No equipment lessor wants to find itself a creditor of a lessee in a reorganization case under chapter 11 of the U.S. Bankruptcy Code (the Bankruptcy Code). However, when such a situation arises, a lessor is not without recourse – even where the facts give rise to situations not specifically addressed by the Bankruptcy Code. This post considers two scenarios highlighting the exposure creditor-lessors may face in the bankruptcy context and provides guidance for minimizing risk of losses: first, when a debtor-lessee continues to use the subject equipment without payment; and second, where the debtor-lessee no longer uses the subject equipment but has not rejected the underlying lease.
The treatment of unexpired leases and executory contracts (which encompasses equipment leases) is codified in section 365 of the Bankruptcy Code. Section 365 provides, in relevant part, that a chapter 11 debtor-lessee is required to perform under the equipment lease after 60 days from entry of the order of relief until the lease is assumed or rejected. A chapter 11 debtor-lessee may assume or reject an equipment lease any time before confirmation of the chapter 11 plan. The time period between the bankruptcy filing and the time the equipment lease is assumed or rejected is, in effect, the “limbo period.” With the exception of the debtor-lessee’s obligations under section 365(d)(5), during the limbo period, the lease is enforceable by, but not against, the debtor-lessee. Accordingly, it is in this limbo period where equipment lessors can be most vulnerable to non-payment and depreciation in the value of the equipment, for example through continued use or lack of maintenance. It is this exact potential exposure that section 365(d)(5) should minimize. Yet, as the hypothetical scenarios illustrate, provisions of the Bankruptcy Code may assist in minimizing lessors’ potential losses, but lessors must play an active role to maximize the protections afforded by the Bankruptcy Code.
Consider the following:
- A lessee files for bankruptcy protection, continues to use equipment subject to a lease, but does so without making payments (or without making the full contract-rate payment) to the lessor during the limbo period. What recourse, if any, does the lessor have?
- A lessee files for bankruptcy protection, does not make any payments to the lessor, but is not using the subject equipment. What can the lessor do?
Under both fact patterns, the debtor-lessee has ceased to perform under the lease. Accordingly, the lessor has a variety of remedies it can pursue: seeking relief from the automatic stay, filing a motion to compel payment, filing an administrative expense claim, and filing a motion to require the debtor-lessee to assume or reject the lease. What constitutes the best course of action for the lessor under the circumstances of each fact pattern will be based upon a host of considerations, including (as highlighted in these fact patterns) whether or not the debtor-lessee is using the equipment.
Regardless of the specific circumstances, however, a lessor will almost always seek to file an administrative claim. Section 503(b) of the Bankruptcy Code preserves the debtor’s estate during the pendency of bankruptcy proceedings by establishing a category of “allowed administrative expenses,” which includes “the actual, necessary costs and expenses of preserving the estate” while in bankruptcy. These expenses receive first priority in the distribution of the unsecured assets of the debtor’s estate. Generally, any post-petition missed lease payments can constitute the basis of an administrative expense claim – a caveat to this general rule is discussed below.
Where the debtor-lessee is not making payment but continues to use the subject equipment, the lessor will most likely consider filing a motion to compel payment or asking the bankruptcy court to require the debtor-lessee to assume or reject the lease. The former of these options addresses the immediate issue of non-payment while the latter option will define the long-term relationship between the lessor and the debtor-lessee. In filing a motion to compel the assumption or rejection of a lease, the bankruptcy court will consider the “reasonableness” of the limit on the time for the debtor’s assumption/rejection determination. The determination of what constitutes a reasonable time to assume or reject a particular executory contract is within the bankruptcy court’s discretion and has to be decided in light of the particular facts of each case. Among the factors that the courts have used to determine what may constitute “reasonable time” for the purposes of section 365(d)(2) of the Bankruptcy Code are the following:
- The nature of the interests at stake;
- The balance of harm to the parties;
- The safeguards afforded to the parties;
- The damage third parties may suffer beyond the compensation available under the Bankruptcy Code;
- The debtor’s failure or ability to satisfy post-petition obligations;
- The purposes of chapter 11;
- The importance of the contract in question to the debtor’s reorganization; and
- Whether the action to be taken is so in derogation of Congress’ scheme as to be said to be arbitrary.
Where a debtor-lessee assumes a lease, it must cure all defaults and provide adequate assurance of future performance upon assumption. Accordingly, assumption of the lease will also address any payments missed post-petition. While it may appear more likely that a debtor-lessee utilizing equipment during the limbo period will assume the lease, a debtor-lessee will generally defer the assumption/rejection decision until confirmation. As such, filing a motion to compel payment or to require the debtor-lessee to assume or reject the lease will help ensure payment while the lessor waits on the assumption/rejection determination.
In the situation where the debtor-lessor is not performing under the lease but is also not utilizing the equipment, the lessor’s concern may be beyond receiving payment and be more focused on possession of the equipment as assumption of the lease is less likely under these facts. One reason for the lack of emphasis on payment is that the lessor may not be entitled to the full payment under the lease where the equipment is not being used. While section 503(b) gives lessors the right to assert an administrative claim for amounts during the limbo period, an administrative claim may only be recoverable to the extent they can prove the debtor used their equipment and can quantify the benefit such use conferred on the estate.
Accordingly, a lessor may prefer to seek relief from the automatic stay to obtain possession of the equipment or, and for the reasons previously discussed, file a motion asking the bankruptcy court to require the debtor-lessee to assume or reject the lease – although these forms of relief can be requested in the alternative in a single motion. The automatic stay generally protects debtor-lessees against actions by non-debtor lessors against estate property, but section 362(d) allows parties to seek the court’s permission to terminate, modify, or condition the automatic stay, among other things: (1) for “cause,” including the lack of adequate protection of an interest in the property, or (2) if the debtor does not have equity in such property and such property is not necessary to an effective reorganization.
While remedies are available in bankruptcy to equipment lessors, it is incumbent upon equipment lessors and their counsel to be cognizant of the facts as they pertain to the debtor-lessee’s performance of the lease and, in turn, to be prepared to act to realize the full benefits of the available remedies.