Treatment of Unexpired Leases and Executory Contracts Under the Small Business Reorganization Act.

In this blog we talk about how leases and other executory contracts are handled in the SBRA reorganization process. First, some general principles. The law only applies to leases or executory contracts that are unexpired. If a tenant waits too long to get their bankruptcy case filed they could lose a number of valuable rights including:

1. Time needed to generate the funds needed to get current, assume the lease and stay in possession.
2. The right to ask for a deferral of the rent for 60 days.
3. The right to have any deferred rent in the first 60 days treated as an administrative expense and paid out over five years.
4. The right to sell a below-market lease to another party thereby generating cash.

Here’s how these rights and options can be lost if a case is filed too late: rent not paid. Landlord sends a notice of default and termination of the lease. If, under state law, the lease is so terminated prior to filing, the landlord is automatically entitled to their property back regardless of the bankruptcy filing because the lease has expired.

Landlord’s in leases and lessor’s under executory contracts basically receive preferential treatment under bankruptcy law. In other areas, bankruptcy law can significantly, even drastically, alter the nature and terms of the contract between the creditor and the client. That is not the case when it comes to leases. With limited exception, landlords lose few of their rights and the tenants legal obligations remain basically unchanged even when a bankruptcy case is filed. For example, on an equipment purchase, under the SBRA, the contract can be written down to the value of the equipment repaid at 6% interest and the amount owed can be paid over an extended period of time. With limited exception, if the tenant wants to stay in leased space, they must get caught up on all past due rent and provide assurance that they can pay the rent in the future or the landlord gets their property back. Such is the power of the commercial landlord lobby!

With the miscellaneous issues now out of the way, let’s look at the tenant’s choices.  As to unexpired leases or other executory contracts, the tenant or lessee has three basic options: first, cure-all past due financial obligations with the possible exception of rent due in the first 60 days after filing, and assume the lease. Second, the tenant or lessee can reject the lease. Third, if the lease has intrinsic value, the lease or other executory contract can be sold to a third party thereby generating funds that the client can use as part of their reorganization plan.

Typical leases would be space rent or vehicle leases. A typical executory contract would be a license agreement, a contract to purchase, a franchise agreement or cable, Internet or cell phone contracts.

In this  blog we cover the basics pertaining to leases and executory contracts. But what if there is past due rent owed? And what if that rent is owed because the client could not conduct business in generate the money to pay the rent due to a government shutdown order? These issues are discussed in another  blog. We would refer you to our building block in case study libraries for further information on this very important topic.

Let’s look at the first option, assumption of the lease. At the outset of the case, the tenant can ask the court to defer rent for 60 days and as part of that motion ask the court to have the rent that has been deferred for 60 days treated as an administrative expense and paid out over five years. Other than that, the tenant must file a motion asking the court for permission to formally assume the lease or other executory contract.  The motion must be heard and ruled on within 120 days of filing.  The court will grant same so long as:

1. the tenant has cured all past due rent obligations, with the exception of any rent deferred and allowed by the judge as an administrative expense, OR,
2. the tenant has convinced the judge that they can promptly cure all required past due rent payments AND,
3. the tenant has proven to the court’s satisfaction that the tenant has the ability to perform its obligations in the future.

If the tenant does not obtain court approval, the lease is by law deemed rejected.  Likewise, if the motion to to assume is not filed within the 120 days, the lease or other executory contract is deemed rejected. It is best to have the motion filed and heard within the 120 days just to be safe.

A second option is to reject the lease. That can be done as part of the initial filing in which case the tenant must vacate the premises shortly after filing. If the tenant waits to reject the lease and does not pay the rent, the rent owed would be considered an administrative priority claim. If the lease is rejected, the creditor would also have a damage claim that would be considered unsecured. In most reorganization cases, unsecured creditors receive little or nothing on their claim.

The third option would be to assume and assign the lease. This would become an issue where the tenant has a below-market lease. The lease can be assigned with or without landlord approval so long as certain conditions are met. First, the tenant would need to cure any default under the lease or curing the default is accomplished as part of the assignment. Second, the new tenant must provide adequate assurance of future performance of the lease obligations. Third, there are a series of special rules for the assumption and assignment of shopping center leases. First, the new tenant must have a financial condition and operating performance similar to that of the client tenant at the time of the original commencement of the lease. Second, the new tenant, the party to whom the client is selling their below-market lease, must provide assurance that any percentage rent due under the lease will not decline substantially. Third, the new tenant must provide assurance that the assumption or assignment of the lease will be subject to the requirements in the lease regarding radius, location, use, or exclusivity, and, finally, the assumption or assignment of the lease will not disrupt any tenant balance in the shopping center.

One important point to note pertains to the payment of rent post filing. The general rule is that once a case is filed, rent payments must restart immediately with the exception of any deferral order granted for rent due in the first 60 days.

Next, let’s look at how leases are handled in bankruptcy where the client is the landlord. In general, the landlord has the same three options, assume the lease, reject the lease or assume and assign the lease. The same deadlines apply. If the landlord client wants to assume the lease, they have 120 days to do so.

A landlord can also reject a lease. But if the landlord does reject the lease the tenant has certain rights as follows: If the lease has already commenced, the tenant may choose to retain its rights in the premises for the remainder of the lease term, including the right to remain in possession of the premises and continue to pay rent. Second, the tenant can treat the lease as terminated, vacate the property and assert a general unsecured rejection claim.

The landlord’s right to reject the lease under bankruptcy law may well collide with governmental orders that prevent or place a moratorium on evictions. The intersection of bankruptcy law with other areas of the law is somewhat common. And as one judge in San Diego recently noted to me, “bankruptcy law typically comes out at the top of the heap.”

Although somewhat limited, the SBRA does provide some planning opportunities with regard to leases and other executory contracts.

1. If it is a below market lease or the license agreement has value, the contract can be sold and monies generated. That money can be used as part of the reorganization process.
2. If past due rent is owed, filing the bankruptcy case would prevent the landlord from utilizing state law to terminate the lease thereby giving the client the right to assume the lease or assume an assign, so long as the conditions discussed earlier are met.
3. Filing also gives the client the option of asking the court to defer rent for up to 60 days and to have that deferred rent paid over five years thereby freeing up cash at the outset.
4. By filing the case, that creates the opportunity for the client to ask the court to forgive or abate the rent. And as to any rent found owed, seek a repayment plan. See our video on options for dealing with past due rent in our video blog library for more on this important subject.
5. Finally, filing the case would almost certainly give the client tenant negotiating room and leverage in working out a deal, leverage that almost certainly would not exist prior to filing where the landlord could and typically does immediately institute eviction proceedings.

To find out more about leases in bankruptcy specifically and the other powerful tools available under the SBRA to protect a business you enjoy and a way of life that you have worked hard to achieve, sign up to attend one of our webinars or call to schedule an appointment to discuss the particulars of your case. The initial consultation, up to one hour, is at no charge. The webinars are free, and include a 20 minute question and answer session at the end.  We would also refer you to the blog and video blog sections of our website for discussions on other topics and points of interest, including case studies where we apply the individual principles covered in these building block videos to real life fact patterns.