Commercial Financing Problems Under the New Bankruptcy Code
| Publication year | 1979 |
| Pages | 1608 |
| Citation | Vol. 8 No. 9 Pg. 1608 |
1979, September, Pg. 1608. Commercial Financing Problems Under the New Bankruptcy Code
Harry M. Sterling, Denver, is president of Sterling, Simon & Rubner, P.C., and is a Visiting Lecturer at the University of Colorado, teaching bankruptcy.
The new Bankruptcy Code becomes effective October 1, 1979.(fn1) Proceedings begun on or after that date will be governed by the new Code, but the new law will affect transactions which have been in place for months, and even years. Many articles will be found now and in the next few months describing the Code, its background, the reason for its passage, and changes made in the present law.(fn2)
This article attempts only to point out some of the problems and suggested solutions in a very narrow field---commercial financing transactions. Many of the changes in the procedure and rights under the new Code were deemed by Congress as necessary because of the changes in the credit practices since 1938, the date of the last major revision of the Bankruptcy Act. The Uniform Commercial Code and the ingenuity of counsel for creditors have led to practices which have resulted in unwarranted losses by some groups of creditors or the debtor in favor of what is deemed to be improper gains by others. Changed circumstances, as usual, is belatedly followed by changed law.
Hopefully, this article illustrates some of the changes and practices in the technique of lenders necessary to meet the changes in the law. Obtaining security is important to many lenders, but retention of security once obtained is even more so. Commercial lending is normally on a secured basis, so this article deals mostly with the changed treatment of security under the Code. However, changes have also been made in the rights and procedures affecting unsecured lenders, and the discussion includes this as well.
The Bankruptcy Code has three chapters which generally apply to liquidation, reorganization, or individual debt plans, Chapters 1, 3 and 5. Thus, creditor rights for the secured lender will be virtually identical, regardless of the form of the proceeding, if the circumstances are identical. Chapter 1 consists mainly of general provisions and definitions. Chapter 3 refers to case administration. This chapter has five of the most significant sections in the Bankruptcy Act which affect lenders; §§ 361 through 365. Chapter 5 deals with creditors, discharge of the debtor, and collection of the estate. Sections of great importance to lenders are found within the last subchapter, §§ 541 through 554. All significant sections apply to particular financing transactions with different problems created, depending on the type of financing.
"Executory Contracts" are not specifically defined under the new Code, nor were they under the 1938 Act.(fn3) For discussion purposes, rules in the Code relating to executory contracts will have effect only when significant future performance under the contract is called for on both sides.(fn4) Likewise, discussion in this area refers only to true leases, not financing arrangements which take the form of leases, but are, in fact, secured loans. Furthermore, a contract is not executory if one party has already fully performed its part, and the other party's performance will normally only be the payment of money. This involves a collection of a receivable, if performance has been by the debtor; or the filing of a claim, if performance has been by a creditor.(fn5)
Section 541 of the Code vests the debtor's estate with all the debtor's property. Section 365 postpones the requirement of performing duties and obtaining the rights of the debtor in true executory contracts or leases until the trustee or debtor "assumes" the contract or lease. No assumption is required of the burdens of performance of contracts or leases automatically, but only upon the considered business judgment by the trustee of the liabilities which may be attendant upon such assumption. The decision to be made is whether or not the gain to the estate of performance by the debtor or the trustee will be greater than the liability or difficulty of such performance.(fn6)
Under the 1938 Act, leases were usually considered as executory contracts,(fn7) and are now specifically included for similar treatment by § 365. The time limit for assumption or rejection of the lease after October 1 is sixty days in liquidation cases, unless the court extends such time.(fn8) After that time, contracts or leases are deemed to be rejected. In rehabilitation cases, the Code does not fix a time limit for such assumption or rejection, but the non-bankrupt party may request the court to act and require assumption or rejection.(fn9) It is this interim period which poses the first problem for the lender.
A lender, secured by a long-term realty lease or lending to a tenant has a vital interest in whether or not the trustee or debtor promptly affirms or rejects. In cases decided under the 1938 Act, a tenant-debtor was liable to the landlord only for reasonable compensation for use and occupancy before assumption or rejection, and not for the rent stated in the lease. A lender to either landlord or tenant can obviously be affected if the rent changes in the middle of the lease.(fn10) Many times, the landlord received much less than the reserved rent.(fn11)
The 1978 Code still leaves this possibility open. However, during this period before assumption or rejection, the landlord is not required to provide services or supplies to the tenant unless the landlord is compensated under the lease terms for such services or supplies.(fn12) A situation where an office building landlord continues to supply utilities and janitorial services to a bankrupt tenant without receiving payment for at least these services will no longer occur.
If the contract or lease is assumed, the non-bankrupt party has significant protection under the 1978 Code. After a default, the trustee or debtor in possession cannot assume or assign the contract or the lease, unless at the time of the assumption the default is cured or "adequate assurance" of cure is presented;
compensation or adequate assurance of compensation is provided for any pecuniary loss resulting from the default; and adequate assurance of future performance under the contract or lease is presented.(fn13) However, the trustee does not have to cure defaults or give adequate assurance of future performance where the default relates to insolvency or financial condition of the debtor, the commencement of the case under the Bankruptcy Code, or the appointment of or taking possession by a trustee or custodian.(fn14)
Because of the delicate balance of the tenant mix attempted by a shopping center developer, special requirements are present to satisfy the "adequate assurance" test for a trustee or debtor lease assumption or assignment in a shopping center. In a shopping center, the tenants' trustee must give adequate assurance as to future performance by a tenant or assignee for the source of rent, that any percentage rent will not decline and that assumption or assignment will not breach any provision in any other lease, financing agreement or master agreement relating to the shopping center, such as a radius, exclusivity, use or tenant mix provision.(fn15)
A rejection of the lease under the 1978 Code is a breach of the lease relating back to the beginning of the case for which a claim for damages may be filed.(fn16) A realty landlord's right to claim(fn17) is subject to the new damage limits of the greater of (1) one year's rent or (2) 15 percent of the remaining term of the lease, not to exceed three years after the earlier of the date of the filing of the petition or the surrender of the possession. In addition, the rent due on such date can be added to the claim.(fn18)
Note, however, that these limits may be affected by actions taken by the trustee or debtor prior to rejection. If the court had authorized the lease of such premises,
the landlord's damages may be increased by (1) his right to "adequate protection" found by the court when the lease was allowed and (2) by payment for use and occupancy.(fn19)
These new rules have application in various types of lease financing arrangements. A lender typically makes loans on the security of the lessee's leasehold. Many times, the lessee builds large buildings on the leased land with the fee title unencumbered by the mortgage. If, through the landowner's bankruptcy, the lease is rejected (1) is there a continuing right to possession, and if so, under what rent and (2) does the lease survive as security for the mortgagee?
Under the 1938 Act, the result was uncertain. In one case,(fn20) a tenant was allowed to retain possession. The court decided that a rejection of the lease could not dispossess it, but the tenant had to pay a greatly increased rental. No decision was made as to whether or not a lease survived as security for a mortgage, because none was involved.
The lender on a real property lease is better protected because the lessee is better protected in cases of rejection under the 1978 Code. If the lease is assumed by the trustee, breaches in the lease must be cured unless they relate to insolvency, receivership or financial...
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