Recent Revisions to the Bankruptcy Code Likely to Affect Commercial Landlords

As nearly everyone has heard, on April 20, 2005, President Bush signed into law the Bankruptcy Abuse and Consumer Protection Act of 2005 (the Act). The effective date of the Act is October 17, 2005, (180 days from the date of enactment), although certain amendments take effect immediately upon enactment, and others on specified trigger dates. With only minimal exceptions, the Act’s amendments are applicable only to bankruptcy cases filed on or after the effective date.

Although commentators and the media have focused on those provisions of the Act affecting individual consumers, the Act also contains a number of new provisions and revisions to existing law that apply primarily to business bankruptcies, and several provisions that apply to landlords and tenants of commercial (nonresidential) properties.

Executory Contracts and Unexpired Leases

Section 365(b)(1)(A) of the Bankruptcy Code has been revised from the current law, which requires that a debtor in bankruptcy must cure, or provide adequate assurance that it will cure, any default in an executory contract or unexpired lease in order to assume (or assume and assign to a third party) such contract or lease. Under the Act, this provision is amended to provide that non-monetary defaults need not be cured as a condition of assumption if it is impossible for the debtor to cure such default by performing non-monetary actions at and after the time of assumption. If the contract is a nonresidential real property lease, however, and the default arises from the failure to operate in accordance with the lease, in order for the debtor to assume or assign the lease, the default must be cured by performance at and after the time of assumption in accordance with the lease, and any pecuniary losses associated with the default must be compensated as part of the cure. The effect of this change is to make it easier for a bankrupt tenant to assume and assign its commercial leases, provided that the lessee cures all monetary and non-monetary defaults on a post-assumption basis. This is in contrast to current law, under which courts in a number of cases involving pre-petition non-monetary defaults have held that such defaults could not be cured, with the result that such leases could not be assumed or assigned by the bankrupt tenant.

The Act benefits commercial landlords by amending Section 365(d)(4) of the Bankruptcy Code, which currently provides that any unexpired lease for nonresidential real property that is not assumed or rejected within 60 days after the petition date is deemed rejected, unless, prior to the expiration of the 60-day period, the court, for cause, extends the time within which the debtor may assume or reject the lease. Under the Act, the deadline for assuming such leases has been extended to the earlier of (i) 120 days from the date of the order for relief or (ii) the date of the entry of an order confirming a plan. The court, for cause, can extend the 120-day period for no more than 90 days, and any further extensions to the time to assume can be granted by the court only with the prior written consent of the lessor. This provision should provide commercial real estate lessors with additional leverage over bankrupt tenants. Under the current law, debtors, particularly those with numerous nonresidential real property leases, routinely request and are granted extensions of the 60-day period, often until the time of plan confirmation, provided that the debtor remains current on all post-petition obligations to the lessor. The Act will force debtors to (i) engage in more extensive pre-bankruptcy negotiations with their landlords, (ii) focus on their need for these leases early in the case and/or (iii) negotiate consensual extensions with the lessors. Lessors are likely to demand concessions from debtors including, perhaps, increased rent in exchange for such consent, although it remains to be seen whether courts will allow debtors to make such concessions. Bad decisions by debtors to assume such leases, however, will enjoy some measure of redemption under new Section 503(b)(7), which is described below.

In an attempt to counter-balance the new requirements contained in revised Section 365(d)(4), the Act adds Section 503(b)(7) to the Bankruptcy Code. Section 503(b)(7) provides that with respect to any lease of nonresidential real property that is first assumed by the debtor and later rejected, the lessor’s administrative expense (i.e., priority) claim will be limited to an amount equal to all monetary obligations (except for penalties) for a two-year period following the later of (i) the rejection date or (ii) the date of turnover of the property, without reduction or setoff, except for amounts actually received by the lessor from a non-debtor entity. Any claim for the remaining amounts due under the rejected lease is deemed to be a general unsecured claim under Section 502(b)(6), and is subject to the limitations set forth in that provision. Under current case law in several circuits (including the Second Circuit), if a debtor lessee first assumes a nonresidential real property lease and later rejects that lease, the lessor would be entitled to assert an administrative expense claim for the entire remaining amount due under the lease, with no Section 502(b)(6) cap. Thus, a wrong choice by a debtor could have disastrous results for its estate. This risk to the debtor’s estate has been significantly reduced as a result of the enactment of Section 503(b)(7).

Assignments of Shopping Center Leases

The Act contains an additional provision which benefits the owners of shopping centers. Currently, Section 365(f) provides that debtors may assume and assign unexpired leases notwithstanding any provision in the lease prohibiting, restricting or conditioning assignment. The Act amends Section 365(f)(1) of the Bankruptcy Code by making this subsection specifically subject to Section 365(b). Section 365(b)(3) conditions the assignment of shopping center leases on compliance with existing contractual “use” provisions (i.e., radius, location, use, exclusivity, etc.). Under the current law, there was a split of authority on this issue, with at least one federal circuit court of appeals holding that overly-restrictive use provisions in shopping center leases may constitute a de facto anti-assignment clause and thus be avoided under Section 365(f)(1). With the amendment of Section 365(f), clearly, the specific requirements of Section 365(b)(3) govern the more general requirements of Section365(f).

Rules Relating to “Single Asset Real Estate” Bankruptcy Cases

The Act amends the definition of “single asset real estate case” contained in Section 101(51B), by eliminating the dollar limitation cap on such cases. Previously, single asset real estate bankruptcy cases were limited to debtors owning only real estate properties and which had aggregate, non-contingent, liquidated, secured debt of no more than $4 million. Section 101(51B), as amended, provides that any bankruptcy case involving a single real property or project, other than residential real property with fewer than four residential units, in which the debtor derives substantially all of its revenue from the operations of the real property, is a “single asset real estate case.”

The provisions governing single asset real estate cases were intended to streamline relatively small Chapter 11 cases involving a single real estate asset, by providing, for example, for termination of the automatic stay with regard to a mortgagee unless (i) a plan has been filed that has a reasonable possibility of being confirmed or (ii) the debtor has begun making monthly payments to the secured creditor in an amount equal to interest at a current market rate on the value of the mortgagee’s interest in the real estate within 90 days from the entry of the order for relief. Under the Act, the time within which the debtor must file such a plan or commence making monthly payments is the later of 90 days after entry of the order for relief or 30 days after the court determines that the debtor is a single asset real estate debtor. The payments to the mortgagee may, in the debtor’s sole discretion and without regard to the restrictions on the use of cash collateral, be made from rents or other income generated from the property post-petition. Further, the Act provides that the monthly payments to the secured creditor are to be in an amount equal to interest at the then applicable non-default contract rate of interest and not at a current market rate as previously required.

By eliminating the $4 million cap on single asset real estate cases, the Act puts at risk any large multimillion dollar single purpose entity (SPE) that owns only real property and which finds itself in a cash liquidity crisis by eliminating its ability to use the 180-day exclusivity period (or longer, if extended up to the limits set forth in amended Section 1121(d)) to refinance or restructure its debts. For many large real estate projects, 90 days simply is too short a time to restructure or refinance. This will likely lead to creative efforts to avoid being defined as a single asset real estate debtor, such as including other assets, such as a second building or development project, in each SPE.

Preferences and Fraudulent Transfers

Several changes have been made to the sections that cover fraudulent conveyances and preferences, two widely used “avoiding powers” in bankruptcy cases.

Section 547(c)(2), which sets out the “ordinary course” defense in preference litigation, has been changed under the Act. Under current law, a preferential transfer may not be avoided to the extent the transfer is (i) a payment of a debt incurred in the ordinary course of the debtor’s business, (ii) made in the ordinary course of business of the debtor and the transferee and (iii) made according to ordinary business terms. Under the Act, Section 547(c) is amended by changing the italicized term in the preceding sentence from “and” to “or.” This amendment will lighten the evidentiary and financial burden on transferees/defendants who use the ordinary course defense by eliminating the need to prove that the transfer was both in the ordinary course of its business with the debtor (i.e., course of dealing) and in accordance with the terms of the relevant industry (usually the creditor’s industry), which is generally difficult to prove and often requires expert testimony.

In addition, the Act has added Section 547(c)(9) to the Bankruptcy Code, which provides that when the debtor’s debts are not primarily consumer debt, a transfer of less than $5,000 in the aggregate, may not be avoided as a preference. For many Chapter 11 debtors, this will have no effect, since it is generally not cost-effective to commence a preference action for amounts less than $5,000. This new provision, in conjunction with the increase in the jurisdictional limits under 28 U.S.C. § 1409(b),¹ may have an impact in cases where litigation or liquidation trusts are in place, and avoidance action litigation “mills” are retained (on commission) to prosecute such actions. In those cases, avoidance actions of less than $5,000 in which the defendant is likely to settle quickly, represent a significant part of the commission recovery.

The Act has also amended the law concerning fraudulent transfers by amending Section 548(a)(1) of the Bankruptcy Code, in a provision that is effective in all cases filed on or after April 20, 2006. While under the current law, the “reach back” period for fraudulent transfers is one year, the new law has increased the “reach back” period to two years. Given a debtor’s (or trustee’s) ability to use, in many cases, the longer reach-back periods under state fraudulent transfer law, this change may not have a significant effect. However, this change does provide access to the longer “reach back” provision without the need for the debtor to prove that an actual creditor existed at the time of the transfer which was fraudulent, which is otherwise required under state fraudulent transaction law.

Chapter 11 Plans of Reorganization

The Act has amended several provisions in Chapter 11 regarding plans of reorganization which could affect the rights and obligations of a debtor landlord or of a landlord with a tenant in bankruptcy.

The Act has amended Section 1121(d) of the Bankruptcy Code in an attempt to speed up Chapter 11 reorganization cases. Under current law, debtors in Chapter 11 cases have a 120-day exclusivity period for filing a plan and a 180-day exclusivity period for obtaining acceptance of that plan. On request of a party in interest, the court may reduce or increase those periods. Under the new law, as amended by the Act, this 120-day period may not be extended beyond 18 months after the entry of the order for relief, and the 180-day period may not be extended beyond 20 months after the entry of the order for relief. This is likely to have a significant impact in large cases, in which courts routinely extend the exclusivity period for two or three years. Debtors in these cases will be under significant time pressure to negotiate consensual plans that will survive the voting process.

The Act also has added Section 1125(g), under which an acceptance or rejection of a plan may be solicited from a holder of a claim or interest without an approved disclosure statement if such holder was solicited prior to the commencement of the bankruptcy case and such solicitation complies with non-bankruptcy law. This new provision should expedite the confirmation of pre-packaged Chapter 11 plans by eliminating the need for the post-petition filing and approval of a disclosure statement or post-petition solicitation of votes.

Finally, the Act has added several provisions that have the intention of better controlling and speeding up the Chapter 11 reorganizations of “small businesses.” The Act defines a “small business” as a debtor which is engaged in commercial or business activities and has less than $2 million in non-contingent liquidated secured and unsecured debts as of the date of filing or the order for relief, and for which a creditors’ committee has not been appointed, or in which the court deems an appointed committee to be insufficiently active. Under the provisions affected by the Act (in Sections 101, 308, 1116, 1121 and 1129), the debtor, the U.S. Trustee and any “DIP” lender are given additional oversight and reporting obligations in such cases. Further, a “small business” debtor is required to file a plan and disclosure statement within 300 days after the date of the order for relief, although exclusivity is extended to 180 days (from 120 days).

As evidenced by the foregoing, the changes in the Bankruptcy Code effectuated by the Act reach far beyond the average consumer debtor and are likely to affect the rights and obligations of many businesses, including landlords, tenants, suppliers and others who conduct business with bankrupt individuals and entities.

The authors wish to thank Holland & Knight partners Richard Lear and Barbra Parlin for their invaluable assistance in the preparation of this article.

¹ The Act requires a bankruptcy trustee (or debtor in possession) to commence a proceeding to recover a non-consumer debt against a non-insider of less than $10,000 only in the district court for the district in which the defendant resides. The current limit to recover a money judgment or property is $1,000.