Every time a new bankruptcy opinion is rendered with respect to a lease, or even a challenge to a lease clause is made in a court, draftspersons and their clients wonder what could have been done to avoid the risks and expense of dealing with the issue. Thus, these days, form leases are being reviewed frequently. Some attempted drafting solutions will be rejected by the court outright as being within the ambit of a statutory prohibition or as interfering with the role of the court in interpreting statutes. In a commercial case, especially one in which the lease grants the landlord alone the right to attorneys' fees, draftpersons may view a questionable clause as possibly intimidating an unsophisticated tenant or as giving the landlord at least an additional argument in court. This article deals with some of the provisions landlords or tenants may attempt to draft into leases to deal with a bankruptcy of themselves or of the other party.
DRAFTING COMMERCIAL REAL ESTATE LEASES
in relation to
CHAPTER 11 BANKRUPTCY CASES
Kenneth L. Samuelson, Esq.
Samuelson Law Offices, LLC
2020 Pennsylvania Avenue, N.W.
#417
Washington, DC 2006
September 18, 2008
[Unless otherwise noted herein, all statutory references are to 11 USC.]
I. Introduction: Basic Bankruptcy Code Provisions Regarding Assumptions, Rejections and Assignments of a Commercial Lease by the Bankrupt Landlord or the Bankrupt Tenant.
Generally, a debtor/Tenant will want to assume the lease if (a) it needs the lease for its reorganization, or (b) the lease is below market and the debtor/Tenant can make a profit by assigning it. A non-debtor/Landlord will generally want to prevent and assumption and assignment unless the Landlord foresees no replacement tenant for a long period of time.
Subject to certain requirements and exceptions, Section 365 allows the debtor to assume or reject a then pending commercial lease, and if the debtor assumes the lease, to assign it, regardless of any prohibitions to the contrary contained in that lease. Specifically, that Section states, in relevant part:
"(a) Except as provided in sections 765 and 766 of this title and in subsections (b), (c), and (d) of this section, the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor.
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(f) (1) Except as provided in subsections (b) and (c) of this section [which deal with the debtor's providing adequate assurances, and the personal services contract, financial accommodations, and pre-termination exceptions discussed herein], 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.
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(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."
Those Sections appear to prohibit lease provisions, even those in a shopping center lease, that prohibit assignments, require the Landlord's consent to assignments, give the Landlord the right to recapture the premises upon an assignment, deny option or extension terms to an assignee, convert percentage rent to minimum rent upon an assignment, or otherwise seek to prevent an assignment or to modify a lease upon an assignment. Such provisions are frequently referred to as "anti-assignment" clauses. In re: Jamesway Corporation, 201 B.R. 73 (Bankr. S.D. N.Y., 1996), 1996 Bankr. LEXIS 1426.
However, as indicated above, there are numerous (a) statutory criteria for the debtor to satisfy in order to be able to assume or assign the lease, and (b) exceptions to the debtor's rights to assume or assign the lease. The following materials address a Landlord's drafting a commercial lease (a) to take advantage of those criteria and exceptions; and (b) to insert other restrictions that, even though they do not expressly prohibit assumptions or assignments, they do have the practical effect of keeping the Landlord in control by discouraging potential assumptions and assignments by imposing requirements that the debtor or the assignee is likely (i) to be unable to satisfy in order to assume the lease under the requirements of the Bankruptcy Code, or (ii) to breach after the closing of the bankruptcy case. The following materials also address what the Tenant would like to draft into the lease to address a bankruptcy of the Landlord.
Moreover, usually in assuming or receiving a lease in bankruptcy the debtor or assignee must accept the entire lease as is, without change. In re: Fleming Companies, Inc., 499 F.3d 300 (3rd Cir., 2007), 2007 U.S. App. LEXIS 19927, Bankr. L. Rep. (CCH) p 80,996, 48 Bankr. Ct. Dec. 188 (2007); Thompkins v. Lil' Joe Records, Inc., et. al, 476 F.3d 1294 (11th Cir., 2007), 2007 U.S. App. LEXIS 2509, 81 U.S.P.Q.2D (BNA) 1791, 47 Bankr. Ct. Dec. 202; 20 Fla. L. Weekly Fed. C 304, cert. den. 128 S. Ct. 613, 169 L. Ed. 2d 393, 2007 U.S. LEXIS 12264 (U.S., 2007); In The Matter Of: Mirant Corporation, et. al. vs. Potomac Electric Power Company, et. al., 197 Fed. Appx. 285 (5th Cir, 2006), 2006 U.S. App. LEXIS 18129, 46 Bankr. Ct. Dec 266.
Lastly, changes made by the Bankruptcy Court to effectuate a proposed assignment apply to only that particular assignment. In other words, once that assignment is consummated in the Bankruptcy proceeding, the assignee is subject to all of those provisions as to any future proposed assignments. Ramco-Gershenson Properties, L.P. v. Service Merchandise Company, Inc., 293 B.R. 169 (Bankr. M.D. TN, 2003). Thus, such provisions in the lease still provide the Landlord with the described protections, outside of the bankruptcy context, to the extent they are enforceable under state law.
II. Provisions a Commercial Landlord May Try to Draft in the Lease vis-à-vis a Bankruptcy of the Tenant.
A. Making Bankruptcy, Receivership, Etc. a Default.
Ipso facto provisions in a commercial lease are usually unenforceable in a Bankruptcy proceeding.
Section 365(b)(2) provides:
"(2) Paragraph (1) of this subsection [which deals with the debtor's right to right to assume a lease that it has defaulted under] does not apply to a default that is a breach of a provision relating to--
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title;
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement; or
(D) the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease."
Section 365(e) provides:
"(e) (1) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on--
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement."
However, even though ipso facto provisions are not enforceable in a Bankruptcy proceeding, the Landlord may still want them in the lease to address the following instances:
(1) A state court eviction or other proceeding may lead to a termination of the lease before the Bankruptcy proceeding is filed by the Tenant or the Landlord, as the case may be. Section 365(c) provides, in relevant part:
"(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if--
* * *
(3) such lease is of nonresidential real property and has been terminated under applicable nonbankruptcy law prior to the order for relief."
(2) The defaults under the default clause should also include insolvencies of guarantors and, in light of recent events, insolvencies of issuers of letters of credit. So long as the guarantor or the issuer, as the case may be, also does not file for bankruptcy, a non-bankruptcy proceeding on account or its insolvency may lead to a termination of the lease, under Section 365(c)(3), before the Bankruptcy proceeding is filed by the Tenant or the Landlord, as the case may be.
B. Defining Various Terms Used in the Bankruptcy Code. Various provisions of the Bankruptcy Code are not defined, or fully defined, in the Bankruptcy Code. For example: "cures", "adequate assurance", "promptly", "penalty provision", "nonmonetary", "impossible", "actual pecuniary loss", "shopping center", "financial condition", "financial accommodations", "substantially", "similar to", "tenant mix or balance", and "substantially the same as would have been required by the landlord upon the initial leasing to a similar tenant". Therefore, a party may seek to include, in the lease, self-serving definitions of those terms. However, such definitions are not binding upon the court and do not create an estoppel. In the Matter of Bryant, 43 B.R. 189 (Bankr. E.D. MI, S.D., 1984), 1984 Bankr. LEXIS 5077, Bankr. L. Rep. (CCH) P70,019.
C. Structuring a Retail Lease, for Space within a Mixed-Use Project, as being Part of a "Shopping Center". Section 365(b)(3) narrows the discretion of the Bankruptcy Court, by expanding the definition of "adequate assurance of future performance", for the benefit of landlords of shopping centers. In re Joshua Slocum Ltd d/b/a JS Acquisition Corporation; George Denney, Party in Interest, 922 F.2d 1081 (3rd Cir. 1990), 1990 U.S. App. LEXIS 22426, Bankr. L. Rep. (CCH) P73,769, 24 Collier Bankr. Cas. 2d (MB) 581.
Therefore, the Landlord will want a Bankruptcy Court to treat the subject lease or other agreement as being one for space within a "shopping center", even in the case of space that is not within a traditional suburban center or mall. In Joshua Slocum, the Court held that a cluster of 3 separate, but relatively contiguous, buildings located in an urban area constituted a "shopping center". In doing so, the Court stated the applicable criteria as follows:
"The bankruptcy court utilized the correct criteria for determining what constitutes a "shopping center." The court's focus on the physical attributes of the Denney Block, however, i.e., the fact that it was located on a typical "Main St." in a downtown district, is not a factor laid out as dispositive in the Bankruptcy Code, Collier's treatise, or either of the above cited cases. Nor is there any intrinsic sense to the bankruptcy court's conclusion that the Denney Block's location makes it fall outside the purview of the definition of "shopping center." The court noted that "a shopping center brings to mind a configuration of stores which are not free-standing or detached in the sense that stores appear in a typical 'Main St.' downtown shopping district. Such a downtown shopping district is usually considered in many communities, as the alternative (emphasis in original) to the archetypal 'shopping center,' i.e., the large enclosed shopping mall." Bankruptcy Court Opinion (Appendix at 218). While it is true that the mall is the archetypal "shopping center," all shopping centers do not necessarily take the form of shopping malls.
Location is only one element in the determination of whether a group of stores can properly be described [**16] as a "shopping center." However, more significant are the following criteria sketched in Collier, Goldblatt and 905 Int'l:
(a) A combination of leases;
(b) All leases held by a single landlord;
(c) All tenants engaged in the commercial retail distribution of goods;
(d) The presence of a common parking area;
(e) The purposeful development of the premises as a shopping center;
(f) The existence of a master lease;
(g) The existence of fixed hours during which all stores are open;
(h) The existence of joint advertising;
(j) Contractual interdependence of the tenants as evidenced by restrictive use provisions in their leases;
(k) The existence of percentage rent provisions in the leases;
(l) The right of the tenants to terminate their leases if the anchor tenant terminates its lease;
(m) Joint participation by tenants in trash removal and other maintenance;
(n) The existence of a tenant mix; and
(o) The contiguity of the stores.
We do not think that the bankruptcy court gave adequate consideration to all of the factors described above and gave undue weight to the testimony that the Denney Block does not look like a shopping center. See Appendix at 98, 219. The bankruptcy court placed what it termed "the physical configuration" of the Denney Block at the center of its analysis, see id. at 219-20: "we find that the physical characteristics of the Denney Block preclude its characterization as a 'shopping center.'" Id. at 218. We are not convinced that the physical configuration of the property plays such a prominent role. Indeed, Collier notes that "the most important characteristic will be a combination of leases held by a single landlord, leased to commercial retail distributors of goods, with the presence of a common parking area." 2 Collier on Bankruptcy para. 365.04[3]. Except for contiguity of stores criterion listed above, the appearance of premises or their location within a downtown shopping district has not been cited as a factor in the determination of whether a group of stores is a "shopping center." All of the stores of Denney Block, except to the extent that they are separated by common areas, are contiguous."
Furthermore, a distant parcel or one owned in fee by the "tenant" may also be within a "shopping center". In In re: Sun TV and Appliances, Inc. and Sun Television and Appliances, Inc., 234 B.R. 356 (Bankr. DE, 1999), 1999 Bankr. LEXIS 633, 34 Bankr. Ct. Dec. 500, the Court held that an outlot, separated by a ring road and a partial physical barrier from the main part of the shopping center, is part of the shopping center. In doing so, the Court adopted the factors stated in Joshua Slocum, supra. and stated, as to the combination of leases factor:
"A. A Combination of Leases
In this case, there are a combination of leases for the enclosed mall and for the out-parcels. However, some of the stores have typical leases, some of the parcels (particularly the out-parcels) are leased under ground leases, and some are conveyed but subject to a Reciprocal Easement Agreement [**8] ("REA"). (Exhibits H-2, H-14, S-1, S-3 & S-7.) The Debtor, however, does not argue that the different forms of agreement are significant and, in fact, concedes that this factor is met. (Debtor's Letter Brief dated March 22, 1999, at p. 3, n. 5.)
We agree. We do not find it significant that the "leases" of the various stores at the Huntington Mall and environs are designated leases, ground leases or reciprocal easement agreements. We are satisfied that each type of agreement provides the "tenant" and the Landlord with similar respective interests in the premises, regardless of which type of agreement is used. Specifically, they give the Landlord and the "tenant" the rights typical of a landlord and tenant at a shopping center, at least with respect to the areas of inquiry relevant under Joshua Slocum. Therefore, we find that the first factor is met."
Therefore, in designing retail areas and drafting the leases with respect thereto, the Landlord wants to incorporate as many of the Joshua Slocum, supra. factors as possible. Putting the retail portions, of a mixed-use project, into their own separate condominium unit within the project may help in that regard. Nevertheless, as described above, neither definitions in the lease or agreement, nor treatment by the parties or with other tenants is binding upon the Bankruptcy Court in defining "shopping center". Ramco-Gershenson, supra.
D. Stating that the Landlord's Providing Tenant Improvements or Allowances is the Making a Loan or Extending Other Debt Financing or Financial Accommodations to be Repaid in the Form of Higher Rent.
Sections 365(c) and (f) provide certain exceptions, to the debtor's statutory rights to assume and assign the lease for Landlords with respect to financing provided by the Landlord, as follows:
Section 365(c) provides, in relevant part:
"(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if--
* * *
(2) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor; or . . ."
(emphasis added)
Likewise, Section 365(e) provides, in relevant part:
"(2) Paragraph (1) of this subsection [which deals with the invalidity of ipso facto provisions] does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if--
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(B) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor."
(emphasis added)
Those exceptions may be useful, for example, where the Landlord is obligated to pay for tenant improvements, but has not advanced those sums as of the time the Tenant declares bankruptcy. In In re: Postle Enterprises, Inc., Dean v. Postle Enterprises, Inc., 48 B.R. 721 (Bankr. AZ, 1985), 1985 Bankr. LEXIS 6177, Bankr. L. Rep. (CCH) P70,531, the lease required the Landlord to pay to the Tenant a construction allowance, which would be payable after the Tenant declared bankruptcy. The Court held that, under the above quoted Sections of the Bankruptcy Code, the lease was not assumable. From the analysis made by that Court, it appears that its ruling may have been different if the Landlord had already advanced the construction allowance monies. Note, however, In re: Charrington Worldwise Enterprises, Inc., 98 B.R. 65 (Bankr. M.D. FL, Tampa Division, 1989), 1989 Bankr. LEXIS 449, Bankr. L. Rep. (CCH) P72,872 involves a different factual scenario and the Court distinguishes Postle; nevertheless, the reasoning of the Court (in Charrington) may be contrary to the analysis in Postle.
E. Limiting the Use of the Premises. Landlord's often try to keep control, even for reasons other for the bankruptcy consequences, also via lease provisions that severely restrict the permitted uses that may be made of the premises (down to similar to the other stores in the tenant's chain or franchise, and the types on items on a restaurant's menu), the trade name under which the premises may be operated, signage, alternations, parking requirements under applicable zoning laws, etc. Many such provisions, particularly in shopping center leases, are enforced by the court in a bankruptcy proceeding for the following reasons:
(1) The tenant or assignee is generally required to assume or accept the lease as it is written [see Fleming, Thompkins and Mirant, all supra].
(2) Section 365(c) protects the non-debtor party in the case of a personal service contract, as follows:
"(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if--
(1) (A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment; or . . ."
(emphasis added)
(3) Likewise, Section 365(e) provides, in relevant part:
"(2) Paragraph (1) of this subsection [which deals with the invalidity of ipso facto provisions] does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if--
(A) (i) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(ii) such party does not consent to such assumption or assignment; or . . ."
(emphasis added)
On the other hand, for the following reasons, a Bankruptcy Court may permit an assumption and assignment of a lease despite such provisions:
(a) Section 365(f)(1) prohibits not only express prohibitions on lease assignments, but also provisions "which are so restrictive that they constitute de facto anti-assignment provisions". Fleming, supra. In Ramco-Gershenson Properties, supra, the Court found even a continuous operations requirement, or "going dark" prohibition, to be a prohibited anti-assignment provision despite the fact that it was in a shopping center lease [however (i) that was a 2003 case and thus before the changes, with respect to non-curable nonmonetary defaults, made by BAPCPA; and (ii) the Court did state that that requirement did apply to the assignee as of the effective date of the assignment].
(b) Section 365(f)(2) requires the Tenant (in case the Tenant is in default of the lease) or the proposed assignee, in order to assume or accept the lease, to provide "adequate assurance of future performance". In applying that test, even with respect to a shopping center lease, the Court can delete clauses of the lease by finding them to be immaterial or not economically important to the Landlord in entering into the lease originally. In Joshua Slocum, supra., the Court held:
"The bankruptcy court does have some latitude in waiving contractual provisions when authorizing a trustee to assume and assign an unexpired lease. Section 365(b)(2) 6 on its face permits the court to ignore so-called ipso facto and forfeiture clauses. [Citations omitted]. However, the court's authority to waive the strict enforcement of lease provisions in the context of shopping center cases like this one is further qualified by § 365(b)(3) of the Bankruptcy Code. 7 Even under the tightly drawn definition of "adequate assurance" in the shopping center context, Congress did not envision literal compliance with all lease provisions; insubstantial disruptions in, inter alia, tenant mix, and insubstantial breaches in other leases or agreements were contemplated and allowed. 8 11 U.S.C. § 365(b)(3)(C), (D) [Citations omitted].
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8 The court's authority to waive strict enforcement of lease provision in the non-shopping center cases will permit deviations which exceed those permitted in shopping center cases. U.L. Radio, 19 Bankr. 537, 544. See also In re Peterson's Ltd., Inc., 31 Bankr. 524 (Bankr. S.D.N.Y 1983) (a change in use was authorized to permit an assignment of a so-called high class tobacco shop to an assignee who sold discounted cigars); In Re Fifth Avenue Originals, 32 Bankr. 648 (Bankr. S.D.N.Y 1983 (a lease assumption and assignment from a high-class boutique selling clothing and accessories for both sexes to Diane von Furstenberg, a designer offering women's clothing and accessories, was approved).
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Appellant takes issue with the bankruptcy court's conclusion that paragraph 20 of the lease at issue, allowing for the termination of the lease by either the landlord, Denney or the debtor-tenant, Joshua Slocum, Ltd., if certain minimum sales figure were not realized, was not enforceable. Central to the bankruptcy court's view was the notion that unless the landlord establishes that a leasehold is in a "shopping center," such a restrictive clause is only enforceable if the landlord is able to establish that such terms are material and jeopardize the economic position of the landlord and/or the landlord's other tenants. The bankruptcy court, working from the premise that the Denney Block is not a "shopping center," looked to case law interpreting § 365 of the Bankruptcy Code and distilled the concepts of "materiality and economic significance." Those cases state that "the [bankruptcy] court does retain some discretion in determining that lease provisions . . . may still be refused enforcement in a bankruptcy context in which there is no substantial economic detriment to the landlord shown, and in which enforcement would preclude the bankruptcy estate from realizing the intrinsic value of its assets." [Citations omitted].
Again, we note our disagreement with the bankruptcy court's premise that the Denney Block is not a "shopping center" within the meaning of 11 U.S.C. § 365(b)(3). We find that although the bankruptcy court was correct in its reliance on those legal precepts in this context, it was incorrect in finding that on these facts, paragraph 20 of the lease, addressing the right of the parties to terminate the leasehold is not "material or economically significant." That conclusion flies in the face of logic and simple common sense. The average sales provision of the lease is material in the sense that it goes to the very essence of the contract, i.e., the bargained for exchange. This clause, intended to benefit both the landlord and the tenant, was negotiated at arms length to accommodate the commercial expectations of the parties. This average sales provision is also reflective of the economic terms of the lease agreement governing occupancy. However, most importantly, the materiality and economic significance of paragraph 20 turn on the fundamental right to remain in or end a contractual relationship.
We find that the average sales provision of paragraph 20 was not merely inserted as an escape hatch in the event that the location became unprofitable for the protection of the tenant. But rather, that particular clause is of financial import to the landlord in insuring occupancy by high volume sales, viable businesses, thus increasing the rent received under the percentage rent clause. The combination of paragraph 4 and paragraph 20 acts as a minimum income guarantee for the landlord. Certainly nothing could be as material or economically significant to landlords as some minimal assurance that there will be a positive return on their investments. The clause is also significant to landlord as well as the other tenants because customers will be attracted to stores where business is perceived as booming. We conclude, therefore, paragraph 20 is a material and economically significant clause in the leasehold at issue."
In Fleming, supra, the subject executory contract was a requirements purchase contract (as distinguished from a shopping center lease) and required that the subject goods be supplied from a particular warehouse. The Tenant, at the direction of the proposed assignee of that contract, rejected the lease for that warehouse, thus preventing the proposed assignee from supplying the goods from that particular warehouse. The parties presented various facts as to whether the subject warehouse requirement was material and economically significant. In not approving the proposed assignment of the subject requirements purchase contract under Section 365(f)(2), the Court adopted the Joshua Slocum, supra test of whether the subject provision is "material and economically significant".
In In re: Morande Enterprises, Inc., 335 B.R. 188 (Bankr. M.D. FL., Fort Myers Division), 2005 Bankr. LEXIS, involving a non-shopping center franchise agreement, the Court indicated that "incidental" restrictions upon assignment would be permitted, as distinguished from an essential component of the contract.
However, as stated above, Section 365(b)(3) limits the court's discretion in this regard with respect to a shopping center lease. See In re: Three A'S Holdings, L.L.C., 364 B.R. 550 (Bankr. DE, 2007), 2007 Bankr. LEXIS 820, 47 Bankr. Ct. Dec. 281; Joshua Slocum, supra; and Sun TV, supra.
Therefore, in drafting the lease, the benefitted party should insert language explaining why the restrictions are personal service contracts and material and economically significant and giving examples of the types of assignments that would be permitted thereunder. Although such self-serving language will not be binding upon the Court, it will serve as argument showing the original intent of the parties.
Nevertheless, except as otherwise provided in Section 365(e)(1)(A) (as discussed below), such lease provisions should apply after the effective date of the assumption. See Ramco-Gershenson Properties, supra.
F. Imposing Performance or Financial Covenants. For reasons other than the Bankruptcy Code, lease provisions may require a tenant to maintain a specified minimum net worth; a retail tenant to produce a specified minimum amount of gross sales; or a retail tenant, after any default with respect to its submission of gross sales reports statements, to deliver expensive, independent CPA audited financial statements each month or quarter. Another such provision may be a cross-default with respect to such other existing and future leases and contracts, particularly any separate leases and contracts between the Landlord and the Tenant themselves.
However, under Section 365(b), such covenants do appear not to be enforceable in a Bankruptcy proceeding to prevent an assumption of the lease. Section 365(b) states, in relevant part:
"(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 losses resulting from such default shall be compensated in accordance with the provisions of this paragraph;
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(2) Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to--
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
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(D) the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease."
(emphasis added)
Furthermore, under Section 365(e)(1)(A), such covenants do not otherwise appear to be enforceable prior to the closing of the bankruptcy case.
"(e) (1) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on--
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;"
(emphasis added)
See In re Sambo's Restaurant, Inc., 24 B.R. 755 (Bankr. C.D. CA, 1982), 1982 Bankr. LEXIS 2896, Bankr.L.Rep. (CCH) P68,936 (cross-default provisions in various leases between the same parties held to be prohibited financial conditions).
However, such performance or financial requirements in a lease may be beneficial to the Landlord in the following ways:
(a) They may provide an early warning that the Tenant is getting into trouble. That information would enable the Landlord to trigger workout negotiations and enable the Landlord to try to get through Landlord/Tenant Court before the Tenant files in the Bankruptcy Court. (This relates to the availability of self-help, which is being addressed by other speakers.) As stated above, Section 365(c) provides, that the debtor may not assume or assign an unexpired lease if
"(3) such lease is of nonresidential real property and has been terminated under applicable nonbankruptcy law prior to the order for relief."
(b) As stated above, such covenants appear to be enforceable after the closing of the case. Ramco-Gershenson, supra.
G. Net, as Distinguished from Gross, Leases. To help a landlord get paid with respect to supplying services to a debtor/Tenant, Section 365(b)(4) provides:
"(4) Notwithstanding any other provision of this section, if there has been a default in an unexpired lease of the debtor, other than a default of a kind specified in paragraph (2) of this subsection, the trustee may not require a lessor to provide services or supplies incidental to such lease before assumption of such lease unless the lessor is compensated under the terms of such lease for any services and supplies provided under such lease before assumption of such lease."
That Section does not require that the costs of such services be specifically stated, by amount or formula, in the lease or denominated as rent. However, doing so would, obviously, reduce any arguments regarding how they fit in the overall calculation of the rent. However, as a practical matter, Section 365(b)(4) may be helpful only with respect to single tenanted buildings and single tenanted retail facilities since it may not be possible service the other tenants of the building or shopping center without servicing the debtor as well.
H. Labeling All Charges as being "Additional Rent". Stating that all charges under the lease are "additional rent" has implications not only under state summary eviction laws and procedures, but also under Section 502(b)(6) of the Bankruptcy Code. That Section limits the amount of damages a Landlord can claim, for a rejection by a debtor/Tenant of the lease, as follows:
"(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds--
(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 . . ."
Although it can be argued that the amount of additional rent is "rent" for the foregoing purposes, labeling the particular amounts as "additional rent" would, obviously, reduced the risk of argument.
I. Requiring the Assignee to Assume the Lease. Sections 365(f) and (k) do not expressly require an assignee to assume the lease, even as to non-recourse provisions. Provisions in the lease requiring the assignee to assume the lease may discourage a large assignee from taking an assignment of a lease from a tenant who never had significant other assets. Section 365(f) states:
"(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."
With such a provision, the issue is whether such an assumption requirement modifies the Lease or merely makes the assignee take the lease as a whole as described above. See In re Allegheny Health, Education and Research Foundation, 265 B.R. 88 (Bankr. W.D. PA, 2001), 2001 Bankr. LEXIS with respect to (1) distinction between assumptions and assignments, and (2) the right of the Bankruptcy Estate to assign just part of the assets.
J. Form of Security Deposit. Is the Landlord better off getting a higher letter of credit, rather than a lower cash deposit? See the other materials in this program.
K. Prohibiting or Limiting Bankruptcy Sales. Especially in retail leases, the Landlord wants to try to limit (1) access to the premises for the purposes of bankruptcy sales, and (2) how long the furniture, fixtures and equipment can remain in the Leased Premises in connection therewith.
III. Provisions a Commercial Landlord May Try to Draft in the Lease vis-à-vis a Bankruptcy of Itself.
Section 365(h)(1) provides, with respect to a bankruptcy of the Landlord:
"(h) (1) (A) If the trustee rejects an unexpired lease of real property under which the debtor is the lessor and--
(i) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection; or
(ii) if the term of such lease has commenced, the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable nonbankruptcy law.
(B) If the lessee retains its rights under subparagraph (A)(ii), the lessee may offset against the rent reserved under such lease for the balance of the term after the date of the rejection of such lease and for the term of any renewal or extension of such lease, the value of any damage caused by the nonperformance after the date of such rejection, of any obligation of the debtor under such lease, but the lessee shall not have any other right against the estate or the debtor on account of any damage occurring after such date caused by such nonperformance.
(C) The rejection of a lease of real property in a shopping center with respect to which the lessee elects to retain its rights under subparagraph (A)(ii) does not affect the enforceability under applicable nonbankruptcy law of any provision in the lease pertaining to radius, location, use, exclusivity, or tenant mix or balance.
(D) In this paragraph, "lessee" includes any successor, assign, or mortgagee permitted under the terms of such lease."
In the case of a Landlord bankruptcy, if the Landlord rejects the lease, a restructuring of the property (for example, replacing a number of small mom-and-pops with a big box, or converting an office building to a hotel) may be the highest and best use. However, as stated above, Section 365(h)(1) gives the Tenant, under certain circumstances, the right to remain in the premises. Therefore, the Landlord wants the lease to provide the Landlord, in addition to the types of rights described above to control the premises, a right to relocate the Tenant, not just within the building or shopping center, but also the ability to a comparable (as defined) building or shopping center.
IV. Provisions a Commercial Tenant May Try to Draft in the Lease vis-à-vis a Bankruptcy of the Landlord. A Tenant should want a timely right to react to a potential or actual bankruptcy of the Landlord. The Tenant usually will not want to find itself being one of the few remaining tenants of a shopping center with only a right of offset for its damages, under Section 365(h)(1). Therefore, one of the things a Tenant should want is a co-tenancy clause, even if it may be an ipso facto clause if exercised after the Landlord files for bankruptcy. Section 365(h)(1).
V. Risks of the Lease or Any Amendments thereto Being Voided. Each party should also want to be sure, as much as possible, that the lease, or any amendments thereto (especially those made while the other party is in crisis), is not voidable by the other party, or the other party's trustee, as debtor in bankruptcy (a) as a lien creditor or as successor to certain creditors and purchasers under Section 544; (b) as a voidable preference under Section 547; or (c) as a fraudulent transfer or obligation under Section 548.
11 USCS § 365
§ 365. Executory contracts and unexpired leases
(a) Except as provided in sections 765 and 766 of this title and in subsections (b), (c), and (d) of this section, the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor.
(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 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.
(2) Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to--
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title;
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement; or
(D) the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.
(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.
(4) Notwithstanding any other provision of this section, if there has been a default in an unexpired lease of the debtor, other than a default of a kind specified in paragraph (2) of this subsection, the trustee may not require a lessor to provide services or supplies incidental to such lease before assumption of such lease unless the lessor is compensated under the terms of such lease for any services and supplies provided under such lease before assumption of such lease.
(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if--
(1) (A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment; or
(2) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor; or
(3) such lease is of nonresidential real property and has been terminated under applicable nonbankruptcy law prior to the order for relief.
(d) (1) In a case under chapter 7 of this title, if the trustee does not assume or reject an executory contract or unexpired lease of residential real property or of personal property of the debtor within 60 days after the order for relief, or within such additional time as the court, for cause, within such 60-day period, fixes, then such contract or lease is deemed rejected.
(2) In a case under chapter 9, 11, 12, or 13 of this title, the trustee may assume or reject an executory contract or unexpired lease of residential real property or of personal property of the debtor at any time before the confirmation of a plan but the court, on the request of any party to such contract or lease, may order the trustee to determine within a specified period of time whether to assume or reject such contract or lease.
(3) The trustee shall timely perform all the obligations of the debtor, except those specified in section 365(b)(2) [subsec. (b)(2) of this section], arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title. The court may extend, for cause, the time for performance of any such obligation that arises within 60 days after the date of the order for relief, but the time for performance shall not be extended beyond such 60-day period. This subsection shall not be deemed to affect the trustee's obligations under the provisions of subsection (b) or (f) of this section. Acceptance of any such performance does not constitute waiver or relinquishment of the lessor's rights under such lease or under this title.
(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.
(5) The trustee shall timely perform all of the obligations of the debtor, except those specified in section 365(b)(2), first arising from or after 60 days after the order for relief in a case under chapter 11 of this title under an unexpired lease of personal property (other than personal property leased to an individual primarily for personal, family, or household purposes), until such lease is assumed or rejected notwithstanding section 503(b)(1) of this title, unless the court, after notice and a hearing and based on the equities of the case, orders otherwise with respect to the obligations or timely performance thereof. This subsection shall not be deemed to affect the trustee's obligations under the provisions of subsection (b) or (f). Acceptance of any such performance does not constitute waiver or relinquishment of the lessor's rights under such lease or under this title.
(e) (1) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on--
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
(2) Paragraph (1) of this subsection does not apply to an executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if--
(A) (i) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to the trustee or to an assignee of such contract or lease, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and
(ii) such party does not consent to such assumption or assignment; or
(B) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor.
(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.
(g) Except as provided in subsections (h)(2) and (i)(2) of this section, the rejection of an executory contract or unexpired lease of the debtor constitutes a breach of such contract or lease--
(1) if such contract or lease has not been assumed under this section or under a plan confirmed under chapter 9, 11, 12, or 13 of this title, immediately before the date of the filing of the petition; or
(2) if such contract or lease has been assumed under this section or under a plan confirmed under chapter 9, 11, 12, or 13 of this title --
(A) if before such rejection the case has not been converted under section 1112, 1208, or 1307 of this title, at the time of such rejection; or
(B) if before such rejection the case has been converted under section 1112, 1208, or 1307 of this title --
(i) immediately before the date of such conversion, if such contract or lease was assumed before such conversion; or
(ii) at the time of such rejection, if such contract or lease was assumed after such conversion.
(h) (1) (A) If the trustee rejects an unexpired lease of real property under which the debtor is the lessor and--
(i) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection; or
(ii) if the term of such lease has commenced, the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable nonbankruptcy law.
(B) If the lessee retains its rights under subparagraph (A)(ii), the lessee may offset against the rent reserved under such lease for the balance of the term after the date of the rejection of such lease and for the term of any renewal or extension of such lease, the value of any damage caused by the nonperformance after the date of such rejection, of any obligation of the debtor under such lease, but the lessee shall not have any other right against the estate or the debtor on account of any damage occurring after such date caused by such nonperformance.
(C) The rejection of a lease of real property in a shopping center with respect to which the lessee elects to retain its rights under subparagraph (A)(ii) does not affect the enforceability under applicable nonbankruptcy law of any provision in the lease pertaining to radius, location, use, exclusivity, or tenant mix or balance.
(D) In this paragraph, "lessee" includes any successor, assign, or mortgagee permitted under the terms of such lease.
(2) (A) If the trustee rejects a timeshare interest under a timeshare plan under which the debtor is the timeshare interest seller and--
(i) if the rejection amounts to such a breach as would entitle the timeshare interest purchaser to treat the timeshare plan as terminated under its terms, applicable nonbankruptcy law, or any agreement made by timeshare interest purchaser, the timeshare interest purchaser under the timeshare plan may treat the timeshare plan as terminated by such rejection; or
(ii) if the term of such timeshare interest has commenced, then the timeshare interest purchaser may retain its rights in such timeshare interest for the balance of such term and for any term of renewal or extension of such timeshare interest to the extent that such rights are enforceable under applicable nonbankruptcy law.
(B) If the timeshare interest purchaser retains its rights under subparagraph (A), such timeshare interest purchaser may offset against the moneys due for such timeshare interest for the balance of the term after the date of the rejection of such timeshare interest, and the term of any renewal or extension of such timeshare interest, the value of any damage caused by the nonperformance after the date of such rejection, of any obligation of the debtor under such timeshare plan, but the timeshare interest purchaser shall not have any right against the estate or the debtor on account of any damage occurring after such date caused by such nonperformance.
(i) (1) If the trustee rejects an executory contract of the debtor for the sale of real property or for the sale of a timeshare interest under a timeshare plan, under which the purchaser is in possession, such purchaser may treat such contract as terminated, or, in the alternative, may remain in possession of such real property or timeshare interest.
(2) If such purchaser remains in possession--
(A) such purchaser shall continue to make all payments due under such contract, but may, offset against such payments any damages occurring after the date of the rejection of such contract caused by the nonperformance of any obligation of the debtor after such date, but such purchaser does not have any rights against the estate on account of any damages arising after such date from such rejection, other than such offset; and
(B) the trustee shall deliver title to such purchaser in accordance with the provisions of such contract, but is relieved of all other obligations to perform under such contract.
(j) A purchaser that treats an executory contract as terminated under subsection (i) of this section, or a party whose executory contract to purchase real property from the debtor is rejected and under which such party is not in possession, has a lien on the interest of the debtor in such property for the recovery of any portion of the purchase price that such purchaser or party has paid.
(k) Assignment by the trustee to an entity of a contract or lease assumed under this section relieves the trustee and the estate from any liability for any breach of such contract or lease occurring after such assignment.
(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.
(m) For purposes of this section 365 and sections 541(b)(2) and 362(b)(10), leases of real property shall include any rental agreement to use real property.
