Chapter One Pre-Bankruptcy Strategies

• Jurisdiction: United States

Chapter One Pre-Bankruptcy Strategies

I. Pre-Petition Termination of the Lease

A. Introduction

Financial distress is rarely a secret. A commercial tenant's financial distress frequently becomes public knowledge well before there is a bankruptcy filing. In high-profile bankruptcies, the likelihood of a bankruptcy filing may be a frequent topic in the media, and indeed, the threat of bankruptcy is a corporate tactic in many instances. Sometimes, but not always, this financial distress gives rise to monetary and/or non-monetary defaults under a lease.

When a bankruptcy filing is on the horizon, a threshold question for an owner/landlord is whether to terminate a commercial lease, assuming that the tenant has breached an affirmative covenant or obligation under the lease that justifies such action. Early termination can prevent the lease from becoming "property of the bankruptcy estate"¹¹ and hence permits a landlord to avoid some, but not all, of the issues that arise in a bankruptcy case.¹² Business considerations normally drive this decision: If the landlord has access to an ample supply of replacement tenants, and if the tenant presents a serious credit risk, termination should be considered. Conversely, in a troubled or depressed market, with few replacement tenants, the landlord may be more interested in preserving cash flow from the debtor-tenant, and may benefit from operating under the protections afforded to landlords under the Code, such as the debtor's obligation to pay rent on a current basis after it files for bankruptcy.

B. The Concept of "Termination" Pertaining to Real Estate Leases

A debtor's leasehold estate does not become property of the bankruptcy estate if the leasehold estate has expired as of the stated term of the lease or has been properly terminated under state law. Section 541(b)(2) states that property of the estate does not include any interest of the debtor under a lease of nonresidential real property "that has terminated at the expiration of the stated term of such lease before the commencement of the case." Section 365(c)(3) states that a debtor cannot assume or assign a lease that "has been terminated under applicable nonbank-ruptcy law prior to the order for relief." This Code language creates some ambiguity because § 541 does not expressly state that a lease that has been "terminated" is not property of the estate. However, the Seventh Circuit in Robinson v. Chicago Housing Auth., 54 F.3d 316 (7th Cir. 1995), held that § 541 should not be read to mean that expiration of the stated term is the only way that leases can expire, and that "any method that fully severs the rights of the tenant in the property renders the lease expired[.]"¹³

Termination under state law, however, is a complex issue that varies from state to state. This is because a lease is both a conveyance of an interest in real property and a bilateral contract. Further, many jurisdictions have statutory provisions that permit a tenant to revive a terminated lease under anti-forfeiture statutes, and other jurisdictions have longstanding equitable principles that permit an otherwise-terminated lease to be resurrected.

Bankruptcy law seeks to follow state law. Accordingly, a lease that has been fully and effectively terminated under state law does not become property of the bankruptcy estate. Thus, in Triangle Laboratories Inc. v. Halvejian (In re Triangle Laboratories Inc.), 663 F.2d 463 (3d Cir. 1981), the Third Circuit followed the preeminent bankruptcy treatise and opined that "for section 365 to apply, the contract or lease must be in existence. If the contract or lease has expired by its own terms or has been terminated prior to the commencement of the bankruptcy case, then there is nothing left for the trustee to assume or assign."¹⁴ The court further stated that this reasoning is consistent "with the recognized principle of bankruptcy law that an executory contract or lease validly terminated prior to the institution of bankruptcy proceedings is not resurrected by the filing of the petition in bankruptcy, and cannot therefore be included among the debtor's assets."¹⁵

The general rule is that a termination of a lease is "final" under the Code if all "final hurdles" have been crossed and the lease is not subject to any form of equitable redemption or statutory grace period. In Executive Square Office Building v. O'Connor & Assoc.,¹⁶ the court held that a bankruptcy court has jurisdiction over a lease if "the final hurdles" to termination have not been cleared under state law:

It has been variously stated that if a lease or contract has already been "terminated" under applicable state law, this leaves the trustee with nothing to assume or reject, but that, "if the termination process has not been completed or, if completed, can be reversed by application of a state anti-forfeiture statute or waiver doctrine, the trustee may still assume."
Perhaps this should be restated to clarify that until the lease-termination process has been completed, there has been no "termination subject to reversal."... [U]ntil such time as such anti-forfeiture or anti-termination hurdles are cleared, it may be imprecise to say that there has been a forfeiture or termination, and somewhat confusing to say that an asserted or alleged forfeiture or termination is subject to reversal when what is intended is that an ultimate termination may still be avoided by a resort to equity or the application of an anti-forfeiture or anti-termination provision under state law. In other words, if the extinguishment of the lease interest is still subject to an existing and available statutory grace proviso or right to resort to equity to prevent a forfeiture or termination, then there has not, as yet, been any ultimate or final termination for the purpose of analyzing whether this court has initial juris-diction[.]¹⁷

In Chart House Inc. v. Maxwell (In re Maxwell),¹⁸ the court considered a former provision under the Illinois Forcible Entry and Detainer Act that stated that a Landlord may give written notice that rent has not been timely paid and that "unless payment is made within a time mentioned in such notice . the lease will be terminated."¹⁹ In construing this provision, the Chart House court held that the expiration of the cure period contained with the notice ends the contractual relationship between landlord and tenant, even if the landlord has not completed an eviction proceeding under state law:

It has been conclusively established that a bankruptcy court cannot resurrect a lease that has been terminated prior to the filing of bankruptcy.
...
In Illinois, the statutory notice procedure for terminating a lease and a forcible entry and detainer action are two distinct things. The former process ends the contractual relationship between the parties, while the forcible entry and detainer action determines rights to possession of property. The bankruptcy court confused the two actions. Executive Square has been persuasively criticized on the same ground. [See In re Foxfire Inn of Stuart Florida Inc., 30 B.R. 30, 31 (Bankr. S.D. Fla. 1983)] (Executive Square "confused expiration or termination of lease with physical repossession of the leased premises").²⁰

In Robinson, the Seventh Circuit questioned whether Maxwell was still good law.²¹ The Court surveyed the state laws and stated that "[t]he general rule throughout the states is that the lease ends when the tenant is no longer entitled to posses-sion."²² The Seventh Circuit held that the right to possession does not end until a judgment for possession is entered, and that a writ of possession was not necessary to complete the termination.²³

In Holoros, a lease expired pre-petition on its own terms. During the lease, the lessee made improvements to the property (paid $76K to build a barn). It's undisputed that the barn became property of the lessor (either once it was completed or upon the lease's expiration). After the lease's expiration, the lessee continued to occupy the land. Within two years of completing the barn, the lessee filed chapter 7. The trustee brought an avoidance action to recover the value of the barn, arguing that the barn was transferred either upon its construction or upon the lease's expiration. The first argument (transfer upon construction) was resolved by interpreting the language of the lease (no transfer at construction). The second argument (transfer upon expiration) was resolved (in part) by citing Robinson and holding that upon the expiration, the lessee had no rights in the lease.²⁴

Even if termination is otherwise complete, a state-created right to revive a lease will prevent the termination from being deemed final. In re Moore²⁵ addressed the question of whether a residential lease is terminated for bankruptcy purposes where there still remains some form of state-created anti-forfeiture rights. The court referred to the large body of existing case law: "Effectively, these courts treat the statutory and/or equity based [sic] forfeiture relief as an interest in property constituting a portion of the bundle of interests aggregating the whole of the lease and leasehold estate and not as a separate property interest."²⁶

Furthermore, In re Ross²⁷ held that a lease was not finally terminated (even if a judgment for possession had been issued) if under state law the tenant still had an equitable right of redemption:

Under Florida law, equity will afford relief against the forfeiture of a lease "whenever it is just and equitable to do so; the only condition precedent ... being the tender of the arrears of rent with accrued interest." Equity will afford relief even when the lessor has obtained a judgment of possession. Therefore, even if a judgment of possession amounts to completion of the termination process, that process can be reversed under Florida's anti-forfeiture doctrine.²⁸

Landlords should anticipate that there will be an issue over termination unless there is...