Bankruptcy abuse

Last month, President Bush signed a new Bankruptcy Abuse, Prevention and Consumer Protection Act of 2005 into law.

The act ncludes a number of amendments to the current bankruptcy code that will have an impact on bankruptcies involving commercial leases.

Overall, the new act changes the time for a tenant to assume or reject a lease, limits a tenant's ability to assign a lease, and limits damages available to a landlord for certain post-bankruptcy defaults.

Current Law Under current law, a debtor may elect to terminate (or "reject" in bankruptcy terms), or maintain ("assume" in bankruptcy terms) any commercial lease, subject to court approval.

If a tenant rejects its lease, it must surrender the premises and the landlord may seek damages from the early termination in the bankruptcy action, although the amount of damages that can be sought is capped by the code.

If the tenant elects to assume its lease, it is basically required to cure all outstanding defaults, and is also required to provide "adequate assurance" of future performance.

Once a lease is assumed, the debtor assumes all obligations under the lease.

If the debtor subsequently defaults, the landlord will be entitled to a priority administrative claim for such damages in the bankruptcy action.

The debtor can also assign the lease to a third party, regardless of whether the lease itself imposes any prohibition, restriction or condition on assignment.As to that period of time during which a tenant evaluates whether to assume or reject a lease, courts in this circuit have interpreted the law as requiring the tenant to pay full rent and perform all obligations under the lease during such period.

Amendments in new act One of the more significant changes affecting commercial leases is an amendment to the time a tenant has to assume or reject a commercial lease.Under the former law, a tenant was required to assume or reject a commercial lease within 60 days after the date it filed bankruptcy, unless the court determined good cause existed to extend such time.

Any failure of a tenant to assume the lease within this time was deemed an automatic rejection.

It was not uncommon, however, for courts to grant tenants extensions up to and even through plan confirmation.

The new act extends the initial period of time to assume or reject a commercial lease from 60 days to the earlier of 120 days or the date a plan of reorganization is confirmed.

The court retains discretion to extend the deadline, but only for an additional 90 days.

Significantly, the new act prohibits any further extensions unless the landlord consents in writing.

The result of the new act is that a tenant has, at a minimum, twice as long to make its election, and may have up to 210 days to assume or reject a lease without ever seeking the consent of the landlord.While the result may appear worse on its face for landlords, some believe it may actually favor landlords by preventing what has become a common practice among some courts to extend the 60-day period to plan confirmation.

The new act should also decrease uncertainty for landlords by preventing a debtor from extending the assumption/rejection decision through or even beyond plan confirmation, a date which could be years after the bankruptcy filing.

Debtor must get consent Another important aspect of the amendment is it now requires a debtor to secure a landlord's consent for extensions beyond 210 days.

This opens the door for landlords and tenants to negotiate any number of alternatives, including kick-outs for failure to meet sales thresholds, in order to accommodate the needs of both parties.

For example, a tenant may be unwilling to assume a lease for a seasonal store until it sees the sales results during the selling season.

The landlord may be forced to agree to an extension rather than face a dark store during that critical time of year.

Conversely, a landlord may be willing to risk a dark store in order to get the premises back.

In that case, the tenant will have to weigh the risk of a post-assumption default (and the new limits on administrative rent claims) against losing what may be a prime location.

Damage claim capped The act also caps a landlord's damage claim for a post-assumption default.Under former law, a landlord was entitled to a priority administrative claim for the entire remaining balance of the lease term if a post assumption default occurred.

The act now limits a landlord's unpaid rent claim to no more than two years following the later of the rejection or the actual abandonment of the premises, and further grants a debtor a right of offset for amounts received by the landlord or to be received from an entity other than the debtor.

Any damages in excess of this new cap will be treated as general unsecured claims, subject to the existing damage cap.

This new provision will reduce any detrimental effect on a tenant who is forced to make a premature assumption of a commercial lease.

Finally, the amendments also impact a tenant's ability to assign the lease.

Currently, the code allows a tenant to assign a lease to a third party, even if the lease itself prohibits assignment.

This may provide a valuable asset to a tenant where the tenant's existing lease is below market.

Tenants in this circumstance will now have to make assignment decisions much earlier in the case, or they will risk running up against the 210-day limitation and a landlord who is unlikely to consent to any further extension.

The act also includes a significant amendment related to assignment of shopping center leases.

Current law indicates that any assignment of a shopping center lease is subject to radius, location, use and exclusivity restrictions.

However,most courts held that the assignment limitations prohibited a shopping center landlord from enforcing these restrictions, creating a conflict between two sections of the existing code.

The new act clarifies this by providing that one section takes precedence over the other, thereby permitting a shopping center landlord to enforce tenant mix and balance restrictions and prevent assignment to a third party that cannot satisfy such restrictions.

In conclusion, the new amendments to the bankruptcy code may have a significant effect on commercial leases with regard to both the amount of time it takes to confirm a plan of reorganization and the options a tenant will have with regard to its commercial leases.

While the amendments appear to favor landlords, it will be interesting to see whether, in practice, debtor's counsel or the courts attempt to spin the amendments back in favor of debtors, as debtors will undoubtedly look for ways to overcome these new limitations.

In the meantime, the new amendments will likely spur negotiations between landlords and tenants, as they try to find a middle ground balancing a landlord's goal of maintaining occupancy and control with a tenant's objective of maximizing its assets and reorganizing its business.

Michael Pagni is a partner at the law firm of McDonald Carano Wilson whose practice focuses primarily on real estate, administrative and transactional law.