American Law Institute Continuing Legal Education (ALI CLE)

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3 American Law Institute Continuing Legal Education (ALI CLE) ALI CLE: The premier national provider of CLE A non-profit organization and the premier national provider of high-level CLE since 1947, American Law Institute Continuing Legal Education (ALI CLE) offers an array of programming featuring the country's most respected law practitioners. These experts provide insights, clarify relevant case law and legislation, and offer practical strategies to help lawyers serve their clients needs with superior counsel. ALI CLE's programs are available in various formats, with in-person conferences and both live and on-demand webcasts. In addition to its sophisticated programming, ALI CLE publishes four national periodicals - The Practical Lawyer, The Practical Tax Lawyer, The Practical Real Estate Lawyer, and the Estate Planning Course Materials Journal - and has cultivated a notable collection of forms upon which lawyers from across the country rely for their varied practices. ALI CLE also offers lawyers an opportunity to access its programming and materials in a cost-effective way via LawPass, a subscription-based platform designed to maximize efficiency and minimize expense. ALI CLE maintains an unparalleled commitment to promoting excellence in continuing legal education a dedicated mission that dates back to its founding. A history of the highest quality CLE since 1947 The American Law Institute (ALI), the parent of ALI CLE, is the leading independent organization in the United States producing scholarly work to clarify, modernize, and otherwise improve the law. Founded in 1923, ALI (made up of 4,000 lawyers, judges, and law professors of the highest qualifications) drafts, discusses, revises, and publishes Restatements of the Law, model statutes, and principles of law that are enormously influential in the courts and legislatures, as well as in legal scholarship and education. In 1947, the American Bar Association (ABA) and ALI formed the American Law Institute-American Bar Association Committee on Continuing Professional Education (ALI-ABA), the first national provider of continuing legal education, with the stated goal of bringing high quality post-admission education to the practicing bar. Over the next 65 years, ALI-ABA provided thousands of courses and publications, becoming renowned for its extensive programming in a wide range of practice areas. In 2012, by mutual agreement, the ABA and ALI chose to move forward separately in their CLE efforts, with the nationally recognized expert faculty and abundant intellectual content of ALI-ABA being absorbed into ALI CLE. Today, ALI CLE carries on the tradition of excellence envisioned in 1947, but with a new generation of CLE offerings and technology platforms designed to meet the practice needs of the 21 st century lawyer.

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5 THE AMERICAN LAW INSTITUTE Continuing Legal Education Commercial Leases Interrupted: What To Do When Bankruptcy Strikes July 16, 2018 Telephone Seminar/Audio Webcast PROGRAM FACULTY BIOGRAPHIES STUDY MATERIALS TABLE OF CONTENTS 1. Commercial Leases Interrupted: What To Do When Bankruptcy Strikes - Slides By Michael M. Parker 2. Commercial Leases Interrupted: What To Do When Bankruptcy Strikes - Outline By Michael M. Parker Page vii ix 1 13 v

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7 PROGRAM July 16, 2018 Program Schedule Eastern Central Mountain National Teleseminar/Webcast Pacific & Arizona Alaska Hawaii 1:00 p.m. 12:00 p.m. 11:00 a.m. 10:00 a.m. 9:00 a.m. 7:00 a.m. Adjournment 2:00 p.m. 1:00 p.m. 12:00 p.m. 11:00 a.m. 10:00 a.m. 8:00 a.m. The Bankruptcy Code offers protections to both commercial landlords and tenants but raises a number of complex legal questions. This 60-minute webcast examines key considerations for a commercial landlord when faced with a tenant s bankruptcy and discusses strategy related to a tenant s right to assume, reject or assign a lease. Join our expert panel as they take an in-depth look at the Bankruptcy Code provisions pertaining to commercial leases, how a commercial landlord can navigate the process, and maximize its recovery, and tenant s protections (including the automatic stay) embedded in the Bankruptcy Code. Topics include: Bankruptcy concepts Pre-bankruptcy planning Obligations before assumption or rejection Lease assumption or assignment Lease rejection Landlord claims Dealing with subtenants Program All times eastern 1:00 p.m. Commercial Leases Interrupted: What To Do When Bankruptcy Strikes 2:00 p.m. Adjournment Total 60-minute hours of instruction: 1.0; total 50-minute hours of instruction: 1.2 Level of Instruction: Intermediate Nothing in this program is legal advice. Neither American Law Institute Continuing Legal Education nor the speakers/authors can warrant that these presentations/materials will continue to be accurate, nor do they warrant them to be completely free of errors when delivered/published. These presentations/materials reflect the viewpoints of their speakers/authors and do not necessarily express the opinions of American Law Institute Continuing Legal Education or its sponsors. The members of the faculty and authors for this program and study materials are contributing their services to further the continuing legal education of their fellow members of the Bar. vii

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9 FACULTY BIOGRAPHIES Michael M. Parker Norton Rose Fulbright US LLP 300 Convent Street Suite 2100 San Antonio, TX For over 20 years Michael Parker has focused his practice on bankruptcy and insolvency-related litigation and workouts in a broad range of industries. He has considerable experience representing large and small buyers of distressed assets in bankruptcy court and federal district court. Michael's pre-law life as a civil engineer and project manager gives him a unique perspective on many industries, helps him to understand and relate to client control desires, and helps him quickly understand and address problems presented. Eric B. Terry Eric Terry Law, PLLC 3511 Broadway St. San Antonio, TX Before forming ET Law, Eric Terry accumulated a wealth of experience by acting as a briefing attorney for two well respected federal judges and practicing for over 16 years at one of America s largest law firms with one of the largest and most experienced business reorganization practice groups. Eric Terry has been recognized as a Super Lawyer in the area of bankruptcy and workouts by Texas Monthly from and as one of the Best Lawyers in America in Bankruptcy and Creditor Debtor Rights/Insolvency and Reorganization Law, , Litigation Bankruptcy, ix

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11 1 THE AMERICAN LAW INSTITUTE Continuing Legal Education Commercial Leases Interrupted: What To Do When Bankruptcy Strikes July 16, 2018 Telephone Seminar/Audio Webcast Commercial Leases Interrupted: What To Do When Bankruptcy Strikes - Slides By Michael M. Parker Norton Rose Fulbright US LLP San Antonio, Texas

12 2 Commercial Leases Interrupted: What To Do When Bankruptcy Strikes Michael Parker, Board Certified Business & Consumer Bankruptcy Law ( ) Eric Terry, Eric Terry Law, PLLC ( ) July 2018 ALI-CLE Commercial Real Estate Leases Webinar Roadmap Bankruptcy concepts Pre-bankruptcy planning for debtor-tenant Obligations before assumption or rejection Lease assumption or assignment Lease rejection Landlord claims Dealing with subtenants Landlord bankruptcy issues 2

13 3 Bankruptcy Concepts Bankruptcy world: Prepetition and postpetition Debtor s rights (expand in bankruptcy) Assumption Assumption and assignment Rejection Claim 3 Pre-bankruptcy Planning for Debtor-Tenant Security deposit or letter of credit Necessity and advantages Differences between the two Accumulating arrearages Termination of the lease Prepetition obligations v. Postpetition obligations 365(d)(3) and payment of property taxes 4

14 4 Obligations before Assumption or Rejection Debtor s right to assume, assume and assign or reject unexpired non-residential lease Purpose of expanded debtor rights Key limitations Lease unexpired, not terminated. 541(a)(1), (b)(2) Assumption of entire lease, as is (cum onere) Tenant must comply with current obligations. 365(d)(3) Pay postpetition rent Pay postpetition property taxes and CAM Stub rent and taxes open issue Time limit: days. 365(d)(4) 5 Obligations before Assumption or Rejection When must request for extension of the time limit occur? ( days - 365(d)(4)) Majority rule request within time period enough to preserve extension Variation on majority rule interim order extending time until hearing on the motion + filed within the 120 days. Minority rule request for extension of time must be heard and entered within the 120 days. Stub rent & expenses Majority rule paid as administrative expense at plan confirmation Minority rule paid timely on demand Variation No payment due on billing date, therefore nothing due 6

15 5 Obligations before Assumption or Rejection Superpriority administrative claim for debtor s failure to comply with 365(d)(3)? Majority rule must be paid at contract rate, but enforcement mechanism is lacking Consequence of non-payment is not a superpriority claim Landlord must be proactive to obtain payment (e.g. Craftsman) Not an administrative claim under 503(b), which means does not have to pass actual and necessary test Minority rule paid as superpriority claim, but may be subject to actual and necessary test Consequence of non-payment is superpriority administrative claim, but may be required to pass actual and necessary test so not necessarily entitled to contract rate 7 Lease Assumption Effect Tenant reaffirms the lease Treats lease as if bankruptcy didn t occur Timing Too early assume obligations, obtain landlord support Too late avoid obligations, landlord battles, more time Debtor obligations Legal standard applied Business judgment rule Cure Adequate assurance of future performance 8

16 6 Lease Assumption & Assignment Effect Tenant reaffirms then sells lease; new tenant, same lease Treats lease as if bankruptcy didn t occur Assignment relieves debtor of any post-assignment liability ( 365(k)(1)) Timing, debtor obligations, legal standard applied, and cure are the same Adequate assurance of future performance applies to buyer, not to debtor. Must show financial wherewithall to perform lease in future + provide substantially similar security deposit. 9 Lease Assumption & Assignment Shopping Center leases Radius, location, use and exclusivity non-monetary default provisions must be cured in Shopping Center leases Shopping Center landlord may use these non-monetary default provisions to box in a debtor, and make it very difficult to lease the space for a non-conforming use Impossible non-monetary default cures Tenant need not cure continuous operation, premises condition and other impossible cure non-monetary default conditions. 365(b)(1) 10

17 7 Lease Assumption & Assignment Non-monetary defaults In many courts, a debtor-tenant need not cure or abide by non-monetary restrictions on a tenant s use, location or exclusivity provisions. These courts view such restrictions as provisions subject to ipso facto provisions of the bankruptcy code that overrule lease language purporting to restrict the rights of a bankruptcy debtor merely because it is a bankruptcy debtor. The use, location and exclusivity provisions unnecessarily burden the debtor s ability to alienate its property to the detriment of the estate s creditors. 11 Lease Rejection Effect Before Assumption = breach of prepetition contract After Assumption = breach of postpetition contract Rejection Termination Timing of rejection Quickly to minimize expenses under 365(d)(3) But often still have equipment or inventory in leased premises, or need facility for GOB sale Nunc Pro Tunc (retroactive) Rejection. Allowed in 1st and 9th circuit under limited circumstances. 12

18 8 Lease Rejection Deemed rejection 364(d)(4) Assume or reject within 120 days (commercial leases) For good cause - assume or reject within additional 90 day extension and the trustee shall immediately surrender Ride through leases Minority case law created rule that allows a commercial lease neither assumed nor rejected to be effectively assumed when the debtor continues to receive the benefits under the lease, debtor will continue to burdened with lease obligations. In re Texaco, Inc. 254 B.R. 536 (Bankr. S.D.N.Y. 2000) 13 Designation Rights Designation rights A trustee s right to designate (direct a debtor) whether a property will be assumed and assigned or rejected. Common before 2005 BAPCPA Now rare because of time limit on assumption. In large retail cases debtors would sell designation rights to a third party who would begin a years long let s make a deal dance with landlords, while simultaneously trying to market the leases. No time for that now. 14

19 9 Landlord Claims Rejection claims capped 502(b)(6) & state law 502(b)(6) Cap 1 years worth of rent or 15% of total rent due, so long as 15% is less than 3 years worth of rent (only applies when long balance on remaining lease term) State Law Cap mitigation of damages Obligation to seek replacement tenant? yes Obligation to sell facility rather than re-lease? open question Postpetition claims for administrative rent Do not count against capped rejection claim Assumption before subsequent rejection claims obtain administrative priority 15 Landlord Claims Calculating the claim Is mitigation required? Did landlord mitigate its damages? Do mitigated damages moot the breach of contract/rejection damages? Calculate one year of rent Escalation of rent? average year? Front end loaded? Back end loaded? Calculate 15% of remaining rent Escalation of rent? average year? Front end loaded? Back end loaded? 15% of time remaining v. 15% of amount 16

20 10 Dealing with Subtenants Rejection = Termination Some courts have suggested the general rule is that rejection operates as a termination of all subservient estates (i.e. subleases and sub-sub leases). In re Park, 275 B.R. 253 (Bankr. E.D. Va. 2002) This argument depends on the 365(d)(4) requirement that upon deemed rejection, the estate be immediately turned over This argument ignores 365(h)(1), providing rights to subtenants upon rejection Rejection Termination in Fifth Circuit Only terminates DEBTOR S rights in the lease 17 Dealing with Subtenants Sublessee may remain in possession (notwithstanding rejection of the lease) from the balance of the remaining lease term to the extent permitted under applicable law. Sublessee may offset the value of any damage caused by a rejection against its rent obligations. Landlord is not held to conditions of sublease, and landlord is not required to perform under the sublease except to the extent landlord provides possession to sublessee. 18

21 Thank you for listening 11

22 12 Disclaimer Norton Rose Fulbright US LLP, Norton Rose Fulbright LLP, Norton Rose Fulbright Australia, Norton Rose Fulbright Canada LLP and Norton Rose Fulbright South Africa Inc are separate legal entities and all of them are members of Norton Rose Fulbright Verein, a Swiss verein. Norton Rose Fulbright Verein helps coordinate the activities of the members but does not itself provide legal services to clients. References to Norton Rose Fulbright, the law firm and legal practice are to one or more of the Norton Rose Fulbright members or to one of their respective affiliates (together Norton Rose Fulbright entity/entities ). No individual who is a member, partner, shareholder, director, employee or consultant of, in or to any Norton Rose Fulbright entity (whether or not such individual is described as a partner ) accepts or assumes responsibility, or has any liability, to any person in respect of this communication. Any reference to a partner or director is to a member, employee or consultant with equivalent standing and qualifications of the relevant Norton Rose Fulbright entity. The purpose of this communication is to provide general information of a legal nature. It does not contain a full analysis of the law nor does it constitute an opinion of any Norton Rose Fulbright entity on the points of law discussed. You must take specific legal advice on any particular matter which concerns you. If you require any advice or further information, please speak to your usual contact at Norton Rose Fulbright.

23 13 THE AMERICAN LAW INSTITUTE Continuing Legal Education Commercial Leases Interrupted: What To Do When Bankruptcy Strikes July 16, 2018 Telephone Seminar/Audio Webcast Commercial Leases Interrupted: What To Do When Bankruptcy Strikes - Outline By Michael M. Parker Norton Rose Fulbright US LLP San Antonio, Texas

24 14 A. Introduction I. BANKRUPTCY ISSUES FOR COMMERCIAL LANDLORDS This brief outline discusses basic bankruptcy issues encountered by commercial landlords on a regular basis. The outline is not comprehensive. Immediately below is a roadmap providing a brief synopsis of each issue to be covered by this outline. After the roadmap, a brief analysis of each of the important bankruptcy issues appears. The outline concludes by asking for questions. B. Roadmap 1. Bankruptcy Concepts. Basic bankruptcy concepts necessary to understand the presentation are defined and explained. 2. Pre-bankruptcy Planning. Key planning considerations before a tenant files bankruptcy are discussed. 3. Obligations Before Assumption or Rejection. This section reviews a tenant s postpetition, pre-decision (assume or reject) obligations. 4. Lease Assumption or Assignment. This section analyzes the assumption or assumption and assignment decision and its consequences. 5. Lease Rejection. This section examines the lease rejection decision and its consequences. 6. Landlord Claims. Key elements of a landlord s damage claim are considered and discussed in this section. 7. Dealing with Subtenants. Considerations for a landlord dealing with a debtor s subtenants are discussed. 8. Questions. This section is merely a reminder to ask your presenters questions. C. Bankruptcy Concepts 1. Bankruptcy World. Bankruptcy practitioners live in a different world, bifurcated (usually) by the filing of a voluntary bankruptcy petition. The debtor s arrearages and obligations BEFORE the bankruptcy filing are considered prepetition arrearages and obligations that can re-arranged in the bankruptcy proceeding (often by only re-paying a portion of the prepetition monetary obligations back)

25 15 Postpetition obligations owed to a commercial landlord (and others), however, must be timely paid under 365(d)(3). The bright dividing line between these two worlds (the petition date) is, however, critical to the bankruptcy. Accordingly, advice as to what to do in a bankruptcy case, will commonly refer to events as prepetition or postpetition. 2. Debtor s Rights. A bankruptcy filing expands a debtor s rights. One important, expanded right, is the right to assume, assume and assign or reject a commercial lease. Thus while a counterparty to a executory contract or lease continues to be bound by such instrument, a debtor is given the opportunity to breach such executory contract or lease, and such breach although occurring in a postpetition world will be treated as a prepetition obligation, which will generate a claim against the bankruptcy estate by the landlord (but not a postpetition obligation). 3. Assumption. With one important exception, before a debtor can be compelled to perform a lease or other executory contract in bankruptcy, a debtor must, with court permission, assume such lease or executory contract. Assumption obligates a debtor to perform. Assumption also obligates a debtor to cure all monetary defaults in the lease. Finally, a debtor seeking to assume a lease must provide the landlord adequate assurance of its ability to perform under the lease in the future. The important exception is 365(d)(3), which provides that a tenant must perform all obligations under a lease. Section 365(d)(3) has been interpreted to require a debtor to continue performing a lease postpetition. 4. Assignment. If a lease is under market, and thereby valuable to the debtor, but does not fit within a debtor s business plan, a debtor may still seek to obtain the benefit of the value by selling the lease to another, who might benefit from such lease. To sell a lease, a debtor must assume it (from the bankruptcy estate) and then assign it (to the buyer). The buyer then becomes responsible for providing the landlord adequate assurance of its ability to perform under the lease in the future. 5. Rejection. A bankruptcy debtor, with court permission, is permitted to reject a lease rather than assume it. A rejection of a lease is treated like a breach of contract that occurred just before the bankruptcy was filed (so that the debtor can pay the landlord reduced bankruptcy dollars on its claim, as opposed to real, postpetition dollars)

26 16 D. Pre Bankruptcy Planning 1. Security Deposit or Letter of Credit a. Security deposits or a letter of credit are often collected from a tenant to assure tenant performance. They also serve to protect a landlord from other issues that arise in bankruptcy. Security deposits collected over time (rather than at the time of lease execution) can present problems for a landlord in a tenant bankruptcy. b. Defenses to 547 (preference) & 548 (fraudulent conveyance) actions. Security deposits and letters of credit held as security deposits, if sufficient in amount (at least one month s rent), typically provide an unassailable defense to preference and fraudulent transfer claims. The exception to this rule is when a landlord holds only a partial security deposit, because the deposit is being paid over time. A security deposit of an inadequate amount or recently transferred to the landlord, would limit protection and might constitute a preference or fraudulent conveyance. c. A letter of credit is NOT capped by 502(b)(6) if no claim is filed. While the independence principle governing letters of credit might allow a landlord to recover from its letter of credit the full amount of rejection damages, to avoid the cap of 502(b)(6), the landlord must NOT file a proof of claim with the bankruptcy court or otherwise assert a claim. All other rejection damages claims asserted by a landlord will be capped by 502(b)(6). 2. Accumulating Arrearages a. A debtor s accumulation of arrearages signals a possible bankruptcy filing and rejection of lease. A debtor is typically advised to accumulate cash before filing a bankruptcy petition. Cash is necessary to survive the bankruptcy. Rent is often one of a debtor s greatest expenses. Therefore, the sudden failure of a tenant to pay timely rent payments is often a precursor to a bankruptcy filing and sometimes a hint that a debtor intends to reject a lease in bankruptcy. 3. Termination of Lease a. Governed by state law (1) Lease = property rights + contract rights. Termination of a lease is governed by state law, which varies. In general, a lease provides both property rights and contract rights to a debtor. Breach of a lease gives a landlord a right to pursue contract damages, but does not automatically allow a landlord to recover possession of lease property

27 17 (2) In theory, a debtor loses all of its property rights in real property after a true foreclosure sale because a true foreclosure sale cuts off or forecloses a debtor s equity of redemption, meaning the debtor has lost all of its rights in the property foreclosed upon. (3) Some state laws don t cut off all of a debtor s rights at the foreclosure sale. (4) Whatever rights a debtor has at filing of a bankruptcy petition, the debtor can enforce in the bankruptcy case. As long as the debtor has some rights in the property foreclosed upon, the debtor can seek to exercise those rights in a subsequent bankruptcy proceeding. The bankruptcy code liberally allows a debtor to cure past defaults. b. Right of Redemption. This can be tricky and varies by state, but as long as a debtor s right of redemption has not been extinguished, the debtor retains a right to revive a lease. c. Payment Grace Periods. Grace periods in a lease can provide a debtor an opportunity for mischief. Grace periods suggest that whatever punishment might apply to given default, the debtor is given another specific period of time to cure such default and hold onto sole possession of the leased premises. d. SuperNova 330 LLC v. Gazes (In re Association of Graphic Communications), Adv. Proc. No (2 nd Cir. Aug. 2, 2012) (where a tenant has the power to revive a lease under applicable state law because of an unexecuted warrant of eviction), that lease is unexpired for purposes of section 365(d)). 4. Prepetition Obligations v. Postpetition Obligations Under 365(d)(3) a. A recurring and unsettled issue concerns the timing of debtor s obligations under 365(d)(3), which requires that a debtor/tenant continue to comply with its obligations (rent, tax escrows, CAM charges, etc), particularly its payment obligations, notwithstanding the bankruptcy filing. The bankruptcy code requires continued performance of those obligations, but provides no explicit remedy for a debtor s failure to comply. Some courts remedy the problem by giving the landlord an administrative claim without a payment, which is not an effective remedy in an administratively insolvent estate, and does not encourage a debtor to comply. Some courts give the landlord a superpriority administrative claim, which the debtor will argue has no statutory basis and is unfair to other creditors. Other remedies include conversion or dismissal of a case, or granting of a superpriority claim, which may encourage appropriate behavior

28 18 b. An excellent example of the problem arises in the payment of property taxes. Section 365(d)(3) creates an opportunity for a debtor to game the system by timing a bankruptcy filing to AVOID having to pay property taxes. By timing a bankruptcy filing after property tax obligations of the landlord arise, but before a tenant is obligated to reimburse a landlord for such tax payments, a tenant can avoid (through rejection) or restructure those obligations. To avoid this problem, a landlord should always require in the lease that a debtor pay tax escrows in advance. Otherwise, a debtor will time the filing of the bankruptcy to occur after the property tax obligation is incurred, but before tenant has to reimburse. E. Obligations Before Assumption or Rejection 1. Under the bankruptcy code, at bankruptcy filing, an estate is created into which all of the debtor s assets are transferred, including debtor s leases. The debtor-inpossession ( DIP ) is then given the right to keep (assume), give away (reject), or keep and sell (assume and assign) all of its leases and executory contracts. A DIP controls the estate. 2. Allowing a debtor-in-possession to assume or reject leases and executory contracts relieves the bankruptcy estate of burdensome obligations, while providing a means whereby the debtor-in-possession can compel others to continue to do business with the debtor-in-possession, at a time when others might be reluctant to do so. In re Chateaugay Corp., 10 F.3d 944 (2nd Cir. 1993). 3. Key limitations on the assumption, assignment or rejection decision for commercial leases. a. Lease must not have expired or terminated prepetition. A debtor cannot revive a lease that has expired by its own terms, or has terminated before the bankruptcy is filed. The lease is property of the estate but the bankruptcy debtor-in-possession steps in to the shoes of the prepetition debtor, and gets no more rights than the debtor had. b. Lease must be assumed in whole ( cum onere ). A tenant cannot assume the parts of the lease a tenant likes and reject the parts it dislikes. c. Time Limit to Make Assumption/Rejection Decision. Per 365(d)(4) a debtor has 120 days to decide to assume or reject a non-residential, real property lease, plus may request an additional 90 days for cause, upon motion filed before the expiration of the 120 day period. (1) Majority Rule an extension request and hearing must occur within 120 day time period to preserve the extension. (2) Variation on Majority Rule within the 120 days court enters interim order extending time to assume or reject until hearing on the motion to extend

29 19 (3) Minority Rule a request for extension of time must be heard and an order entered within the 120 days. d. Tenant (DIP) must comply with all terms of lease (with certain exceptions) under 365(d)(3). (1) Tenant (DIP) must pay rent going forward. (a) Tenant (DIP) not required to pay rent arrears (taken care of by plan, if lease assumed). (2) Tenant (DIP) must pay escrow for property taxes, CAM after the bankruptcy filing. (a) Tenant (DIP) not required to timely pay escrow arrears (taken care of by plan, if lease assumed). (3) Tenant s (DIP s) non-performance under the lease may constitute grounds to lift the stay (and terminate the lease) but more likely will trigger a motion to compel a debtor s compliance. 365(d)(3). e. Superpriority Administrative Claim for Tenant s (DIP) Failure to Comply? (1) Majority rule rent must be paid at contract rate, but payment enforcement mechanism is lacking. (a) (b) (c) Consequence of non-payment is not superpriority claim. Landlord must be proactive to obtain payment (e.g. Craftsman). Obligation is not an administrative claim under 503(b), which means it does not have to pass actual and necessary test, but is treated to the same priority as administrative claim. (2) Minority Rule rent is paid as superpriority claim, but may be subject to actual and necessary test. (a) Consequence of non-payment is superpriority administrative claim, but may be required to pass actual and necessary test so not necessarily entitled to contract rate. f. Stub Rent & Expenses (1) Partial rent for period after petition date, but before next rent due date

30 20 F. Lease Assumption (2) Majority Rule paid as administrative expense at plan confirmation. (3) Minority Rule paid timely on demand. (4) Variation No payment due on billing date, therefore nothing due. 1. Effect. New tenant agrees to comply with all of the terms of the lease going forward. Defaults are cured and the lease is treated like bankruptcy had no effect on it. New tenant in same lease. 2. Timing. Timing of assumption is critical (given unknowns in the case) but must be assumed no later than the earlier of days or plan confirmation. a. Too early. Assumption too early may saddle a debtor with additional obligations it can t handle moving forward and my limit a debtor s flexibility in restructuring its obligations in a plan. b. Too late. Assumption too late may cause a landlord to take actions in a case, which such landlord would not otherwise take (moving to compel compliance). In short, assumption of a lease often makes the landlord the debtor s ally. Before assumption, landlord is debtor s opponent. 3. Debtor Obligations. The debtor-tenant is equally obligated after the bankruptcy filing to fulfill all of its duties under the lease this includes payment of property taxes and CAM charges. 4. Standard. The standard for court to determine if assumption is appropriate is the Business Judgment Rule. The Business Judgment Rule says that a court should generally defer to a debtor-in-possession s judgment if it s in the best interest of the business. This means it is rare that a debtor-in-possession is ever denied the ability to assume or assume and assign a commercial lease. 5. Cure. To assume, or assume and assign, a lease, the debtor-tenant must cure all monetary defaults under the lease. Accordingly, landlord concerns about nonpayment should be more acute when the lease in question is over market, and likely to be rejected, as opposed to when a lease is under market and valuable. 6. Adequate Assurance of Future Performance. Debtor must establish its ability to adequately perform under the lease in the future + plus provide landlord a substantially similar security deposit. 7. Assignment

31 21 a. Assumption prerequisite. Debtor-tenant must be able to assume a lease before it can assign a lease, so all of the assumption requirements previously discussed apply to an assumption and assignment. b. An assignment decision depends upon tenant s (i) need for the lease and (ii) lease s market value. c. Debtor-Tenant will try to hide its need for the facility to maximize its leverage. No need implies the debtor might reject the lease or sell the lease to another (if the lease is undermarket). d. The debtor may assign (sell) a lease notwithstanding ipso facto clauses (clauses prohibiting assignment upon bankruptcy filing). This means that if lease is below market then a lease has some value to tenant, even if tenant no longer needs to continue its use of the lease. e. Key: A debtor-tenant s ability to sell a lease allows a debtor-tenant that might not otherwise be able to benefit from an undermarket leasehold estate, to sell that interest and benefit from the equity, if any, built up in the leasehold estate. f. Adequate Assurance of Future Performance. Debtor-tenant must establish its buyer has the means to adequately perform under the lease in the future. An equivalent security deposit is one element of that adequate assurance. 8. Key Exceptions a. Shopping Center Leases (1) Radius, location, use, exclusivity non-monetary default provisions must be cured in Shopping Center lease cases. By implication, it is less clear if these defaults must be cured in other contexts. (2) A Shopping Center landlord may use these non-monetary default provisions to box in a debtor-tenant, and make it very difficult to lease the space for a non-conforming use. b. Impossible Non-Monetary Default Cures (1) A debtor-tenant need not cure continuous operation, premises condition and other impossible cure non-monetary default conditions. 365(b)(1)

32 22 G. Lease Rejection 1. Effect (2) In many courts, a debtor-tenant need not cure or abide by nonmonetary restrictions on a tenant s use, location or exclusivity provisions. These courts view such restrictions as provisions subject to ipso facto provisions of the bankruptcy code that overrule lease language purporting to restrict the rights of a bankruptcy debtor merely because it is a bankruptcy debtor. The use, location and exclusivity provisions unnecessarily burden the debtor s ability to alienate its property to the detriment of the estate s creditors. a. Rejection before assumption of the lease. A lease rejection is treated as a breach of contract that occurred the day before a bankruptcy filing, such that breach of contract damages are paid in prepetition dollars. 365(g)(1) (most common). b. Rejection after assumption of the lease. (i.e. debtor-tenant first assumes and then rejects lease - changed its mind). Rejection is treated as a breach of contract at the time of the rejection, such that breach of contract damage claims are entitled to administrative priority in the bankruptcy proceeding. 365(g)(2)(A). c. Assumption before conversion, subsequent rejection. Treats breach as if it occurred the day before the conversion. d. Assumption after conversion, subsequent rejection. Treats breach as if it occurred the day it occurs. 2. Rejection Termination a. In the Fifth Circuit and other courts, a breach of a lease does not effect a termination of the lease. In other words, rejection of a lease by a debtortenant does not extinguish the lease or liens in the lease. Eastover Bank for Savings v. Austin Development Co. (In re Austin Development Co.), 19 F.3d 1077 (5 th Cir. 1994). b. One bankruptcy court (In re Jermaine Johnson and Christie LaFaye Johnson, Case No (Bankr. S.D.Fl. Nov. 17, 2011) has held that, even though a residential real property lease had been deemed rejected under section 365(d)(1) of the bankruptcy code as a result of the chapter 7 trustee s failure to timely assume the lease, the lease remained in effect after the debtor s no-asset chapter 7 case was closed. As a result, the individual debtor tenants remained liable to their landlord for unpaid rent incurred after the deemed rejection

33 23 3. Timing a. If debtor-tenant knows in advance that tenant will be rejecting the lease in bankruptcy, then it behooves the tenant to reject as soon as possible after filing bankruptcy petition. b. But often a tenant is not ready. (1) Prepared to move out at filing? (2) Need some time to conduct GOB sale? (3) Need some time to remove equipment? (4) Need some time market the property to others? c. Nunc Pro Tunc (Retroactive) Rejection. (1) Timing of the breach effects the PRIORITY and amount of the claim that the landlord can assert. (2) Many debtor-tenants attempt to hold onto leasehold estates without paying rent (so that they can liquidate assets, remove equipment, conduct GOB sales) and then turn around and file a motion requesting that a bankruptcy court reject a lease nunc pro tunc. Such a rejection treats the lease as having been rejected as of a prior date in history even though the debtor got the benefit of the additional possession of the leasehold estate. (a) (b) Therefore, it is important for a landlord to diligently pursue payment of rent postpetition. It is generally important to move to compel a tenant to quickly decide to assume or reject, to impress on the court that the landlord has other revenue generating uses for the property that the debtor-tenant is indirectly prohibiting. (3) Courts allow retroactive rejection under the right factual circumstances. In re At Home Corp., 392 F.3d 1064 (9 th Cir. 2004); In re Thinking Machines, 67 F.3d 1021, 1028 (1 st Cir. 1995). 4. Deemed Rejection 364(d)(4) a. Assume or reject within 120 days (commercial leases) b. Assume or reject within 90 day extension

34 24 c. The statutory language: and the trustee shall immediately surrender is often overlooked or downplayed by courts. 5. Ride Through Leases a. Minority case law created rule that allows a commercial lease neither assumed nor rejected to be effectively assumed. When a debtor-tenant continues to receive the benefits under the lease, debtor will continue to be burdened with lease obligations. In re Texaco, Inc. 254 B.R. 536 (Bankr. S.D.N.Y. 2000). 6. Designation Rights a trustee s right to designate (direct a debtor) whether a property will be assumed and assigned or rejected. H. Landlord Claims a. Common before 2005 BAPCPA. b. Now rare because of day time limit on assumption. c. In large retail cases debtors would sell designation rights to a third party who would begin a years long let s make a deal dance with landlords, while simultaneously trying to market the leases. No time for that now. 1. Three Claim Types a. Rejection Claims (for breach of the lease) b. Prepetition Arrearages (rent, tax & insurance escrows) c. Postpetition Rent 2. Rejection Claim a. Treated like prepetition arrearage claims even though rejection occurs postpetition b. Rejection claims are capped (1) 502(b)(6) Cap. The cap on damages found in 502(b)(6) prevents a lessor who files a claim against the estate from reaping an unfair share of the bankruptcy estate over the remaining pool of unsecured creditors. In re Stonebridge Technologies, 430 F.3d 260, (5 th Cir. 2005). (2) Mitigation of Damages Cap. Most state laws (not all) require a landlord to mitigate its damages. State law determines the amount of a landlord claim even though bankruptcy law may cap that amount. Accordingly, a landlord who immediately re-leases a

35 25 c. Calculating the claim facility in which a debtor has rejected a lease for the same or better rental rate will not have any rejection damages other than the costs associated with re-letting the facility. (1) Rent Reserved : Landlords seek to expansively define Rent Reserved in lease terms but rent reserved is subject to cap. (2) Is mitigation required? (a) Did landlord mitigate its damages? (b) Do mitigated damages moot the breach of contract/rejection damages? d. Calculate one year of rent (including estimated tax escrows) (1) Escalation of rent? average year? Front-end loaded? Back-end loaded? (2) 15% of time remaining v. 15% of amount e. Calculate 15% of remaining rent (1) Escalation of rent? average year? Front-end loaded? Back-end loaded? (2) 15% of time remaining v. 15% of amount f. Compare 1 year with 15%, use greater amount g. Add Arrearages (including tax escrow arrearages) h. Determine effect of collateral/letter of credit i. Treat like a secured claim/don t violate the stay of 362(a) 3. Prepetition Arrearage Claim a. Added to rejection claim damages b. Arrearage claim NOT part of capped claim (i.e. not part of capped amount) c. Security deposit can be used to first satisfy arrearage claim

36 26 4. Postpetition Claims for Administrative Rent a. Superpriority? (1) Majority: treated like an administrative claim (2) Minority: treated like a superpriority administrative claim b. 365(d)(3) Claim v. 503(b) Administrative Claim (1) Majority: 365(d)(3) claim paid like a 503(b) claim, but no actual and necessary test required. Contract rate applies. (2) Minority: 503(b) claim authorized by 365(d)(3) must pass actual and necessary test which means contract rate might not be applicable. c. Problem: enforcement mechanism is lacking. Landlord must be proactive to obtain payment (e.g. Craftsman) In re Goody s Family Clothing, Inc., 443 B.R. 5, (Bankr. D. Del. 2010) (the debtor must be engaged in the use and occupancy of the premises in order to grant an administrative expense to a landlord). In re: Ace Mortgage Funding, LLC, Case No (Bankr. D. Del. 2011)(J. Sontchi)(no claim for administrative rent where landlord took possession and control of the leased premises immediately after the petition date and only provided limited access to the trustee, even though the trustee did not move to reject the lease.) 5. Assumption Then Rejection Claims Obtain Administrative Priority This rarely happens, but on occasion a debtor s circumstances change after they have assumed a lease. The changed circumstances convince a debtor to reject a lease it already assumed. The majority rule in such cases appears to be that the landlord s damages are treated like non-avoidable administrative expenses of the bankruptcy estate given that the breach/rejection occurred after court approved assumption of the lease. I. Dealing with Subtenants 1. Rejection = Termination a. Some courts have suggested general rule is that rejection operates as a termination of all subservient estates (i.e. subleases and sub-subleases). In re Park, 275 B.R. 253 (Bankr. E.D. Va. 2002) b. Argument depends on 365(d)(4) requirement that upon deemed rejection, estate be immediately turned over

37 27 c. Argument ignores 365(h)(1), providing rights to subtenants upon rejection 2. Rejection Termination in Fifth Circuit a. Only terminates debtor s rights in the lease b. Sublessee may remain in possession (notwithstanding rejection of the lease) from the balance of the remaining lease term to the extent permitted under applicable law. c. Sublessee may offset the value of any damage caused by a rejection against its rent obligations. d. Landlord is not held to conditions of sublease, and landlord is not required to perform under the sublease except to the extent landlord provides possession to sublessee. e. In re Amicus Wind Down Corporation, Case No (D. Del. Feb. 24, 2012)(Friendly Ice Cream Corporation) (J. Gross)(Debtor cannot reject lease (and sublease) when subtenant has not yet surrendered possession; under both the Code and a lease rejection procedures order, debtor-tenant was required to provide landlord with possession of the premises (not just tenant s right of possession encumbered by the sublease) and debtortenant was in best position to evict subtenant). 3. Section 365(h)(1)(A)(ii) of the Bankruptcy Code provides that, in the event that a debtor rejects a sublease, the subtenant may nonetheless retain its rights under such lease. Although rejection of a lease frees the debtor from its performance obligations, a debtor s tenant (or, as in this case, subtenant) is permitted to continue to use and possess the property in accordance with the payment and payment timing terms set forth in the lease or sublease. The Amicus court held that because, under New York law, there is no privity of contract between an over-landlord and a sublessee, the over-landlord could face significant cost and legal challenges in attempting to evict the subtenant. The over-landlord s difficulties would likely be significantly heightened in light of the subtenant s chapter 7 case. Accordingly, the bankruptcy court held that the debtors were best situated to bear the burden of evicting the subtenant. J. Questions?

38 2

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