A Debtor/Tenant Seeks to Assume Or Assign a Commercial Lease

FOUR ISSUES TO WATCH

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GETTING THE LANDLORD PAID

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A DEBTOR/TENANT SEEKS TO ASSUME OR ASSIGN A COMMERCIAL LEASE

Kenneth L. Samuelson

Deckelbaum Ogens & Raftery

Washington, D.C.

January 10, 2008

Introduction: The Context in which the Following Assumption and Assignment Issues Arise

The following materials addresscertain issues that may arise in a bankruptcy proceeding of a tenant/debtor who elects to assume and assign its commercial real estate lease. In general terms, the legal context for those issues is (all references to Sections and Subsections herein, except where otherwise noted, are to 11 U.S.C.):

1.Unlike a sale of property, abankrupt tenant’s occupancy of the premises, or the continued existence of a lease,continues a relationship that may have a substantial impact on the financeability and synergies of the shopping center or office complex.The landlord and the tenant may negotiate amendments to the lease subject to Court approval.

2.For the period from the date the tenant files the bankruptcy petition until the date the tenant assumes or rejects the lease (a) the tenant must timely perform all of its obligations under the lease (except the ipso facto ones), and (b) the landlord’s claims therefor have priority over general unsecured creditors. Subsection 365(d)(3).

3.If the lease is in default at the time the tenant files its bankruptcy petition, then, as more fully discussed in part below, the tenant cannot assume the leaseunless, subject to certain exceptions, the tenant:

(A) cures, or provides adequate assurance that the trustee will promptly cure, such default; . . .

(B) compensates, or provides adequate assurance that the trustee will promptly compensate [the landlord] . . . for any actual pecuniary loss to [the landlord] . . . resulting from such default; and

(C) provides adequate assurance of future performance under such contract or lease.

Subsection 365(b)(1).

4.Once the tenant assumes the lease, the amounts thereafter due thereunder are subject to priority as, or in a manner similar to, administrative expenses.

5.If the tenant assumes, and later rejects, the lease, the landlord is entitled to priority, as an administrative expense, of the following until the bankruptcy estate is closed:

(7) with respect to a nonresidential real property lease previously assumed under section 365, and subsequently rejected, a sum equal to all monetary obligations due, excluding those arising from or relating to a failure to operate or a penalty provision, for the period of 2 years following the later of the rejection date or the date of actual turnover of the premises, without reduction or setoff for any reason whatsoever except for sums actually received or to be received from an entity other than the debtor, and the claim for remaining sums due for the balance of the term of the lease shall be a claim under section 502(b)(6);

Subsection 503(b)(7).

6.If the tenant initially rejects the lease, that rejection is treated as a breach, for which the landlord has only an unsecured, non-priorityclaim for damages. Furthermore, that claim is limited to:

(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease, following the earlier of--
(i) the date of the filing of the petition; and
(ii) the date on which such lessor repossessed or the lessee surrendered, the leased property; plus
(B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates;

Subsection 502(b)(6). Furthermore, the tenant may try to limit the landlord’s claim even more by seeking to have its rejection retroactive to the later of (a) the date the tenant vacated the premises, or (b) the date the tenant filed the bankruptcy petition. Lastly, although there is a split of authority, the better-reasoned cases hold that (a) if a lease is rejected, the foregoing cap on the landlord’s damages applies to only the landlord’s claims to rent and other damages caused by the rejection itself; and, thus (b) that cap does not apply to the landlord’s claims for failures to repair or restore, and other such non-monetary breaches that would exist by act or omission of the tenant separate from the tenant’s rejection or acceptance of the lease. In re El Toro Materials Company, Inc., 2007 U.S. App. LEXIS 22991, Bankr. L. Rep (CCH) P81,021, 48 Bankr. Ct. Dec. 255 (2007).Even those surviving claims not subject to the cap, however, would be only unsecured non-priority claims.

Of course, several business considerationswill influence the landlord’s inclination to encourage the tenant to accept or reject the lease and when to do so. Such considerations include: (a) whether the lease is below market (given that, regardless of the language of the lease, the landlord is unlikely to get any profits from the assignment, but could wind up stuck with the remaining term of a below market lease); (b) whether the assumption will result in the tenant’s curing prior defaults, the monies for which would otherwise not be available for unsecured non-priority creditors; (c) whether, after the assumption, the tenant is likely to remain a credit or default risk, including whether the tenant is likely to windup rejecting the lease after assuming it; (d) to what extent the tenant will be a draw or a hindrance to the shopping center or office complex; (e) whether the landlord can find better, or even suitable, replacement tenants who would be interested in leasing the premises, how long that process would take, and how much it would cost the landlord in funds not reimbursable from the bankruptcy estate; and (f) other business relations, if any, the landlord has or may have with the tenant or its principals.

The applicable changes wrought by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), to the following provisions, are noted below.

1.NEW DEADLINE FOR THE TENANT TO ACCEPT OR REJECT A COMMERCIAL LEASE

Subsection 365(d)(4) provides:

(4) (A) 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

(ii) the date of the entry of an order confirming a plan.

(B) (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.

The days of the tenant’s getting endless extensions to assume or reject commercial leasesappear to be over. BAPCPA re-wrote this entire Subsection. Under BAPCPA, the Bankruptcy Court may grant only one extension without the landlord’s consent and it must be granted, if at all, within the deadline specified above.

Federal Rule Bankruptcy P. 9006, which allows the Court to extend deadlines on account of “excusable neglect,” (a) applies only deadlines to set by the Bankruptcy Rules, not to deadlines set by statute; and (b) usually does not excuse “inadvertence, ignorance of the rules, or mistakes construing the rules.” In re: Tubular Technologies, LLC, 348 B.R. 699, 2006 Bankr. LEXIS 1653 (2006), the foregoing being a quote fromIn reRoasters Corp., 2000 Bankr. LEXIS 1916, 2000 WL33673776, which in turn was citing and quotingPioneer Investment Services Co. v. Brunswick Associates Ltd. Partnership, 507 U.S. 380, 113 S.Ct. 1489, 123 L.Ed.2d 74 (1993) (“Tubular 2”). See also In re Tubular Technologies, LLC, 362 B.R. 243, 2006 Bankr. LEXIS 1282, 46 Bankr. Ct. Dec. 215 (2006). Furthermore, the general equity powers of the Court underSubsection 105(a) cannot be used to extend a statutory deadline or otherwise go beyond the confines of the statute. Tubular 2, id. See also In re Tubular Technologies, LLC, 372 B.R. 820, 2007 Bankr. LEXIS 2633, 48 Bankr. Ct.Dec. 204 (2007) (attorney’s possible malpractice, in this case, for not acting timely). and Bowles v. Russell, 127 S. Ct. 2360 (2007) (courts have no power to extend deadlines set by statute).

The foregoing requires the tenant: (a) to file a motion for the 90-day extension, usually with a motion for a expedited hearing date therefor, in time to allow for the normal time for responses to motions [20 days under Fed.R.Bankr.P. 2002(a)(2)] in case the Court does not grant the motion to expedite; and (b) to get the hearing scheduled in time for the Court to hear argument, and to render its decision, on the motion to extend, within the Subsection 365(d)(4)(A) deadline. The tenant may be excused, however, if the delay is for reasons beyond the tenant’s control, such as a failure by the Court to render its decision despite the tenant’s diligent efforts to remind it to do so. Tubular 2, id at 348 B.R. at 710.

2.METHODS OF CHOOSING AN ASSIGNEE

A.Holding an Auction, Usually with a Stalking Horse Bid

Usually, to sell a debtor/tenant as a going concern or to sell its assets, the bankruptcy estate hires a business broker, to work with the debtor or the trustee, to market the property. The best response, for purchase either as a going concern or of particular assets, is then negotiated into an asset purchase agreement and that agreement becomes what is generally referred to as the “Stalking Horse Bid.” Then, an auction is held. If a Stalking Horse Bid is obtained, it is used as the floor for that auction. An auction can proceed without a Staking House Bid, however, if one cannot be timely obtained. See, for example, In re: The Bombay Company, Inc., et al., Jointly Administered under Case No. 07-44084 in the U.S. Bankruptcy Court for the Northern District of Texas, Fort Worth Division (2008) (Order entered authorizing an auction to assign numerous retail leases promptly after the bankruptcy estate sold the tenant’s inventory in going out of business sales, so as to close the stores as soon as possible in order to minimize administrative rent in the interim. See Item 2 of the Introduction above.) Regardless of the procedure employed, at each step, the appropriate court orders need to be obtained to authorize and govern the process and give interested parties an opportunity to object. Several casesexplain the applicable procedures and contain some of the documents, motions and orders employed to implement such bids and auctions. See, for example, In re Dura Automotive Systems, 2007 Bankr. LEXIS 2764 (2007); and the motions filed, and the Orders entered, in In re: The Bombay Company, supra and In Re: Three A’s Holdings, LLC, Case No. 06-10886 in the U.S. Bankruptcy Court for the District of Delaware (2006) (the “Tower Records” case). If the lease is in default, accompanying court orders are necessary to establish (1) the amounts and actions necessary to cure those defaults, to compensate for actually pecuniary loses, and to provide the requisite adequate assurances of such cures or compensation or of future performance; and (2) how those amounts and actions are to be paid or performed and such assurances given. (See Item 3 of the Introduction above.)

In negotiating the Stalking Horse Bid, the contract purchaser (the“Stalking Horse Bidder”) may seek to include various provisions, in that bid, to be incorporated in the accompanying Court motions and orders, that may give it advantages in the auction process or discourage other potential bidders. For example:

(1)Break-Up Fees and Expense Reimbursements. Break-up fees and expense reimbursements are amounts payable, generally with priority as administrative expenses, to the Stalking Horse Bidder in the event the subject assets are sold to another bidder at the auction. Those provisions are similar to those encountered in a number of non-bankruptcy merger and acquisition agreements. They are justified as necessary costs of preserving the bankruptcy estate under Subsections 503(b)(1) and 507(a)(2) since (a) the Stalking Horse Bidder is taking a major risk, because of the auction process or because of the usual reservations of rights contained in the bidding documents, of losing all of the time, money and lost opportunity costs it has invested in the negotiations and in performing the accompanying due diligence; (b) by showing its interestin purchasing the assets, the Stalking Horse Bid induces other bids in a compressed negotiation and due diligence period; and (c) the Stalking Horse Bid provides a floor to the bidding. On the other hand, break-up fees and expense reimbursements advantage the Stalking Horse Bidder because they are credited against the amount of its bid, but not against the amount of the bid by any other bidder. In fact, those fees and reimbursements are valuable enough that the Stalking Horse Bid may mandate that the purchaser thereunder be the only Stalking Horse Bidder. Consequently, the Bankruptcy Court may require that (a) the non-privileged due diligence materials, even if gathered by the Stalking Horse Bidder, be placed in an on-line “war room” available to all bidders; (b) the amount of the Break-Up Fee take into account the value of those materials thus made available to the other bidders (generally Break-Up Fees do not exceed 2% to 3% of the ultimate purchase price of the subject assets); and (c)the amount of the expense reimbursement be limited accordingly. See Dura Automative, id.; and In Re: Food Management Group, LLC, 359 B.R. 543, 2007 Bankr. LEXIS 381, 47 Bankr. Ct. Dec. 225 (2007). However, see Calpine Corp. v. O’Brien Environmental Energy, Inc., 181 F.3d 527 (3rd Cir. 1999) refusing to approve a break-up fee, finding that it was not necessary to induce the bidding in that case.

(2)Short Auction Date. Having less time to perform due diligence may discourage potential bidders. On the other hand, the Stalking Horse Bidder may have performed a great deal of due diligence while negotiating the Stalking Horse Bid. (See above regarding break-up fees and expense reimbursements.)

(3)High Deposits and IrrevocableBids. The bidding deposit set, by the Stalking Horse Bid and the accompanying court orders, may be so high as to discourage potential bidders who would not be able to raise that much cash or a letter of credit so quickly. On the other hand, the Stalking Horse Bidder has had time and information, while negotiating the Stalking Horse Bid. Furthermore, to protect the bankruptcy estate by retaining its alternatives in case of a default by the winning bidder, the bidding procedures may require that the bids and the deposits of the losing bidders (or at least of the second highest bidder) be irrevocable and be held until the actual transfer of the assets (via settlement) actually occurs. Tying up bids and deposits for long obviously may scare away other potential bidders.

(4)High Bid Increments. The bidding procedures will often set the minimum increments between bids. Obviously, the higher those increments are, the more they tend to weed-out other bidders.

(5)Short Settlement Dates. The bidding procedures will also set the outside settlement date. Obviously, the shorter that is the less time potential bidders have to raise the requisite funds. Again, on the other hand, the Stalking Horse Bidder has had time and information during the negotiations.

(6)Requiring Disclosure of Bidder’s Confidential Financial Information. If the bidding procedures require the other potential bidders to disclose their own confidential financial information to the debtor (whose principals may later become competitors) or to the Stalking Horse Bidder, under the theory that that is necessary for such other bidders to show that they are financially qualified, that requirement may, obviously, discourage certain of those potential bidders.

(7)Requiring All Bids to be on the Same Form as the Stalking Horse Bid. If and to the extent that the bidding procedures require that all bids be on a form of contract that is substantially identical (but for price) as the Stalking Horse Bid, that requirement may discourage certain potential bidders.

(8)Requiring the Winning Bidder to Pay-Off Related Financing. If the bidding proceduresrequire payment of the debtor’s existing financing and such financing was provided by the Stalking Horse Bidder,or a party related to the Stalking Horse Bidder, and contains substantial applicable prepayment penalties. Such a requirement mayadda substantial burden to potential bidders.

B.Selling Designation Rights

The Bankruptcy Code does not expressly provide for designation rights; they are creatures of practice. In a designation-rights situation:

(1)The tenant assigns to a third party (a “Designation Rights Purchaser”), all of tenant’s rights, under Section 365, to determine which of the tenant’s leases shall be assumed and assigned, and thus which ones shall be rejected, all subject to the requirements of Section 365. That assignment is set forth in a designation-rights agreement entered into by and between the tenant and the Designation Rights Purchaser and approved by the Court (a “Designation Rights Agreement”).

(2)The person or entity selected to be the Designation Rights Purchaser is selected by an auction process approved by the Court.

(3)The sale of designation rights process is usually used, if at all, in a situation in which the tenant is a retailer who (a) has a large number of leases;(b) needs a lot of cash up-front to continue to operate its business and/or to wind-down;(c) would rather have a fixed amount, than take its chances in the marketplace, for assignments of the leases; and (d) may not have sufficient retained employees or time to handle the marketing of those leases.