Circuit Court Addresses Post-Petition Lease Obligations Questions remain regarding other courts and whether lessors are still at a disadvantage.

Transcription

1 Leasing Law Circuit Court Addresses Post-Petition Lease Obligations Questions remain regarding other courts and whether lessors are still at a disadvantage. Arecent decision by a U.S. Circuit Court of Appeals helps equipment leasing companies collect rentals in true lease transactions that come due after a lessee s chapter 11 bankruptcy filing, commonly called post-petition rental payments. Leases intended for security, such a dollar out leases, are governed by different rules in bankruptcy proceedings and are treated like secured loans. The discussion that follows relates only to true leases of equipment. Lessors can claim rentals that come due during the initial 59- day period as administrative expenses. However, recovery of administrative expenses ie not as automatic as are recovery of rentals. The Ha-Lo Industries case (2003 U.S. App. LEXIS (September 3, 2003)) decided by the Seventh Circuit Court of Appeals involved a real estate lease. Enacted in 1984, section 365(d)(3) of the Bankruptcy Code requires that all bankruptcy debtors timely perform all the obligations of the debtor arising from and after the [bankruptcy] order for relief under any unexpired lease of nonresidential real property. This provision affecting commercial real property has an equipment lease counterpart in section 365(d)(10) of the 12 November/December 2003

2 Code (for whose 1994 enactment ELA was the driving force). Section 365(d)(10) requires that chapter 11 debtors timely perform all obligations of the debtor first arising from or after 60 days after the order for relief in a case under chapter 11 under an unexpired [commercial] lease of personal property. These post-petition lease payment obligations subsist until the debtor-lessee elects to assume or reject (i.e., continue or discontinue) the real estate or equipment lease. Because these two provisions are parallel, differing materially in chapter 11 proceedings only as to the 59-day waiting period for equipment leases, cases decided under section 365(d)(3) for real estate leases have direct and persuasive application to equipment leases in chapter 11 cases under section 365(d)(10). As explained in In re MUMA Services Inc., 279 B.R. 478, 487 (Bankr. D. Del. 2002): Given the similarities between section 365(d)(3) and section 365(d)(10), we conclude that the Third Circuit would construe section 365(d)(10) in the same manner. It should be remembered that equipment lessors can claim rentals that come due during the initial 59-day period in the chapter 11 case as administrative expenses. See MUMA Services, at pp for a discussion of this majority view and a listing of the cases that have addressed this issue. However, recovery and the amount of recovery of administrative expenses are not as automatic as are recovery of equipment lease rentals that come due on day 60 and thereafter in a chapter 11 proceeding. Aligning the Courts In the recent Ha-Lo case, real estate lease payments were due monthly in advance on the first of each month. During the post-petition period, the debtor rejected the real estate lease and vacated the premises by November 4. Was the debtor obligated to pay the landlord rent for the whole month of November (the so-called performance date rule ), or only the pro-rated rent for the four days occupancy before the debtor rejected the lease and vacated the premises (the so-called proration rule )? The Seventh Circuit applied the performance date rule and held that section 365(d)(3) requires the debtor to pay all obligations that arise post-petition up to the time of rejection. Since the full rental obligation for November became due and payable post-petition and pre-rejection, the entire rental amount had to be paid with no deduction for the substantial part of the month after rejection. This brings the Seventh Circuit into alignment with the two other Circuit Courts of Appeal that have addressed this issue. The Third Circuit (covering Delaware, New Jersey and Pennsylvania) in In re: Montgomery Ward Holding Corp., 268 F.3d 205, 209 (3d. Cir. 2001) adopted the performance date rule, explaining: [I]t is difficult to find a textual basis for a proration approach. On the other hand, an approach which calls for the trustee [or debtor] to perform obligations as they become due under the terms of the lease fits comfortably with the statutory text. The Sixth Circuit (covering Kentucky, Michigan, Ohio and Tennessee) in In re: Koenig Sporting Goods, Inc., 203 F.3d 986 (6th Cir. 2000) also has adopted the performance date rule. Generally, this is good news for equipment leasing companies. Chapter 11 debtors have to pay in full all equipment lease obligations that come due from day 60 onward until the lease is assumed or rejected. However, this seemingly straightforward and apparently helpful performance date rule adopted now by three Circuit Courts of Appeal raises issues that add complexity and, perhaps, variability to the results an equipment leasing company may experience in its lessee s chapter 11 proceeding. While the three Circuit Courts of Appeal to address the issue have adopted the performance date rule, at least as to payments due in advance, there is a conflict between the Seventh Circuit and the Third Circuit with respect to lease payments due in arrears where a part of the lease payment obligation accrued pre-petition. In the recent Ha-Lo case, the Seventh Circuit distinguished its earlier decision in In re: Handy Andy Home Improvement Centers, Inc., 144 F.3d 1125 (7th Cir. 1998). That case involved a landlord s attempted flow-through of real estate taxes to a debtor-tenant for past tax periods. The flow-through billing occurred post-petition but subsumed, in large part, taxes that accrued during the pre-petition period. The landlord urged the performance date rule, but the court applied a proration rule expressing concern about saddling a reorganizing debtor with sunk costs that accrued pre-petition. In the recent Ha-Lo decision, involving lease payments in advance, the court distinguished this earlier Handy Andy decision on the basis of these sunk costs concerns and the fact that the lease payment at issue in Ha-Lo arose entirely postpetition and prerejection. The Seventh Circuit s Handy Andy decision directly conflicts with the Third Circuit s decision in Montgomery Ward that also involved the post-petition November/December

3 Even in jurisdictions that have adopted the performance date rule, circumstances could arise where it could be used to the advantage of a debtor, and to the disadvantage of a lessor. billing and collection of real estate taxes that had accrued pre-petition. In permitting the landlord to recover these tax pass-throughs, the Third Circuit recognized that the Seventh Circuit had reached the opposite conclusion and opted for a proration approach in Handy Andy. (268 F.3d at 211.) Several lower courts have adopted the proration rule. See In re Furr s Supermarkets, Inc., 283 B.R. 60 (10th Cir. B.A.P. 2002); In re: All For A Dollar, Inc., 174 B.R. 358 (Bankr. D. Mass. 1994). A very substantial number of these proration decisions involve this same issue of substantial post-petition lease payments due in arrears for real estate taxes that had accrued at least in part pre-petition; and this pre-petition accrual aspect appears to play an important part of those courts reasoning as it did in the Handy Andy case. See In re: Child World, Inc., 161 B.R (S.D.N.Y. 1993); In Re: Learningsmith, Inc., 253 B.R. 131 (Bankr. D. Mass. 2000); In re Victory Markets, Inc., 196 B.R. 6 (Bankr. N.D.N.Y. 1996). Courts that have adopted the proration rule for obligations that accrued pre-petition have done so because of the perceived more equitable or fair results it produces. The perceived inequity of burdening debtors with large obligations that accrued during the pre-petition period has been characterized by these courts as inconsistent with the usual treatment of claims having pre-petition and post-petition aspects. Some courts have looked to the policy of narrowly construing statutory priorities in order to treat creditors as equally as possible. (In re Child World, Inc., 161 B.R. 571, 576 (S.D.N.Y. 1993). In any event, the cases are in conflict and cannot be reconciled on the basis of the pre-petition or post-petition accrual or the advance or arrears aspects of the lease payment obligation. Whether distinct and consistent rules will coalesce around these aspects will have to await further case law or legislative developments. We will also have to wait to see if lower courts that have followed the proration rule and are not bound by these Circuit Court decisions will nevertheless align with the trend towards the performance date rule reflected in the Circuit Court decisions. See Urban Retail Properties V. Loews Cineplex Entertainment Corporation, 2002 U.S. Dist. LEXIS 6168 (S.D.N.Y. 2002) following the recent line of authority refusing to adopt the proration approach. Advantage: Lessee? Even in those jurisdictions that have adopted the seemingly beneficial performance date rule, circumstances could arise where this rule could be used to the advantage of a chapter 11 debtor, and to the disadvantage of an equipment leasing company. After all, the performance date rule necessarily has a magic date element that can be manipulated in favor of the debtor who generally can choose the timing for its bankruptcy filing and its rejection of an equipment lease. As explained in In re: McCrory Corporation, 210 B.R. 934, 940 (S.D.N.Y. 1997): Reliance strictly on the billing date would result in a windfall either to the landlord or the debtor-tenant a windfall would flow to the debtor-tenant where annual taxes for the coming year fell due one day before the petition is filed Could a debtor take advantage of the performance date rule by purposely failing to make an equipment lease payment on the first of a month and filing a bankruptcy petition the next day so as defer the mandatory lease payment date for as long as possible? This timing circumstance was involved in In re: Appletree Markets, Inc., 139 B.R. 417 (Bankr. S.D. Tex. 1992) where the court held that a debtor filing on January 2 was not obligated under section 365(d)(3) to pay real estate lease rent (whether payable monthly, quarterly or annually) [that] fell due on January 1, 1992 the day before the debtors filed for [bankruptcy] relief. See also The _ Off Card Shop, Inc., 2001 Bankr. LEXIS 988 (Bankr. E.D. Mich. 2001), vacated 2002 Bankr. LEXIS 507 (Bankr. E. D. Mich. 2002). On the other hand, In re: Travel 2000, Inc., 264 B.R. 444 (Bankr. W.D. Mich. 2001) applied the proration rule to benefit landlords where the debtor-lessee filed its bankruptcy petition on February 2 and 14 November/December 2003

4 rejected the real estate leases effective on February 28. While one may applaud this result, the holding can not be squared with the performance date rule, nor can an equipment leasing company count on employing the performance date rule or the proration rule as it sees fit depending on which rule yields a more favorable result. Under section 365 of the Code, chapter 11 debtors have broad latitude to determine if and when they will assume or reject equipment leases. While bankruptcy court approval is needed to assume or reject an equipment lease, that approval usually is available since courts apply a business judgment test that accords to debtors significant discretion in this regard. Using this timing flexibility, can chapter 11 debtors use the performance date rule offensively? For example, will the debtor time the rejection of an equipment so as to occur just before a lease payment due date and thus minimize its section 365(d)(3) or (10) mandatory payment obligations? If a debtor Could a debtor purposely fail to make a lease payment on the first of a month and file a bankruptcy petition the next day so as defer the mandatory lease payment date as long as possible? waits to reject a lease just before a quarterly equipment lease rental is due, the debtor-lessee has maximized its use of the personal property and minimized its post-petition payment November/December

5 obligation under the performance date rule. This adverse impact on the lessor is exacerbated if the quarterly lease payment is due in arrears. Finally, could the pre-bankruptcy planning for a debtor-lessee (such as a national retail chain) with significant real estate or equipment lease obligations include consideration of where to file its bankruptcy petition under the liberal venue provisions applicable to bankruptcy proceedings? The debtor-lessee may select a bankruptcy court in a jurisdiction that endorses the rule under section 365 (d)(3) and (10) most advantageous to that debtor s particular circumstances and plans. What We Know Given these complexities, what can be concluded about these decisions? 1. Results may vary depending on which of the two rules has been adopted in the jurisdiction where the debtor-lessee s bankruptcy case is pending. 2. Whether an equipment leasing company fares better under the performance rule or the proration rule may depend on the lease payment structure and the timing of the debtor-lessee s actions in the chapter 11 proceeding; 3. Widely spaced lease payments, particularly those due in arrears, may permit a debtor-lessee more latitude to manipulate the results in its favor under the performance date rule; and 4. With the plethora of recent cases and the substantial disagreement in those decisions, Ha-Lo likely is not the last word on this subject. ELT thanks John C. Chobot, corporate counsel at Lucent Technologies and adjunct professor at Seton Hall Law School, for this month s column. 16 November/December 2003