How Bankruptcy Affects Landlords, Part 1
By Thomas Rice and Patrick Huffstickler
I. INTRODUCTION
Section 365 of the Bankruptcy Code,
11 U.S.C. § 365, addresses issues
involving executory contracts and unexpired
leases. It is the longest section of the
Bankruptcy Code and clearly demonstrates
the importance of the debtor’s executory
contracts and unexpired leases as assets of
the bankruptcy estate.
Issues involving unexpired leases can
play a vital role in many different types of
bankruptcies. A debtor’s ability to maintain
retail operations in various leased
locations may be critical to the ultimate
success of a plan of reorganization.
Furthermore, the debtor’s ability to reject
leases that have become burdensome,
while limiting the damages related to such
rejection, can often lead to a more efficient
and profitable use of the debtor’s
remaining assets. Additionally, if the
debtor is capable of finding a willing purchaser,
then the unexpired lease may provide
additional value to the debtor
through either eliminating all damages
related to the rejection of the lease or by
creating a surplus of funds to the debtor.
The playing field relating to unexpired
leases, however, has been changed with the
enactment of the Bankruptcy Abuse
Prevention and Consumer Protection Act
of 2005 (BAPCPA).1 The ratification of
BAPCPA created a shorter time frame for
the debtor to operate its leased locations
without obtaining support from landlords.
Additionally, the debtor’s ability to assign
leases to interested third parties has been
modified.
Even with the changes in the
Bankruptcy Code, a debtor’s unexpired
leases remain a very crucial and valuable
asset that could affect a debtor’s ability to
reorganize. Due to the wide scope of
Section 365 and the wealth of case law interpretating this section of the
Bankruptcy Code, this paper will address
some general concepts, including the new
provisions set forth in BAPCPA, while citing
representative case law, without
attempting to be exhaustive.
II. CREATION OF THE BANKRUPTCY
ESTATE, AUTOMATIC STAY, IPSO
FACTO CLAUSES, AND RELIEF FROM
STAY
A. Creation Of The Bankruptcy Estate
Leases as Property of the Estate: Upon commencement of the bankruptcy
case, a bankruptcy estate is created and
the estate is comprised of, among other
things, “all legal or equitable interests of
the debtor in property as of the commencement
of the case.” 11 U.S.C. §
541(a)(1). This provision includes any
rights that the debtor may hold in an
unexpired lease as of the date of the bankruptcy
filing. See e.g., In re Rickel Home
Centers, Inc., 209 F.3d 291 (3d Cir. 2000);
In re Palace Quality Servs. Indus., 283 B.R.
868 (Bankr. E.D. Mich. 2002). In this
regard, it should be noted that property of
the estate does not include any interest of
the debtor as a lessee under a lease of nonresidential
real property that is terminated
at the expiration of the stated term of the
lease before the commencement of the
case. 11 U.S.C. § 541(b)(2). Additionally,
property of the estate ceases to include any
interest of the debtor as a lessee under a
lease of non-residential real property that
terminates at the expiration of the stated
term of the lease and the expiration date
occurs during the time the bankruptcy
case is pending. Id. See also, Erickson v.
Polk, 921 F.2d 200 (8th Cir. 1990); In re
Hickory Point Indus., Inc. 83 B.R. 805
(M.D. Fla. 1988).
Practice Point: It should be emphasized
at this point that property of the estate
does not include rights under leases that
were appropriately terminated under
applicable non-bankruptcy law (i.e., state
law) prior to the time that the bankruptcy
case was filed. See In re Gande
Restaurants, 162 B.R. 345 (Bankr. M.D. Fla.
1993). Thus, if the landlord anticipates a
bankruptcy filing by the tenant and desires
to have control of the leased premises free
of the bankruptcy case, the landlord, if the
opportunity is available, should terminate
the lease prior to the bankruptcy filing, so
that the subsequently bankrupt former
tenant has no Bankruptcy Code protected
interest in the leased premises. Of course,
termination has to be effectuated properly
and a great deal of litigation has arisen in
bankruptcy courts over whether a lease
was properly terminated pre-petition. See,
e.g., In re Trang, 58 B.R. 183 (Bankr. S.D.
Tex. 1985). A further point to note is that
termination in this regard should be complete
termination of the lease, and not
simply termination of the right of possession
(which is allowed under many state
laws, including Texas). As the bankruptcy
courts do not favor lease forfeitures (as
leases are seen as valuable assets of the
bankruptcy estate in many instances), less
than complete termination may allow the
bankruptcy court to protect the debtor
(potentially by allowing debtor to retain
control and possession of the leased premises)
to the detriment of the landlord. See,
e.g., Hart Envtl. Mgmt. Corp. v. Sanshoe
Worldwide Corp. (In re Sanshoe Worldwide
Corp.), 993 F.2d 300 (2d Cir. 1993); Vanderpark Props., Inc. v. Buchbinder(In re
Windmill Farms, Inc.), 841 F.2d 1467 (9th
Cir. 1988); In re Dash, 267 B.R. 915 (Bankr.
D.N.J. 2001); In re 1345 Main Partners, 215 B.R. 536 (Bankr. S.D. Ohio 1997);
In re Old
Pike Pub, Inc., 115 B.R. 13 (Bankr. D.R.I.
1990).
B. Automatic Stay
Also, upon commencement of the
bankruptcy case, one of the fundamental
protections for the debtor arises, the automatic
stay. In the context of the
landlord/tenant relationship, the automatic
stay prevents the landlord or tenant
from terminating the lease. See In re Borbridge, 66 B.R. 998 (Bankr. E.D. Pa.
1986) (reviewing existing case law on
applicability of the automatic stay to leases).
It also prevents the landlord, or in
certain instances, the tenant, from
attempting to collect lease obligations that
arose prior to the date of the bankruptcy
filing. The automatic stay, arising under
section 362 of the Bankruptcy Code operates
as a stay of the commencement or
continuation of judicial, administrative, or
other action or proceeding against the
debtor that could have been commenced
before the commencement of the case to
recover a claim against the debtor that
arose before the commencement of the
bankruptcy case, and acts as a stay of any
act to obtain possession of property of the
estate, or of property from the estate, or to
exercise control over property of the
estate. 11 U.S.C. § 362(a)(1), (2), (3), and
(6). Thus, forcible entry and detainer or
eviction actions are stayed by the filing of
a bankruptcy case. See, e.g., In re Smith
Corset Shops, Inc., 696 F.2d 971 (1st Cir.
1982).
Similarly, personal property leases can
not be cancelled and, in fact, the debtor
can insist on performance from the other
contracting party. Prior to the debtor’s
assumption or rejection of the contract, a
personal property lease under Chapter 11 is
not enforceable against the debtor party,
but is enforceable against the non-debtor
party. NLRB v. Bildisco & Bildisco, 465
U.S. 513, 532 (1984). The only remedy a
non-debtor party has to the continued
enforcement of its obligations under the
lease is to request an order from the court
under Section 365(d)(2), requiring the
debtor to assume or reject the contract.
See In re Grant Broadcasting of
Philadelphia, Inc., 71 B.R. 891 (Bankr. E.D.
Pa. 1987). Unfortunately for such party, it
can only insist on compensation as an
administrative claim in an amount equal
to the benefit conferred on the estate. In
re Globe Metallurgical, Inc., 312 B.R. 34, 39,
(Bankr. S.D.N.Y. 2004); In re Patient Educ.
Media, 221 B.R. 97, 101 (Bankr. S.D.N.Y.
1998); Broadcast Corp. of Georgia v. Broadfoot, 54 B.R. 606 (N.D. Ga. 1985);
Beneke Co. v. Economy Lodging Sys. (In re
Economy Lodging Sys.), 234 B.R. 691
(B.A.P. 6th Cir. 1999); In re Gamma
Fishing Co., 70 B.R. 949 (Bankr. S.D. Cal.
1987). See also, Bethlehem Steel Corp. v. BP
Energy Co. (In re Bethlehem Steel Corp.),
291 B.R. 260, 264 (Bankr. S.D.N.Y. 2003)
(Contract rate is presumed to be reasonable
value of goods or services unless party
challenging rate introduces convincing
evidence to the contrary).
On the other hand, as stated above,
leases that have been terminated under
appropriate non-bankruptcy law pre-petition
are not assets of the estate. In recognition
of this situation, section 362(b) of
the Bankruptcy Code provides that the filing
of bankruptcy does not operate as a
stay of any act by a lessor to the debtor,
under a lease of non-residential real property,
that has terminated by expiration of
the stated term of a lease before the commencement
of or during a case under the
Bankruptcy Code to obtain possession of
such property. 11 U.S.C. § 362(b)(10).
C. Exceptions to the Automatic Stay
for Residential Real Property
Under BAPCPA, Congress enacted additional
exceptions to the automatic stay
relating to a landlord’s ability to pursue
remedies under a residential real property
lease. Each of these new enactments places
additional burdens on both the debtor and
the landlord in the landlord’s attempt to
recover possession of the premises.
1. Ability to Cure Monetary Defaults
In the event the landlord has obtained
a judgment for possession of the premises
prior to the debtor seeking bankruptcy
protection, the landlord may continue to
pursue recovery of the premises thirty (30)
days after the petition date, if the debtor
has not met the standards set out in section
362(l). Section 362(b)(22) provides:
The filing of a petition. . . does not
operate as a stay-
(22) subject to subsection (l), under
subsection (a)(3), of the continuation
of any eviction, unlawful detainer action, or similar proceeding
by a lessor against a debtor
involving residential property in
which the debtor resides as a tenant
under a lease or rental agreement
and with respect to which the lessor
has obtained before the date of the
filing of the bankruptcy petition, a
judgment for possession of such
property against the debtor.
11 U.S.C. § 362(b)(22). Under section
362(l), the debtor is given the opportunity
to demonstrate through a certification
filed with the Court, which is executed
under penalty of perjury, that (1) applicable
nonbankruptcy law in the jurisdiction
where the debtor resides provides the
debtor an opportunity to cure the monetary
default that gave rise to the judgment
for possession and (2) the debtor deposited
with the clerk of the court, any rent
that would come due during the 30-day
period following the filing of the bankruptcy
petition. 11 U.S.C. § 362(l)(1). If
the debtor is able to comply with section
362(l)(1) and files an additional certification
that the debtor has cured within the
30-day period all monetary defaults for
which the judgment of possession was
obtained, then section 362(b)(22) is not
applicable, unless the landlord objects to
either of the certifications. If the landlord
objects to either certification, then the
bankruptcy court will hold a hearing in
ten (10) days to consider the objection. 11
U.S.C. § 362(l)(3)(A). If the court upholds
the objection, then section 362(b)(22) shall
apply immediately and relief from the
automatic stay will not be required to continue
any action for eviction or unlawful
detainer. 11 U.S.C. § 362(l)(3)(B).
Additionally, in filing the bankruptcy
petition, the debtor is now required to
indicate that a judgment for possession of
residential real property was obtained prepetition.
11 U.S.C. § 362(l)(5). If the
debtor does make the indication required
under section 362(l)(5) and fails to make
the certifications under sections 362(l)(1)
or (2), then section 362(b)(22) shall apply
immediately and no further relief from the
automatic stay will be required. 11 U.S.C. §
362(l)(4).
2. Endangerment of the Residential Real
Property
In addition to the protection of the
landlord’s ability to continue pursuit of
eviction remedies based on a pre-petition
judgment of possession, BAPCPA provides
an exception to the automatic stay where
the debtor is either endangering the residential
real property or illegally using controlled
substances on the residential real
property. Section 362(b)(23) provides:
The filing of a petition . . . does not
operate as a stay-
(23) subject to subsection (m),
under subsection (a)(3), of an eviction
action that seeks possession of
the residential property in which the
debtor resides as a tenant under a
lease or rental agreement based on
endangerment of such property or
the illegal use of controlled substances
on such property, but only if
the lessor files with the court, and
serves upon the debtor, a certification
under penalty of perjury that
such an eviction action has been
filed, or that the debtor, during the
30-day period preceding the date of
the filing of the certification, has
endangered property or illegally
used or allowed to be used a controlled
substance on the property.
11 U.S.C. § 362(b)(23). Upon the filing
of the certification by the landlord, the
debtor has fifteen (15) days to object to the
landlord’s certification or section
362(b)(23) will apply. 11 U.S.C. §
362(m)(1). The debtor may file an objection
to the truth or legal sufficiency of the
landlord’s certification and the court shall
hold a hearing on the objection within ten
(10) days after filing and service of the
objection. 11 U.S.C. § 362(m)(2)(A)—(B).
Depending on the court’s decision, either
section 362(b)(23) will apply, if the court
accepts the landlord’s certification, or the
automatic stay will remain in place, if the
court approves the debtor’s objection. 11
U.S.C. § 362(m)(2)(C)-(D). If the debtor
fails to object within the 15-day period,
then section 362(b)(23) shall apply immediately
and further relief from the automatic
stay will not be required to pursue
eviction of the debtor. 11 U.S.C. §
362(m)(3).
D. Ipso Facto Clauses
Section 362 of Bankruptcy Code needs
to be read in tandem with section 365 of
the Bankruptcy Code. One issue that
often arises when a party files bankruptcy
is that the landlord, upon reviewing its
contract or lease, discovers a standard provision
that states the agreement can be terminated,
or that the contract or lease is
automatically terminated, if the other
party files bankruptcy. Unfortunately for
the non-bankrupt party, and fortunately
for the bankrupt, Congress, when it
rewrote the bankruptcy laws in 1978, felt
that such provisions should not be
enforceable (which was the opposite of the
situation that existed prior to the enactment
of the Bankruptcy Code as the prior
Bankruptcy Act recognized and allowed
the bankruptcy courts to enforce such
provisions). Such provisions, known in
bankruptcy parlance as ipso facto clauses,
are unenforceable under section 365(e)(1)
of the Bankruptcy Code. 11 U.S.C. §
365(e)(1). Again, however, section
365(e)(1) does not serve as a basis for
revival of a lease terminated prior to the
bankruptcy filing. See, e.g., Comp III, Inc.
v. Computerland Corp., 136 B.R. 636
(Bankr. S.D.N.Y. 1992). As noted by
another court, where the debtor breached
a contract and the contract was terminated
as a result of the breach, the termination is
valid and does not arise out of an ipso
facto clause. Nemko, Inc. v. Motorola, Inc.,
(In re Nemko, Inc.), 163 B.R. 927 (Bankr.
E.D.N.Y. 1994). In addition to allowing
the stay to be lifted for “cause,” a court
can also grant relief from the stay, if the
landlord can demonstrate that the debtor
has no equity in the property and the
debtor cannot show that the property is
necessary for an effective reorganization.
11 U.S.C. § 362(d)(2).
E. Relief From The Stay
While the automatic stay prohibits termination
of a lease once the bankruptcy
case is filed and section 365(e)(1) invalidates
automatic termination through ipso
facto clauses, the other party to the lease
can still attempt to terminate the agreement
post-petition by filing a motion for
relief from the automatic stay pursuant to
section 362(d). Section 362(d)(1) of the
Bankruptcy Code allows the bankruptcy
court to grant relief from the stay by terminating,
annulling, modifying, or conditioning
the stay for cause. 11 U.S.C. §
362(d)(1). With respect to leases, cause has
been found to exist for lifting the automatic
stay, where, for instance, the landlord
allegedly terminated the lease pre-petition
for non-payment of rent. See In re
Masterworks, Inc., 94 B.R. 262 (Bankr. D.
Conn. 1988). Also, even if the termination
issue is unclear, the bankruptcy court may
lift the stay to allow the parties to address
the issue in state court. See In re Escondido
West Travelodge, 52 B.R. 376 (S.D. Cal.
1985).
Avoidance of Landlord’s Lien
The Bankruptcy Code provides that a
trustee or DIP may avoid the fixing of a
statutory lien on property of the debtor for
rent or distress for rent. 11 U.S.C. § 545 (3)
– (4). The Fifth Circuit has further elaborated
on the term rent in avoiding the fixing
of a lien on a royalty interest. Duck
Lake Acquisition Partners LP v. Gulfport
Energy Corp. (In re WRT Energy Corp.),
169 F.3d 306 (5th Cir. 1999). See also In re
A&R Wholesale Distrib., Inc., 232 B.R. 616,
620 (Bankr. D.N.J. 1999)(citing numerous
cases affirming avoidance of landlord’s
lien).
1 The Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005 was signed into
law on April 20, 2005.
Thomas Rice is a shareholder with the
law firm of Cox Smith Matthews
Incorporated specializing in bankruptcy
matters. He has practiced law for 6 years
and has extensive experience in representing
debtors, creditors, and chapter 11 Trustees in
numerous national, regional, and local
bankruptcy cases. Mr. Rice graduated from
the University of California, Los Angeles in
1995 and from the Pepperdine University
School of Law in 1999 (cum laude).
Patrick L. Huffstickler is a shareholder
with the law firm of Cox Smith Matthews
Incorporated specializing in bankruptcy
matters. He has practiced law for 20 years
and has extensive experience in representing
landlords and tenants in numerous national,
regional, and local bankruptcy cases. Mr.
Huffstickler also handles uniform commercial
code and other commercial litigation
matters. Mr. Huffstickler represents commercial
landlords, including retail malls and
shopping centers, with respect to numerous
issues involving real property leases, including
negotiating and drafting termination
and modification agreements, in both bankruptcy
and non-bankruptcy matters. Mr.
Huffstickler graduated from Trinity
University in 1983 (cum laude) and from the
University of Texas School of Law in 1986
(with honors).
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