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A Tenant’s Efforts to Assume and Assign a Commercial Lease in a Chapter 11 Triggers Lots of Issues to Fight About

A tenant’s right to assume, and then possibly assign, its lease involves more than whether the tenant has met the statutory criteria. Procedural issues are involved such as whether and when to hold an auction, with or without a stalking horse bid; whether the stalking horse bid, or the bidding terms and procedures governing any such auction, unduly favor the stalking horse bid over other potential buyers (including the break-up fee); and whether, particularly in the case of multiple leases, the debtor or Trustee should sell designation rights instead of assigning the leases.


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January 10, 2008
Introduction: The Context in which the Following Assumption and Assignment Issues Arise
The following materials address certain 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, a bankrupt 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 lease unless, 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.
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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-priority claim 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 considerations will 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 nonpriority
creditors; (c) whether, after the assumption, the tenant is likely to remain a credit or
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default risk, including whether the tenant is likely to wind up 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 leases
appear 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 from In re Roasters Corp., 2000 Bankr. LEXIS
1916, 2000 WL33673776, which in turn was citing and quoting Pioneer 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 under
Subsection 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
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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 cases explain 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:
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(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 interest in
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 Irrevocable Bids. 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
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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 procedures require 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 may add a 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.
(4) Designation Rights Agreements are subject to negotiation. Consequently,
they vary. Generally, however, they provide the following: (a) upon signing the Designation
Rights Agreement, the Designation Rights Purchaser pays the tenant a large sum, in cash, as
consideration for the assignment of the designation rights; (b) the Designation Rights Purchaser
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has an exclusive period, within the acceptance/rejection period described above, within which to
market the leases (the “Marketing Period”), including by seeking to assign the leases to third
parties or to itself or to negotiate new leases or termination agreements with the landlords; (c) the
Designation Rights Purchaser may be required to pay some or all of the amounts due as rent and
otherwise under the leases during the Marketing Period (see Item 2 of the Introduction above);
(d) during the Marketing Period, the Designation Rights Purchaser may terminate the parties’
respective obligations, under the Designation Rights Agreement, on a lease-by-lease basis, by
electing to drop leases from the program; (e) if, during the Marketing Period, the Designation
Rights Purchaser selects particular leases for the tenant to assume and assign, as described above,
the tenant, at the Designation Rights Purchaser’s directions, is obligated to try to obtain the
requisite Court approvals therefor; (f) the Designation Rights Purchaser may be required to
select, for assumption and assignment, a specified minimum number of leases; (g) for a lease that
the Designation Rights Purchaser wants the tenant to assume and assign, if the lease is in default
and the assumption and assignment is approved by the Court, the Designation Rights Purchaser
may be required to pay some or all of the amounts, and take some of all the actions, necessary to
cure defaults, to compensate for actually pecuniary loses, and to provide the requisite adequate
assurances of such cure or compensation or of future performance and the ultimate assignee will
be required to give the assurances as to future performance (see Item 3 of the Introduction above
and Paragraph 4 below); (h) the Designation Rights Purchaser keeps all of the proceeds of the
assignment and assumption for those leases it thus selects; and (i) the tenant may remain liable
for all rejection damages (see Items 5 and 6 of the Introduction above).
For examples of post-BAPCPA decisions in which Designation Rights Agreements have
been used, see In re Three A’s Holdings, L.L.C., 364 B.R. 550, 2007 Bankr. LEXIS 820, 47
Bankr. Ct. Dec. 281 (2007); and In re Ames Department Stores, Inc., 348 B.R. 91, 2006 Bankr.
LEXIS 1898, 46 Bankr. Ct. Dec. 213 (2006).
3. TENANTS’ RIGHTS NOT TO CURE NONMONETARY DEFAULTS THAT ARE
IMPOSSIBLE TO CURE AT THE TIME THAT THE LEASE ASSUMPTION IS SOUGHT BY
THE TENANT
Subsection 365(b)(1) provides:
(b) (1) If there has been a default in an executory contract or unexpired lease of
the debtor, the trustee may not assume such contract or lease unless, at the time of
assumption of such contract or lease, the trustee–
(A) cures, or provides adequate assurance that the trustee will promptly cure,
such default other than a default that is a breach of a provision relating to the
satisfaction of any provision (other than a penalty rate or penalty provision)
relating to a default arising from any failure to perform nonmonetary obligations
under an unexpired lease of real property, if it is impossible for the trustee to cure
such default by performing nonmonetary acts at and after the time of assumption,
except that if such default arises from a failure to operate in accordance with a
nonresidential real property lease, then such default shall be cured by performance
at and after the time of assumption in accordance with such lease, and pecuniary
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losses resulting from such default shall be compensated in accordance with the
provisions of this paragraph;
(B) compensates, or provides adequate assurance that the trustee will
promptly compensate, a party other than the debtor to such contract or lease, for
any actual pecuniary loss to such party resulting from such default; and
(C) provides adequate assurance of future performance under such contract or
lease.
(emphasis added)
All of the language underlined or emphasized in the above quote of Subsection 365(b)(i)(A) was
added by BAPCPA.
The “impossibility” terminology was added by BAPCPA and generally refers to defaults
that, by the time of the attempted assumption of the lease, are “historic facts.” “Historic facts”
(such as a violation of an operating covenant and a failure to maintain the premises) cannot be
cured by going back in time. In re Bankvest Capital Corp., 360 F.3d 291, 2004 U.S. App.
LEXIS 4810, Bankr. L. Rep. (CCH) P80,062, 42 Bankr. Ct. Dec. 210 (2004); In re Michael and
Janell Williams, 299 B.R. 684, 2003 Bankr. LEXIS 1084 (2003); In re Christopher Vitanza, 1998
Bankr. LEXIS 1497 (1998); In the Matter of: GP Express Airlines, Inc., 200 B.R. 222, 1996
Bankr. LEXIS 1128 (1996). BAPCPA also added the duty to reimburse the landlord for
pecuniary losses, but did not define how to calculate the amount of such reimbursements.
4. THE COURT’S POWER TO IGNORE LEASE CLAUSES IN CONNECTION WITH
AN ASSIGNMENT
Subsections 365(b), (f) and (l) provide, in relevant part:
(b) . . .
(3) For the purposes of paragraph (1) of this subsection and paragraph (2)(B) of
subsection (f), adequate assurance of future performance of a lease of real
property in a shopping center includes adequate assurance–
(A) of the source of rent and other consideration due under such lease, and in
the case of an assignment, that the financial condition and operating performance
of the proposed assignee and its guarantors, if any, shall be similar to the financial
condition and operating performance of the debtor and its guarantors, if any, as of
the time the debtor became the lessee under the lease;
(B) that any percentage rent due under such lease will not decline
substantially;
(C) that assumption or assignment of such lease is subject to all the provisions
thereof, including (but not limited to) provisions such as a radius, location, use, or
exclusivity provision, and will not breach any such provision contained in any
other lease, financing agreement, or master agreement relating to such shopping
center; and
(D) that assumption or assignment of such lease will not disrupt any tenant
mix or balance in such shopping center.
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* * *
(f) (1) Except as provided in subsections (b) and (c) of this section,
notwithstanding a provision in an executory contract or unexpired lease of the
debtor, or in applicable law, that prohibits, restricts, or conditions the assignment
of such contract or lease, the trustee may assign such contract or lease under
paragraph (2) of this subsection.
(2) The trustee may assign an executory contract or unexpired lease of the
debtor only if–
(A) the trustee assumes such contract or lease in accordance with the
provisions of this section; and
(B) adequate assurance of future performance by the assignee of such contract
or lease is provided, whether or not there has been a default in such contract or
lease.
(3) Notwithstanding a provision in an executory contract or unexpired lease of
the debtor, or in applicable law that terminates or modifies, or permits a party
other than the debtor to terminate or modify, such contract or lease or a right or
obligation under such contract or lease on account of an assignment of such
contract or lease, such contract, lease, right, or obligation may not be terminated
or modified under such provision because of the assumption or assignment of
such contract or lease by the trustee.
* * *
(l) If an unexpired lease under which the debtor is the lessee is assigned pursuant
to this section, the lessor of the property may require a deposit or other security
for the performance of the debtor’s obligations under the lease substantially the
same as would have been required by the landlord upon the initial leasing to a
similar tenant.
(emphasis added)
Only the language underlined or emphasized above in Subsection 365(f)(1) was added by
BAPCPA.
Generally, the tenant is required to assume and assign the entire lease, not just the
favorable parts thereof. In re: Fleming Companies, Inc., 499 F.3d 300, 2007 U.S. App. LEXIS
19927, Bankr. L. Rep. (CCH) P80,996, 48 Bankr. Ct. Dec. 188 (2007); Michael and Janell
Williams, supra; GP Express Airlines, Inc., supra. That conclusion would seem to be reinforced,
as to shopping center leases, by the amendment made by BAPCPA to Subsection 365(f)(1) as
stated above.
[This portion is being revised.]

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