Chapter Three Lease Assumption
| Jurisdiction | United States |
I. Introduction
Because a commercial lease is considered to be an executory contract, the debtor is given the statutory right to either "assume" the lease, making its obligations binding on the estate, or conversely "reject" the lease, resulting in a "breach" that is deemed to occur prior to the petition date. Once assumed, a lease may be assigned to third parties.
Assumption is favorable to the landlord in that it assures the continuance of the lease and requires that the debtor cure all or most pre-petition defaults. Assumption may be viewed as unfavorable to the landlord where the lease is below market, where the landlord would prefer to find a new tenant, or where the tenant remains a credit risk.
Once the bankruptcy case has commenced, a landlord's typical concern will be to obtain a quick determination on the issue of whether the tenant is going to assume or reject its lease. Many landlords seek prompt rejection and recovery of the premises. This may occur where the landlord fears that the tenant will leave the space dark or will seek to assume and assign the lease to a new tenant who may alter the tenant mix or create a credit risk. Conversely, if a landlord obtains a prompt assumption, the landlord may be able to ensure that it receives immediate payment of current rent and the cure of any unpaid arrearages.
Debtors sometimes hope to delay a final decision on assumption or rejection until the prospects for either a sale of the lease or a reorganization are clearer. In particular, debtors prefer to delay the decision to assume or reject until they know whether it is likely that a plan of reorganization will be confirmed or whether the lease can be assigned to a third party. Otherwise, assumption merely creates a cash drain to the estate, since the lease payments are deemed an administrative expense that must be paid in accordance with the lease terms.
The assumption or rejection of a lease is a significant turning point in a bankruptcy case, with serious consequences for debtor, landlord and other creditors. Once assumed, the lease becomes a binding obligation of the estate, the subsequent breach of which results in an administrative expense priority claim.184
Once a lease is assumed, the lease may be assigned to a third party, despite any provision in the lease forbidding assignment. In 1984, Congress adopted the so-called shopping center amendments to the Code,185 which were designed to protect landlords from assignments that did not comply with such provisions as the radius, use or exclusivity provisions in shopping center leases. Despite the 1984 amendments, the trend in many courts had been to permit assignment of a lease absent a showing of a material injury to the landlord. This has now been changed under BAPCPA § 365(f)(1). Prior to BAPCPA, if a lease was assumed and later rejected, the damage claim was not subject to the statutory cap that pertains to the ordinary rejection of a lease. See In re Klein Sleep Products Inc., 78 F.3d 18, 28-29 (2d Cir. 1996). However, this has now been addressed in amended § 503(b)(6), discussed below, which generally seeks to limit the amount of an administrative expense claim of a landlord.
Lastly, while assumption is supposed to be of the lease in its entirety, it would appear that several courts have suggested that some lease modifications may be permitted in the context of an assumption — once again signifying a major departure from state property law.
Generally, the decision to assume or reject is said to be based on the debtor's exercise of its business judgment. With respect to lease rejection, this standard has become so elastic that, according to some views, it is no standard at all. Few, if any, cases demonstrate the court's willingness to second-guess the debtor's business judgment.
If a lease is in default, then assumption requires that most defaults be cured, that compensation be paid for losses arising from such default, or that the debtor provide assurances of a prompt cure.186 This Code section may permit a debtor to cure defaults that, under ordinary state law principles, would not be curable and might have otherwise justified termination of the lease. The cure requirements are higher if the lease is a shopping center lease.187
II. Time Period for Assumption
A. § 365(d)(4)(A)
Section 365(d)(4)(A) states:
Subject to subparagraph (B), an unexpired lease of nonresidential real property under which the debtor is the lessee shall be deemed rejected, and the trustee shall immediately surrender that nonresidential real property to the lessor, if the trustee does not assume or reject the unexpired lease by the earlier of —
(i) the date that is 120 days after the date of the order for relief; or(B)
(ii) the date of the entry of an order confirming a plan.
(i) The court may extend the period determined under subparagraph (A), prior to the expiration of the 120-day period, for 90 days on the motion of the trustee or lessor for cause,
(ii) If the court grants an extension under clause (i), the court may grant a subsequent extension only upon prior written consent of the lessor in each instance.188
Thus, failure to assume within such 120 days, if not extended, will cause the lease to be deemed rejected.189
B. Time to Seek Extension Under BAPCPA: Sword of Damocles
Under BAPCPA, the time period in which a debtor must assume or reject a lease has been dramatically shortened from a potentially unlimited period (see above) to 210 days. This has led some to conclude that retail bankruptcy cases are now more difficult, despite some earlier predictions that debtors would still be able to assume and assign their leases "in bulk" transactions to "designation buyers" — that is, an entity that the court approves as being designated to exercise the right to assume and assign large groups of leases for a debtor (see below).190
In the ABI Report, it was stated that "[t]he Commissioners suggested that the current deadline [of 210 days] is preventing potential debtors from using chapter 11, at least on a voluntary and timely basis, and is making it more difficult for retail chains to reorganize their businesses."191
Another issue noted by the commissioners was that "postpetition lenders have been requiring debtors in possession to make their decisions about nonresidential real property leases as early as 120 to 150 days after the petition date to permit these lenders to preserve their security interest in the debtors' leaseholds before the expiration of the section 365(d)(4) deadline."192
The cases appear to evidence a strict interpretation of the time limits. In re Tubular Techs. LLC193 held that BAPCPA's amendment to § 365(d)(4) puts to rest the prior judicial split on whether the deadline to assume a lease may be extended after such a time period has lapsed. The court held that § 365(d)(A) indicates that a debtor may not obtain an extension of time to assume a lease if the extension is not granted within the first 120 days. This view of the effect of the 2005 reforms is supported by commentators.194
Under BAPCPA, an extension after an initial 90-day extension may only be upon the "prior written consent of the lessor." Whether the courts will begin to find forms of implied consent is unclear. The courts may also find ways to encourage consent from landlords. Experience has shown that landlords are frequently willing to extend the time where the parties are in meaningful negotiations.
C. Strategic Considerations
Extensions of the time to assume or reject were routinely granted prior to BAPCPA. This has now changed. Congress intended to work a "sea change" into the timing of the assumption and rejection period. Some may feel that the new time restraints will be unworkable. Certainly, the attempt to market and sell large blocks of retail space in a complex case may prove difficult. The technique of selling "designation rights" may also become more difficult, since this method typically permitted a buyer of the designation rights to try to market a large group of leases for many months before seeking an assumption of only those leases for which it could find a new tenant. Further, as BAPCPA may force debtors in retail cases to make concessions to landlords in order to bargain for extensions beyond 210 days, such debtors will likely work more closely with landlords in the pre-filing period, just as they currently do with major banks and lenders. One avenue to force a decision is to file a motion to request the court to set a deadline for the debtor to assume or reject the lease under § 365(d)(2).
III. Legal Standards for Assumption
A. Lease Not in Default
The Code contains no express standard for the assumption or rejection of a lease that is not in default. A debtor's decision to assume or reject must only satisfy the business-judgment standard and is therefore accorded a high degree of deference by the courts. A leading circuit court decision states the rule as follows:
As long as assumption of a lease appears to enhance a debtor's estate, court approval of a debtor-in-possession's decision to assume the lease should only be withheld if the debtor's judgment is clearly erroneous, too speculative or contrary to the provisions of the Bankruptcy Code.195
In Lubrizol Enters. v. Richmond Metal Finishers (In re Richmond Metal Finishers Inc.),196 the court held that bankruptcy court approval should be withheld only where the trustee's decision is "so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice."197 Because of such decisions, it is extremely difficult for a landlord to establish that assumption does not satisfy the business-judgment test.198
B. Assuming a Lease that Is in Default
If there has been a default in an unexpired lease, the debtor/tenant may not assume the lease unless, at the time of assumption, the debtor cures the existing defaults or, alternatively, provides...
To continue reading
Request your trial