Much has been written about the risk that a transaction denominated and documented as an equipment “lease” may be recharacterized a security interest. Indeed, it is old hat that UCC 1-203 is the basis of the analytical framework for determining whether an ostensible lease is actually a disguised security device. And, it is well understood that if the agreement at issue places the benefits and burdens of asset ownership on the so-called lessee, then a reviewing court will treat the transaction as a security interest and will treat the parties as secured lender and debtor, rather than as lessor and lessee. The result of such recharacterization can cause a lot of pain to the would-be lessor, unless that party made a prophylactic filing to comply with Article 9′s perfection rules.
Equipment lessors seem, at least in our experience, to understand all of this. Consequently, they tend to make the requisite filing and when an oversight occurs, they tend to understand the consequences of that oversight. Interestingly, equipment lessors commonly seem to not understand all of the rights and remedies they have in the absence of recharacterization.
So, what’s a true equipment lessor to do in the face of the Chapter 11 of its lessee?
The Debtor Has Three Basic Options
In bankruptcy, an unexpired lease is deemed an executory contract and is controlled by Bankruptcy Code § 365. Executory contracts are generally defined as agreements in which there are mutual obligations outstanding as of the filing of the bankruptcy petition. In essence, the lease continues as it did before the agreement, with payments being made and equipment being leased.
The debtor (or trustee if a case is filed under Chapter 7 or if one has been appointed in a Chapter 11) has three basic options when it comes to executory contracts:
- assume the agreement;
- reject the agreement; or
- assume and assign it to a third party.
Timing to Decide
Under Chapter 7, the trustee has 60 days to assume, or assume and assign the lease before it is deemed automatically rejected, though this period can be extended by court order. In Chapter 11, in contrast, the debtor has until confirmation of a plan to decide whether to assume or reject a contract unless the lessor persuades the court (though a motion) to shorten the period of time. In deciding whether to grant or deny such a motion, “a bankruptcy court should ensure that assumption or rejection occurs within a ‘reasonable time,’ with ‘[w]hat constitutes a reasonable time’ being ‘left to the bankruptcy court’s discretion in light of all relevant facts and circumstances.’ The movant bears the burden of demonstrating cause to shorten the debtor’s time to decide to assume or reject a lease.” In the Matter of Memory Lane of Bremen, LLC, 535 B.R. 901, 906 (Bankr. N.D. Ga. 2015) (internal citations omitted).
The Three Debtor Options Explored
The assumption of an executory contract means the reaffirmation of the terms of the agreement. In other words, things generally stay as they were. If the debtor assumes an executory contract, it is required to cure (i.e., satisfy) all arrearages under the lease.
In many instances, however, the cure cost is prohibitively expensive. In those situations where the debtor wants to assume the executory contract but cannot afford the cure cost, it may try to negotiate a lower cure cost or otherwise seek to amend the lease with the lessor.
The rejection of an executory contract is deemed a prepetition termination of the agreement and the lessor is entitled to rejection damages — as provided for under the lease. Rejection is essentially a breach of contract, and damages are treated as general unsecured claims. A lessor has an affirmative duty to mitigate damages where possible. Decisions on this point can be burdensome on the lessor. See, e.g., In re Phar-Mor, Inc., 336 B.R. 326, 334 (Bankr. N.D. Ohio 2006) (“once a lessor mitigates its damages by re-letting the equipment, the lessor cannot claim damages from the debtor for the period covered by the new lease â€” even if subsequently the new lessee defaults in its obligations to the lessor”).
Objecting to a motion to reject is an option, and advisable to the extent that the goal is to preserve the right to seek administrative status for claims related to post-petition use or damage of the equipment, or for expenses related to recovering the equipment. However, challenging a debtor’s decision to reject is rarely worthwhile because the standard that the bankruptcy court uses when reviewing such a challenge is very deferential to the debtor.
Assumption and Assignment
Finally, a debtor that decides to assume a lease agreement can then seek to assign it to a third party. This is commonly done in the context of a sale of the debtor’s business as a going concern.
“Seek” is an important word in the paragraph above. Under Bankruptcy Code § 365(c)(1), a debtor may not assume or assign an executory contract or unexpired lease if: “(a) applicable law excuses the lessor party from accepting performance from or rendering performance to an entity other than the debtor; and (b) such party does not consent to such assumption or assignment.” So, this acts as a restriction on a debtor’s authority to assign an executory contact to a third party. However, under Bankruptcy Code § 365(f)(1), the trustee may assign such contract or lease notwithstanding a provision in an executory contract or unexpired lease or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease.
More specifically, how do sections 365(c)(1) and 365(f)(1) reconcile?
In In re Nedwick Steel Co., Inc., the Bankruptcy Court for the Northern District of Illinois denied the assignment of a distribution agreement over a creditor-contract party’s objection. 289 B.R. 95, 95 (Bankr. N.D. Ill. 2003). In that case, the debtor attempted to assume and assign a distribution agreement with one of its creditors to a direct competitor of that same creditor. The bankruptcy court, looking to state law, reasoned:
[t]here are three statutory restrictions on the assignment of contracts: (1) where assignment would materially change the duty of the other party; (2) where it would materially increase the burden or risk imposed on him by his contract; and (3) where it would impair materially his chance of obtaining return performance. A fourth restriction is where assignment is precluded by the contract of the parties. Bankruptcy law modifies the fourth restriction by invalidating agreements that prevent the assignment of executory contracts.
Id. at 97 (internal citations omitted). The Nedwick court concluded that UCC 2-210(2), as adopted under Illinois law, prevented the assignment of the contract where it was found to “materially change the duty of the other party, or increase materially the burden or risk imposed on him by his contract, or impair materially his chance of obtaining return performance.”
Using similar reasoning, the Bankruptcy Court for the Western District of Pennsylvania overruled a lessor’s objection to the assumption and assignment of an executory contract noting that the inconsistency between 365(c)(1) and 365(f)(1) was “illusory.” See In re United Foundry Co., Inc., No. BR 05-73035 BM, 2006 WL 6884429, at *6 (Bankr. W.D. Pa. Nov. 2, 2006). In that case, the court reasoned, “[w]hen determining whether Â§ 365(c)(1) trumps Â§ 365(f)(1) in a given instance one must determine why an ‘applicable law’ precludes assignment of the contract. Subsection 365(c)(1) comes into play only when the ‘applicable law’ in question precludes assignment on the rationale that the identity of the party to the initial contract other than the non-debtor party was material to the contract.” Id. at *7.
Accordingly, equipment lessors hoping to prevent the assignment of a lease agreement to a third party need to demonstrate to the court that: 1) there is an applicable law precluding the assignment to the proposed assignee; and 2) the identity of assignee was material to the initial lease agreement. Absent such a showing, a court will likely approve the assignment of the lease.
Debtor Must Perform While Deciding
If a borrower filed bankruptcy while owing an equipment lessor money pre-petition, the lessor has a mere general unsecured claim for the money owed as of the petition date unless and until the debtor decides to assume (and thus cure all defaults).
Obligations that accrue post-petition, on the other hand, are a different story. Under Bankruptcy Code Â§ 365(d)(5), the debtor generally must timely perform all its obligations under the lease, which arise 60 days after the petition date, until such lease is assumed or rejected. During these 60 days, bankruptcy courts have reasoned that post-petition and pre-assumption/rejection lease payments are entitled to administrative expense status so long as the debtor benefitted from the post-petition use of the equipment. See In re Pettingill Enterprises, Inc., 486 B.R. 524, 533 (Bankr. D.N.M. 2013) (“[M]ere possession of the leased property does not constitute a benefit to the estate under Section 503(b) â€¦ The debtor in possession must actually use the property to warrant the lessor’s administrative expense claim.). After 60 days, lessors are automatically entitled to an administrative expense claim for unpaid lease payments.
As a practical matter an equipment lessor must remain vigilant in protecting its post-petition rights during this pre-assumption/rejection period — including monitoring the use of equipment and requiring timely lease payments. And an equipment lessor should be prepared to file a motion to compel payment (and/or compliance generally) as necessary. After all, no one else is likely to enforce an equipment lessor’s rights for it.
Strategies and Tactics
If you understand the above, then you’re ready for a little advanced training (and a little bit of review). Assume that Larry Lessor, your client, calls you and tells you that it leased some equipment to Debtco, a company that recently filed Chapter 11. Here are some things to consider and maybe do (in rough chronological order):
1. Lease or Loan. Ask that Larry provide you with all relevant transactional documents and do a UCC search for the “leased” equipment. Understanding whether Larry has a lease or a disguised security device will prove essential in strategizing.
2. Creditors’ Committee. Larry can seek to participate in the case through serving on the official committee of unsecured creditors, which the Office of the United States Trustee will form if there is enough creditor interest in one. Creditors’ committees are entitled to retain their own counsel and financial advisers at no cost to the committee members, individually.
3. Critical Trade. Although most general unsecured creditors have to wait until the end of a Chapter 11 case to be paid its pre-petition arrearages, it is sometimes possible to get paid near the beginning of the case. This requires the debtor to believe a credit is “critical.” As with a number of the topics we touch on in this article, there is a lot of complexity and nuance to this.
4. Seek Payment for Post-Petition Obligations. Larry should, as noted above, carefully monitor his equipment and watch for timely rental payments from Debtco. In the event that Debtco is not living up to its end of the bargain, Larry should promptly move to compel Debtco to adhere to the lease.
5. Assess the Market. If the market is soft and a lessor is too aggressive, the result can be a “be careful what you wish for” situation. In other words, a lessor shouldn’t fight too hard to get its collateral back if it doesn’t really want it back. Larry should assess whether the leased equipment is above, at, or below market value in order to decide what he wants to happen. If Debtco has a sweetheart deal, Larry may want Debtco to reject the lease so that Larry can re-lease the equipment to another party on a more favorable deal. Inversely, if Larry is happy with the lease terms, he may want to maintain the status quo and support Debtco’s restructuring (or sale).
6. Preserve Right to Seek Admin Claim if Rejection. Bankruptcy Code § 503(b) provides that an administrative claim will only be allowed after notice and a hearing. If Debtco rejects Larry’s lease, he should file a motion for allowance of his post-petition / pre-rejection claim on an administrative basis.
7. Beware Debtor Attempt to Cherry Pick. If Debtco and Larry entered into a master leasing agreement — whereby Larry leased specific equipment to Debtco on an as needed basis under subcontracts, Debtco may attempt to “cherry pick” among these agreements, choosing the most favorable while rejecting the others. Larry should argue that the master agreement is controlling, and accordingly, Debtco must decide to assume or reject all or none of the subject equipment.
Michael Brandess and Jon Friedland are partners with Sugar Felsenthal Grais & Hammer, a boutique law firm with offices in NYC and Chicago, focusing on corporate transactions and securities, restructuring, and estate planning for high—net-worth families and individuals.
The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.