Lease Payments. It is not uncommon for a retailer with financial problems to be past due on lease payments. Filing for bankruptcy often gives a debtor “breathing room” to evaluate its financial condition, including profitability (or not) of non-residential real-property leases. Depending on the applicable law, this “breathing room” may also free up some cash flow for the debtor.
Under 11 U.S.C. § 365(d)(3) of the Bankruptcy Code, a debtor must timely perform all obligations under a lease. Unfortunately, the term “obligations” is left undefined by the Bankruptcy Code. This omission has led to a difference of opinion among bankruptcy courts about what Congress meant by its use of the word “obligations.”
There are two approaches used by courts to interpret the meaning of “obligations”. Some courts adopt the “billing approach,” and other courts adopt the “pro-ration approach.” Under the billing approach, a court will look to see when a debtor’s obligation arose to determine if it has to timely perform that obligation. Under the pro-ration approach, a court will require the debtor to pay that portion of the lease obligation that accrues during the period after the bankruptcy filing and up to the date the lease is rejected.
The following hypothetical illustrates the differences in the two approaches. Assume that the lease provides that rent is due on the first day of the month. On July 1 the retailer does not pay the rent. On July 15 the retailer files for bankruptcy. On Sept. 1 the debtor does not pay the Sept. rent. On Sept. 2 an order rejecting the lease is entered by the Court effective immediately.
Under the pro-ration approach, the debtor must pay the landlord rent on a prorated basis from the petition date, July 15th, through and including Sept. 2. Under the billing approach, because the debtor incurred the obligation for the month of July on July 1, which was before the bankruptcy filing, the debtor is not required to pay July rent as it is a pre-petition obligation. The debtor will be required to pay Aug. and Sept. rent. If the landlord wants to be paid for the post-petition (stub period) for July, it should file a motion to ask for administrative-expense treatment of that amount. The landlord will be required to prove that such an amount is an actual and necessary expense of the debtor’s estate. Also note that 11 U.S.C. § 365(d)(3) is not limited to only lease payments. It may include rent, taxes, common-area-maintenance fees, etc.
Accordingly, depending on the method used by the bankruptcy court, and the specific terms of the lease, a debtor may be able to “create” some extra cash flow by strategically selecting a filing date in a court that subscribes to the billing approach. Given that retail debtors often have many unexpired leases, this increased cash flow may be a helpful boost at the beginning of a bankruptcy case.
Sale of Lease Designation Rights. The Bankruptcy Code provides the debtor with the ability to extract value from its unexpired leases of real property. Under the Bankruptcy Code a debtor has the ability to force its lessors to accept lease assignments, which would otherwise be prohibited by anti-assignment provisions in the leases. A debtor may sell to a third party this right to decide which of its leases to assume and to whom they should be assigned. The sale of lease designation rights is a common practice in large retail cases where the debtor leases numerous facilities.
Under this practice, the debtor transfers to a third party, for a limited time, the right to direct the debtor to assume and assign unexpired leases. Upon the sale of the designation right, the designation rights purchaser pays an initial sum to the debtor and may also agree that if an assignee pays a premium for the lease that it will be split on some basis. The purchaser then markets the lease to potential tenants and during such time pays the carrying costs associated with the lease until it is ultimately assigned or rejected. When the designation rights purchaser has an agreement with an assignee, the debtor will seek bankruptcy court approval to assume and assign the lease to the assignee on the terms negotiated. A lease that is not assigned during the specified time period is normally rejected and the premises are returned to the landlord. The obvious benefit from this practice is that the sale of the lease designation right provides cash to the debtor while at the same time relieving it from lease payments during the designation period.