessors who find themselves ensnarled in court proceedings as a result of a lessee's filing for bankruptcy protection. In Re: Federal-Mogul Global Inc v. Computer Sales International considered whether two lower courts properly modified an equipment lease under 11 U.S.C. '365(d)(5) of the Bankruptcy Code ' formerly codified at 11 U.S.C. '365(d)(10) ' by permitting proration of payment obligations as of the date of rejection of the leases. The Third Circuit reversed, holding that modification of the lease terms was improper.

In October 2001, Federal-Mogul Corporation, a large automotive parts supplier ('Federal-Mogul' or the 'Debtors') filed for relief under Chapter 11 of the Bankruptcy Code in Delaware. Computer Sales International ('CSI') is a lessor of computer equipment. CSI's customers identify equipment from third-party vendors that they wish to lease and then the customer and CSI execute a sale and lease-back transaction. Starting in 1992, CSI and Federal-Mogul entered into a Master Lease Agreement that set forth the basic terms of all future equipment leasing transactions. Over the following years, Federal-Mogul leased thousands of pieces of equipment from CSI under some 70 leasing schedules. The Master Lease Agreement provided for monthly rental payments that were due in advance on the first day of each month.

In 2002, Federal-Mogul negotiated a new computer leasing arrangement with IBM. As a result of that, the Debtors requested Bankruptcy Court approval of the new leases as well as the rejection of the CSI leases. Federal-Mogul planned to replace more than 4,200 pieces of equipment in 60 locations. In order to minimize costs, Federal-Mogul sought permission to reject the leases in piecemeal fashion, as each individual item was replaced. The Bankruptcy Court held a hearing and granted permission to reject the leases, despite the opposition of CSI. The order directed that the rejection would take effect 'upon the Debtors giving notice to the applicable Computer Equipment Lessor' (the '2002 Order').

With court approval, Federal-Mogul began replacing the leases. When it rejected a lease mid-month, it did not pay on the first the full monthly payment due, but instead remitted a prorated payment some time later, reflecting the number of the days up to the date of rejection. CSI objected and demanded payment for the entire month in which the lease was rejected pursuant to the clear terms of the Master Lease Agreement. As a result of Federal-Mogul's refusal to make full payments, CSI filed a motion to compel and enforce the lease obligations. After a hearing in January 2003, the Bankruptcy Court issued an Order (the '2003 Order') denying the motion on two grounds: 1) under the 2002 Order, CSI waived any argument to full lease payments, and 2) equity supported the modification of the terms of the Master Lease Agreement to allow for proration. The District Court affirmed on substantially similar grounds.

Both the Bankruptcy and District courts held that CSI waived any argument against proration by not raising the issue before the Bankruptcy court when Federal-Mogul moved for permission to reject the CSI leases or by not appealing the 2002 Order. The District Court found that proration was implicit both in the motion to reject and in the Bankruptcy Judge's Order, even if not explicitly stated in either, and that CSI's motion was, therefore, untimely. (See, Computer Sales Int'l, Inc. v. Federal-Mogul Global, Inc. (In re Federal-Mogul Global, Inc.), 331 B.R. 160, 166 (D. Del. 2005).

At issue before the Third Circuit was whether the 2002 Order allowing rejection of the leases ' which was a final order appealable to the District Court ' also decided the issue of proration. A finding that the issue had not been decided would then mean that the Bankruptcy and District Courts erred in so concluding and in their holding that CSI had waived its right to object to the proration.

In a single paragraph of Federal-Mogul's motion to reject the leases, titled 'Relief Requested,' the Debtors requested permission to 'reject' a number of leases 'pursuant to section 365(a)' of the Bankruptcy Code. Nowhere in its motion papers did Federal-Mogul reference proration, nor did it seek modification of its lease obligations under '365(d)(5). Moreover, the Bankruptcy Court's 2002 Order stated that 'the Debtors are authorized to reject each of the Rejected Master Lease Schedules pursuant to 11 U.S.C. '365(a)[,] with such rejection taking effect upon the Debtors giving notice to the applicable Computer Equipment Lessor. ' that all of the equipment subject to a Rejected Master Lease Schedule has been replaced and either is available for shipment or has been lost or disposed.' Subsequently, during CSI's challenge to the Debtors' prorated payments, the Bankruptcy Court in 2003 found the right to prorate implicit in the 2002 Order and stated on the record that 'the order rejecting the lease[s] says that they're rejected the date we tell you they're rejected, and the order, the motion specifically said that means you get paid up to that date.' The District Court agreed with the Bankruptcy Court's interpretation of the motion going so far as to say that proration was the raison d'etre of the rejection motion.

Third Circuit Analysis

The Third Circuit began its analysis by stating that under '365(d)(5) of the Bankruptcy Code the trustee shall 'timely perform' all the lease obligations unless the court, after notice and a hearing and based on the equities of the case, orders otherwise. Although subsection 365(d)(5) gives bankruptcy courts the power to modify debtors' lease obligations after notice and a hearing, such grant of authority is not the same as the '365(a) power to approve the debtor's acceptance or rejection of unexpired leases. Nothing in the language of '365(a) gives bankruptcy courts the power to amend lease obligations. To amend a lease obligation, the Third Circuit held, a debtor must move under '365(d)(5) and give notice to the adverse party; the court must hear the issue, and it must affirmatively order the modification.

The court noted the similarity to In re Montgomery Ward, where the court held that a lease of real property rejected under '365(d)(3) required all sums due pre-rejection owing irrespective of whether the sums can otherwise be prorated. Centerpoint Properties v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 268 F.3d 205, 209 (3d Cir. 2001). The court stated: 'Against this background, we do not conclude that mere rejections of equipment leases alter the obligation to pay the entire amount that came due on the first of the month preceding the rejections.' Thus, the court concluded, under '365(d)(5) it was Federal-Mogul's obligation to move the Bankruptcy Court to allow it to modify its lease obligations and to stipulate what modifications it desired and that 'under these circumstances, construing the Bankruptcy Court's order to deprive CSI of the ability to litigate the issue of modification would play at cross-purposes with the burden ' shifting scheme that Congress has enacted.'

As such, the court held that, at a minimum, debtors should make their requests to modify lease obligations explicit by invoking '365(d)(5) and noting the equities that support modification. Debtors should not 'conflate the '365(a) power to assume or reject with the '365(d)(5) power to modify, as those powers are distinct.'

The court then disposed of the Bankruptcy Court and District Court's alternative ruling that the 'equities of the case' supported the modification of the leases. In its affirmance, the District Court stated that 'despite the existence of a bargained-for lease, equity could sustain a decision to prorate the rents because the Debtor no longer had possession of the property. The rehabilitative purposes of the Code would also be served by allowing a proration of the rents in this case because more money would be available for reorganization and/or distribution to other unsecured creditors.' (In re Federal-Mogul, 331 B.R. at 169).

Disagreeing with the courts below, the Third Circuit concluded that 'the equities weigh heavily against the Debtors.' The court observed that the 'procedural posture of the Debtors' request cuts against them.' The Debtors did not properly seek modification until all of the leases had been rejected; then they sought retroactive rather than prospective modification. Similarly, the Debtors controlled the date of rejection. If they did not want to pay for a full month as required by the lease, they could have rejected toward the end of the month instead of a few days into the month. The court noted that CSI urged it to follow the Fourth Circuit Court of Appeals and hold that retroactive modification is prohibited as a matter of law by '365(d)(5) (See CIT Communications Fin. Corp. v. Midway Airlines Corp. (In re Midway Airlines), 406 F.3d 229, 240 (4th Cir. 2005), but the court declined to make such 'a bright line rule.' Nonetheless, the court noted that '365(d)(5) 'is structured so that vigilant debtors should not need a retroactive remedy.'

Lastly, the court noted that there is nothing in this case inequitable about holding the Debtors to their bargain with CSI. The Master Lease Agreement called for payment in advance on the first day of the month. 'Equitable remedies are traditionally reserved for situations in which the operation of law would render an unfair, unjust, or otherwise extreme result' the court held. 'Simply noting in passing that modification will be convenient or provide minimally more money
for reorganization is not enough to rewrite the terms to which the parties agreed.'

Conclusion

To conclude, In Re: Federal-Mogul Global Inc v. Computer Sales International provides equipment lessors with strong protections of their lease rights. Debtors must clearly invoke '365(d)(5) when moving to modify lease terms and must clearly state the equitable basis for doing so. While the court declined to forbid retroactive proration as a matter of law, it still made clear that the best approach for Debtors is to request such relief in advance of a hearing on the merits. Finally, whether a debtor would succeed in prospectively obtaining proration by arguing the equities may require something more than showing the obvious costs savings given the court's admonition that there is nothing inequitable about lessors' receiving the benefit of their bargain under their leases.

William F. Taylor, Jr., ([email protected]) is a partner in the Wilmington, DE, office of McCarter & English, LLP and represented CSI throughout the case and argued the cause to the Third Circuit Court of Appeals. Eduardo J. Glas ([email protected]) is a partner in the Debtor/Creditor and Commercial Litigation Department of McCarter's Newark, NJ office.

On March 15, 2007, the U.S. Court of Appeals for the Third Circuit (the 'Third Circuit') issued an important decision regarding the rights of equipment lessors who find themselves ensnarled in court proceedings as a result of a lessee's filing for bankruptcy protection. In Re: Federal-Mogul Global Inc v. Computer Sales International considered whether two lower courts properly modified an equipment lease under 11 U.S.C. '365(d)(5) of the Bankruptcy Code ' formerly codified at 11 U.S.C. '365(d)(10) ' by permitting proration of payment obligations as of the date of rejection of the leases. The Third Circuit reversed, holding that modification of the lease terms was improper.

In October 2001, Federal-Mogul Corporation, a large automotive parts supplier ('Federal-Mogul' or the 'Debtors') filed for relief under Chapter 11 of the Bankruptcy Code in Delaware. Computer Sales International ('CSI') is a lessor of computer equipment. CSI's customers identify equipment from third-party vendors that they wish to lease and then the customer and CSI execute a sale and lease-back transaction. Starting in 1992, CSI and Federal-Mogul entered into a Master Lease Agreement that set forth the basic terms of all future equipment leasing transactions. Over the following years, Federal-Mogul leased thousands of pieces of equipment from CSI under some 70 leasing schedules. The Master Lease Agreement provided for monthly rental payments that were due in advance on the first day of each month.

In 2002, Federal-Mogul negotiated a new computer leasing arrangement with IBM. As a result of that, the Debtors requested Bankruptcy Court approval of the new leases as well as the rejection of the CSI leases. Federal-Mogul planned to replace more than 4,200 pieces of equipment in 60 locations. In order to minimize costs, Federal-Mogul sought permission to reject the leases in piecemeal fashion, as each individual item was replaced. The Bankruptcy Court held a hearing and granted permission to reject the leases, despite the opposition of CSI. The order directed that the rejection would take effect 'upon the Debtors giving notice to the applicable Computer Equipment Lessor' (the '2002 Order').

With court approval, Federal-Mogul began replacing the leases. When it rejected a lease mid-month, it did not pay on the first the full monthly payment due, but instead remitted a prorated payment some time later, reflecting the number of the days up to the date of rejection. CSI objected and demanded payment for the entire month in which the lease was rejected pursuant to the clear terms of the Master Lease Agreement. As a result of Federal-Mogul's refusal to make full payments, CSI filed a motion to compel and enforce the lease obligations. After a hearing in January 2003, the Bankruptcy Court issued an Order (the '2003 Order') denying the motion on two grounds: 1) under the 2002 Order, CSI waived any argument to full lease payments, and 2) equity supported the modification of the terms of the Master Lease Agreement to allow for proration. The District Court affirmed on substantially similar grounds.

Both the Bankruptcy and District courts held that CSI waived any argument against proration by not raising the issue before the Bankruptcy court when Federal-Mogul moved for permission to reject the CSI leases or by not appealing the 2002 Order. The District Court found that proration was implicit both in the motion to reject and in the Bankruptcy Judge's Order, even if not explicitly stated in either, and that CSI's motion was, therefore, untimely. (See, Computer Sales Int'l, Inc. v. Federal-Mogul Global, Inc. (In re Federal-Mogul Global, Inc.), 331 B.R. 160, 166 (D. Del. 2005).

At issue before the Third Circuit was whether the 2002 Order allowing rejection of the leases ' which was a final order appealable to the District Court ' also decided the issue of proration. A finding that the issue had not been decided would then mean that the Bankruptcy and District Courts erred in so concluding and in their holding that CSI had waived its right to object to the proration.

In a single paragraph of Federal-Mogul's motion to reject the leases, titled 'Relief Requested,' the Debtors requested permission to 'reject' a number of leases 'pursuant to section 365(a)' of the Bankruptcy Code. Nowhere in its motion papers did Federal-Mogul reference proration, nor did it seek modification of its lease obligations under '365(d)(5). Moreover, the Bankruptcy Court's 2002 Order stated that 'the Debtors are authorized to reject each of the Rejected Master Lease Schedules pursuant to 11 U.S.C. '365(a)[,] with such rejection taking effect upon the Debtors giving notice to the applicable Computer Equipment Lessor. ' that all of the equipment subject to a Rejected Master Lease Schedule has been replaced and either is available for shipment or has been lost or disposed.' Subsequently, during CSI's challenge to the Debtors' prorated payments, the Bankruptcy Court in 2003 found the right to prorate implicit in the 2002 Order and stated on the record that 'the order rejecting the lease[s] says that they're rejected the date we tell you they're rejected, and the order, the motion specifically said that means you get paid up to that date.' The District Court agreed with the Bankruptcy Court's interpretation of the motion going so far as to say that proration was the raison d'etre of the rejection motion.

Third Circuit Analysis

The Third Circuit began its analysis by stating that under '365(d)(5) of the Bankruptcy Code the trustee shall 'timely perform' all the lease obligations unless the court, after notice and a hearing and based on the equities of the case, orders otherwise. Although subsection 365(d)(5) gives bankruptcy courts the power to modify debtors' lease obligations after notice and a hearing, such grant of authority is not the same as the '365(a) power to approve the debtor's acceptance or rejection of unexpired leases. Nothing in the language of '365(a) gives bankruptcy courts the power to amend lease obligations. To amend a lease obligation, the Third Circuit held, a debtor must move under '365(d)(5) and give notice to the adverse party; the court must hear the issue, and it must affirmatively order the modification.

The court noted the similarity to In re Montgomery Ward, where the court held that a lease of real property rejected under '365(d)(3) required all sums due pre-rejection owing irrespective of whether the sums can otherwise be prorated. Centerpoint Properties v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 268 F.3d 205, 209 (3d Cir. 2001). The court stated: 'Against this background, we do not conclude that mere rejections of equipment leases alter the obligation to pay the entire amount that came due on the first of the month preceding the rejections.' Thus, the court concluded, under '365(d)(5) it was Federal-Mogul's obligation to move the Bankruptcy Court to allow it to modify its lease obligations and to stipulate what modifications it desired and that 'under these circumstances, construing the Bankruptcy Court's order to deprive CSI of the ability to litigate the issue of modification would play at cross-purposes with the burden ' shifting scheme that Congress has enacted.'

As such, the court held that, at a minimum, debtors should make their requests to modify lease obligations explicit by invoking '365(d)(5) and noting the equities that support modification. Debtors should not 'conflate the '365(a) power to assume or reject with the '365(d)(5) power to modify, as those powers are distinct.'

The court then disposed of the Bankruptcy Court and District Court's alternative ruling that the 'equities of the case' supported the modification of the leases. In its affirmance, the District Court stated that 'despite the existence of a bargained-for lease, equity could sustain a decision to prorate the rents because the Debtor no longer had possession of the property. The rehabilitative purposes of the Code would also be served by allowing a proration of the rents in this case because more money would be available for reorganization and/or distribution to other unsecured creditors.' (In re Federal-Mogul, 331 B.R. at 169).

Disagreeing with the courts below, the Third Circuit concluded that 'the equities weigh heavily against the Debtors.' The court observed that the 'procedural posture of the Debtors' request cuts against them.' The Debtors did not properly seek modification until all of the leases had been rejected; then they sought retroactive rather than prospective modification. Similarly, the Debtors controlled the date of rejection. If they did not want to pay for a full month as required by the lease, they could have rejected toward the end of the month instead of a few days into the month. The court noted that CSI urged it to follow the Fourth Circuit Court of Appeals and hold that retroactive modification is prohibited as a matter of law by '365(d)(5) (See CIT Communications Fin. Corp. v. Midway Airlines Corp. (In re Midway Airlines), 406 F.3d 229, 240 (4th Cir. 2005), but the court declined to make such 'a bright line rule.' Nonetheless, the court noted that '365(d)(5) 'is structured so that vigilant debtors should not need a retroactive remedy.'

Lastly, the court noted that there is nothing in this case inequitable about holding the Debtors to their bargain with CSI. The Master Lease Agreement called for payment in advance on the first day of the month. 'Equitable remedies are traditionally reserved for situations in which the operation of law would render an unfair, unjust, or otherwise extreme result' the court held. 'Simply noting in passing that modification will be convenient or provide minimally more money
for reorganization is not enough to rewrite the terms to which the parties agreed.'

Conclusion

To conclude, In Re: Federal-Mogul Global Inc v. Computer Sales International provides equipment lessors with strong protections of their lease rights. Debtors must clearly invoke '365(d)(5) when moving to modify lease terms and must clearly state the equitable basis for doing so. While the court declined to forbid retroactive proration as a matter of law, it still made clear that the best approach for Debtors is to request such relief in advance of a hearing on the merits. Finally, whether a debtor would succeed in prospectively obtaining proration by arguing the equities may require something more than showing the obvious costs savings given the court's admonition that there is nothing inequitable about lessors' receiving the benefit of their bargain under their leases.

William F. Taylor, Jr., ([email protected]) is a partner in the Wilmington, DE, office of McCarter & English, LLP and represented CSI throughout the case and argued the cause to the Third Circuit Court of Appeals. Eduardo J. Glas ([email protected]) is a partner in the Debtor/Creditor and Commercial Litigation Department of McCarter's Newark, NJ office.