Is Bankruptcy Reform Another Feather in the Cap of Commercial Real Estate Landlords?
 
October 21, 2003
 
Stephen A. "Steve" Bogorad- Washington

Is Bankruptcy Reform Another Feather in the Cap of Commercial Real Estate Landlords?

Although bankruptcy reform appears to have been derailed once again by a dispute concerning the discharge of debts arising from protests at abortion clinics, the bill will undoubtedly resurface as the lending industry is determined to crack down on what it considers to be abuses of the system by consumer debtors.  While consumer bankruptcy provisions are the focus of a substantial portion of the bankruptcy reform legislation (H.R. 975) before Congress, and those provisions have received the bulk of attention in the press, the proposed bankruptcy reform legislation also includes an amendment to Section 365(d)(4) of the Bankruptcy Code that could dramatically affect virtually every business bankruptcy Chapter 11 case filed.

Under the current version of Section 365(d)(4) of the Bankruptcy Code, if the debtor does not assume or reject an unexpired lease of nonresidential real property in which the debtor is the lessee “within 60 days after the date of the order for relief, or within such additional time as the court, for cause, within such 60-day period, fixes, then such lease is deemed rejected, and the [debtor] shall immediately surrender such nonresidential real property to the lessor.”  11 U.S.C. § 365(d)(4).  Because the assumption of  a non-residential real property lease could give rise to a very large administrative claim against the debtor’s estate if the debtor subsequently determines that it no longer has any use for the leased premises,[1] debtors rarely, if ever, make a decision to assume or reject such a lease within the first 60 days of a bankruptcy case.  Instead, debtors routinely request, and courts routinely grant, extensions of time to assume or reject unexpired leases of non-residential real property.

Read literally, Section 365(d)(4) allows bankruptcy courts to grant only a single extension of time to assume or reject leases of nonresidential real property, providing that the Court can grant an extension for “such additional time as the court, for cause, within such 60-day period, fixes.”  Therefore, if a court were to grant an initial 90-day extension of time to assume or reject nonresidential leases, Section 365(d)(4) would appear to preclude a subsequent grant of a further extension of time because any such subsequent extension would not be granted within the initial 60-day period.  However, with very limited exception,[2] bankruptcy courts and appellate courts have ignored the literal language of Section 365(d)(4), and have, instead, held that multiple extensions of the 60-day period to assume or reject may be granted.

In practice, most courts have adopted one of two approaches.  Some courts have routinely granted extensions of time to assume or reject leases of non-residential real property until plan confirmation, while other courts have routinely granted a series of shorter extensions that effectively provide the debtor with the same relief, i.e., the ability to defer making an assumption/rejection decision until plan confirmation.  Most courts include in their orders extending the time within which to assume or reject a non-residential real property lease an express provision allowing landlords to file a motion seeking a shortening of the time to assume or reject particular leases. While these provisions provide some protection to aggrieved landlords who may have a particularly compelling reason to require an early decision as to their lease (e.g., that the landlords are unable to refinance their own mortgages and face foreclosure or bankruptcy themselves unless the debtor is forced to assume or reject their lease), such provisions effectively shift to the landlord the burden of establishing cause to shorten the time, whereas the Bankruptcy Code contemplates a short 60-day period of time for assumption or rejection unless the debtor can establish the existence of cause to extend the time.

The practice of routinely granting debtors until plan confirmation to decide whether to assume or reject nonresidential real property leases would come to a screeching halt if the bankruptcy reform legislation currently before Congress ever passes.  Section 404 of H.R. 975 contains an amendment to Section 365(d)(4) of the Bankruptcy Code that would significantly limit the power of bankruptcy courts to extend the time to assume or reject leases of nonresidential real property absent the consent of the landlord.  Section 404(a) of H.R. 975 would amend Section 365(d)(4) so that it would read as follows:

(4)(A) Subject to paragraph (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 proposed amendment would double, from 60 to 120 days, the initial deadline by which debtors must assume or reject leases of nonresidential real property, and would allow courts to grant an additional 90-day extension of that period upon a motion by the debtor, the trustee, or the landlord.  If the amendment is passed, given the prior practice of bankruptcy courts across the country, one can expect that courts will routinely grant the 90-day extension, such that debtors will have 210 days from the petition date to assume or reject leases of nonresidential property in virtually every Chapter 11 case.  However, the proposed amendment to Section 365(d)(4) would prohibit bankruptcy courts from granting any further extension of time to assume or reject, beyond the first 210 days of the bankruptcy case, unless the landlord provides “prior written consent” to each such extension.  The proposed amendment would, therefore, grant landlords an absolute veto over any further extension of time — beyond 210 days — to assume or reject the landlord’s particular lease.  By requiring the landlord’s “prior written consent” as a prerequisite for any further extension, the amendment is drafted so as to prevent bankruptcy courts from “inferring” consent from a landlord’s failure to object to a motion for a further extension of time.

This proposed revision to Section 365(d)(4) of the Bankruptcy Code would dramatically affect virtually every significant business Chapter 11 case.  The proposed 210-day period to assume or reject nonresidential real property leases, which could not be extended without the prior written consent of the landlord, would force debtors to assume or reject all such leases long before plan confirmation in most business bankruptcy cases, unless the debtor is able to work out an alternative arrangement with the landlord.  While 210 days (essentially seven months) is sufficient to obtain confirmation of a prepackaged plan, and perhaps sufficient to obtain confirmation of a plan in small business bankruptcy cases in jurisdictions with less-crowded dockets, it is very rare that a business reorganizes under Chapter 11 within seven months.  Retail bankruptcy cases are almost always filed in January, after the holiday shopping season, and the debtors in those cases seem to always want to get through at least one back-to-school season and one holiday season under the protection of Chapter 11 before making any large-scale store closure decisions.  Under the proposed amendment, if a retail company files for Chapter 7 in early January, the 210-day period will expire in early August, before the back-to-school shopping season begins, meaning the debtor will have to make store closing decisions without having any post-petition sales experience during any of the traditional strong sales periods.

Debtors will continue to be loath to prematurely assume nonresidential real property leases because, once such a lease is assumed, any claims by the landlord under the lease will be afforded administrative priority.  The rental obligations under a long-term lease often represent one of the largest financial obligations of a debtor.  If a debtor is forced to assume a lease before knowing whether it will be able to reorganize, i.e., before plan confirmation, and the debtor’s case is subsequently converted to Chapter 7, or the debtor’s estate is liquidated under Chapter 11, the debtor’s estate is subject to a potentially huge administrative claim by the landlord for any damages flowing from the post-assumption rejection of the lease.  By contrast, if the debtor can delay making assumption/rejection decisions until plan confirmation, the debtor can later reject the nonresidential real property lease and limit the landlord’s rejection claim to a pre-petition unsecured claim, that is subject to the cap of Section 502(b)(6) of the Bankruptcy Code.

Under the proposed amendment to Section 365(d)(4), debtors will be forced to negotiate with landlords for the right to defer the assumption/rejection decision beyond 210 days.  If a landlord refuses to consent to a further extension of the 210-day period to assume or reject leases, the debtor will be forced to assume the lease or surrender the space to the landlord.  These negotiations will be largely market driven.  In strong real estate markets, with low vacancy rates, landlords will be in the driver’s seat, as they will be more willing to risk an early rejection, knowing that there is tenant demand for their space.  By contrast, in weaker real estate markets, with high vacancy rates, landlords will be more amenable to granting extensions of time to assume or reject as landlords will be happy to collect post-petition rent in such circumstances. 

The proposed amendment will likely lead to creative negotiated settlements.  For example, a landlord that would like to take back some, but not all of the debtor’s space, might be able to obtain an agreement from the debtor to reduce its leased premises (through a court-approved lease amendment) in exchange for an extension of time to assume or reject the nonresidential real property lease.  Alternatively, a landlord might insist on immediate lease assumption, but agree to a lease amendment that would limit the administrative expense claim flowing from a subsequent rejection.  Such a contractually agreed-upon cap on lease rejection damages could mirror the cap set forth in Section 502(b)(6), or it could be a different calculation.  While it is impossible to predict all of the permutations of how the proposed amendment to Section 365(d)(4) would play out in the real world, one thing is clear:  the proposed amendment would significantly increase the leverage of commercial lessors in the bankruptcy context.

For more information, e-mail Steve Bogorad at stephen.bogorad@hklaw.com or call toll free, 1-888-688-8500.

1. See e.g., In re Klein Sleep Products, Inc., 78 F.3d 18 (2d Cir. 1996).

2. See e.g., Debartolo Properties Management, Inc. v. Devan, 194 B.R. 46 (D. Md. 1996); In re Coastal Industries, Inc., 58 B.R. 48 (Bankr. D. N.J. 1986).