I.               INTRODUCTION

Lease agreements in the United States are subject to special treatment in bankruptcy cases that is often contrary to the terms of the lease itself or relevant non-bankruptcy law.  This article discusses several of the most important matters impacting a commercial landlord in the U.S. bankruptcy case of its tenant, including the tenant’s assumption (i.e., ratification), rejection (i.e., anticipatory repudiation) or assignment of a lease; lease obligations pending assumption, rejection or assignment; and the treatment of claims arising from the assumption, rejection or assignment of a lease. 

II.             DEBTOR’S LEASE OBLIGATIONS PENDING ASSUMPTION OR REJECTION OF A NONRESIDENTIAL REAL PROPERTY LEASE

Section 365(d)(3) of the U.S. Bankruptcy Code requires a debtor-tenant to continue performing its postpetition (i.e., post-bankruptcy) obligations under a nonresidential real property lease until it is assumed, rejected or assigned.  In addition to rent, such obligations generally include taxes, insurance, common area maintenance, utilities, repairs, clean-up costs, late charges, interest and other monetary obligations.  However, certain lease obligations are expressly excluded from the debtor’s performance duties, including penalty rates or provisions arising from the debtor’s failure to perform non-monetary obligations, as well as so called “ipso facto” provisions that impose obligations or penalties based on the commencement of a bankruptcy case by or against the debtor or the financial condition of the debtor, or the appointment of a bankruptcy trustee.

III.           REJECTION OF AN UNEXPIRED LEASE IN BANKRUPTCY

The “business judgment rule” is the standard that governs a U.S. bankruptcy court’s approval of a debtor’s decision to reject an unexpired lease.  Under this rule, the debtor’s determination that rejection of the lease will benefit the bankruptcy estate will be accepted by the court unless shown to be manifestly unreasonable.  Generally, the potential damages to the non-debtor party resulting from rejection is not relevant to the court’s analysis, although the court may refuse to authorize rejection of a lease where the lessor would suffer disproportionate damage (e.g., where most of the benefit of rejection would be captured by a third party rather than the bankruptcy estate).

IV.           ASSUMPTION OF AN UNEXPIRED LEASE IN BANKRUPTCY

As with lease rejection, the business judgment rule is the standard that governs a U.S. bankruptcy court’s approval of a debtor’s decision to assume an unexpired lease.  Pursuant to Bankruptcy Code Section 365(b)(1), if there has been a default under a lease, in order to assume such lease, the debtor must:

1.          cure (or provide adequate assurance of prompt cure of) pre- and post-petition defaults;

2.          compensate (or provide adequate assurance of prompt compensation of) all pecuniary loss resulting from pre- and post-petition defaults; and

3.          provide adequate assurance of future performance under the lease.

Generally speaking, all monetary defaults must be cured in order for a debtor-tenant to assume a lease under Section 365(b)(1).  Pursuant to Section 365(b)(2), certain defaults are excluded from those that must be cured, including defaults related to “ipso facto” provisions and penalty rates or provisions.  In addition, the debtor need not cure nonmonetary defaults under a real property lease that are impossible to cure by performing nonmonetary acts (e.g., violation of a prohibition against “going dark”), although, such defaults must be prospectively cured at the time of lease assumption, and the lessor must be compensated for any pecuniary loss resulting from the prior defaults.

V.             ASSUMPTION AND ASSIGNMENT OF AN UNEXPIRED LEASE IN BANKRUPTCY

Pursuant to Bankruptcy Code Section 365(f)(1), a debtor in a U.S. bankruptcy case may assign a lease in accordance with Section 365(f)(2) notwithstanding lease provisions that purport to prohibit, restrict or condition assignment.  Assignment under Section 365(f)(2) requires assumption of the lease pursuant to Section 365(a) and a showing of adequate assurance of future performance under the lease by the proposed assignee, even if there have been no defaults under the lease.  Pursuant to Section 365(l), the landlord may require a deposit or other security from the assignee comparable to what the landlord would have required upon the initial leasing to a similar tenant.  The assignment of a lease must be approved by bankruptcy court order. 

Pursuant to Bankruptcy Code Section 365(k), the assignment of a real property lease pursuant to Bankruptcy Code Section 365(f) relieves the bankruptcy estate of all claims resulting from a subsequent breach of the lease.  Since landlords often make various year-end accounting adjustments with their tenants (e.g., to reflect the difference between actual expenses for certain items and the estimated amount previously charged to tenants), it is prudent for a landlord to obtain a carve-out for certain post-assignment adjustments for a specified period in the order authorizing assignment of the lease. 

VI.           CLAIMS ARISING FROM REJECTION OF A LEASE IN BANKRUPTCY

The calculation of a claim arising from lease rejection is based on the lease terms and relevant non-bankruptcy law, with certain adjustments required by U.S. bankruptcy law. 

Bankruptcy Code Section 502(b)(6) limits the maximum recovery for a landlord’s claim arising from termination of a real property lease to (1) any unpaid rent owed under the lease, plus (2) a portion of the remaining future rent, equal to the rent reserved in the lease for the greater of one year or 15% (not to exceed three years) of the remaining term of the lease.  Charges generally treated as “rent reserved” include minimum rent, real estate taxes, insurance, common area maintenance charges and annual capital improvement fees.  Charges typically excluded from “rent reserved” include utility charges, maintenance and repair expenses, remodeling and reconstruction costs, service charges, re-letting fees, attorneys’ fees, janitorial expenses, liquidated damages and interest. 

Once the Section 502(b)(6) cap is calculated, any security deposit (whether in the form of cash or a letter of credit) securing the debtor-tenant’s lease obligations generally must be deducted in determining the landlord’s maximum allowable claim for lease termination damages. 

VII.         CONCLUSION

As is apparent from the foregoing discussion, the filing of a bankruptcy case by a tenant in the United States presents a number of challenges for a commercial landlord, based on various provisions of the U.S. Bankruptcy Code that may change the parties’ otherwise applicable rights and obligations pursuant to the terms of the lease and applicable non-bankruptcy law.