In a recent decision, Cannery Row Co. v. Leisure Corp. (In re Leisure Corp.), the Bankruptcy Appellate Panel of the Ninth Circuit concluded that a bankruptcy court is not compelled to allow a debtor to exercise a renewal option contained in a nonresidential real property lease when there is a postpetition default under the lease. Rather, the court found that postpetition defaults in violation of section 365(d)(3) of the Bankruptcy Code, which requires a debtor's timely performance postpetition of obligations under a lease until the lease is assumed or rejected, should be one factor for the bankruptcy court to consider in deciding whether a debtor may renew the lease. In so deciding, the court distinguished the facts of Leisure Corp. from those of Coleman Oil Co. v. Circle K Corp. (In re Circle K Corp.), and interpreted the holding in the latter case, in which the United States Court of Appeals for the Ninth Circuit permitted a debtor to exercise a lease renewal option despite the existence of prepetition and some de minimis postpetition defaults under the lease.
Unexpired Lease Rights
Section 365 of the Bankruptcy Code grants a debtor/lessee sixty days after the commencement of a chapter 11 case, unless the court extends the sixty-day period, to decide whether to assume or reject an unexpired lease of nonresidential real property. Additionally, section 365(d)(3) of the Bankruptcy Code requires that a debtor timely perform all obligations arising under an unexpired lease of nonresidential real property from the commencement of the case until the time the lease is assumed or rejected. As the court in Leisure Corp. observed, the purpose of section 365 is "to balance the state law contract right of the creditor to receive the benefits of his bargain with the federal law equitable right of the debtor to have an opportunity to reorganize."
In In re Circle K Corp., the Ninth Circuit had considered whether debtors in possession could renew leases postpetition when there were prepetition and some de minimis postpetition defaults under the leases. The leases specifically prohibited the lessee from exercising the renewal option if there were any outstanding defaults under the leases. The Ninth Circuit held that the bankruptcy court had the power to permit the debtors to renew the leases without first curing the defaults.
Ninth Circuit Reasoning
The Ninth Circuit reasoned that section 365, together with the automatic stay provision of section 362, is intended to provide an extension of a debtor's time to cure any defaults until the debtor has had an opportunity to decide whether to assume or reject a lease. If a bankruptcy court could not allow a debtor/lessee to renew a lease without first curing defaults, the basic purpose of section 365 would be thwarted. That is, if a debtor cured defaults in order to exercise an option to renew, and then later decided to reject the lease, the debtor would have given a preference to the lessor who would otherwise hold a prepetition claim for prepetition defaults. On the other hand, if a debtor did not cure defaults and could not renew, the lease would expire and the debtor would have lost the opportunity to choose whether to assume or reject. The practical effect of requiring a debtor to cure defaults, the court concluded, would be to require an early decision by the debtor of whether to assume or reject the lease. Thus, in effect, "the debtor would be denied the benefit of section 365's 'suspension time' in order to determine whether to assume or reject the lease." Therefore, the Ninth Circuit held that the debtors could exercise their option to renew the leases without first curing the prepetition defaults.
In contrast to the debtor's prepetition defaults in Circle K, In re Leisure Corp. involved a debtor's alleged material postpetition defaults in payment under a lease. In Leisure Corp., before filing for protection under chapter 11, the debtor in possession had entered into an agreement as tenant under a lease that contained five one-year options to renew, provided there were no material defaults under the lease. After filing under chapter 11, the debtor attempted to exercise an option to renew the lease by giving notice and tendering a check in the required amount. The lessor returned the check, claiming that the debtor could not exercise the option to renew due to the existence of material prepetition and postpetition defaults in payment under the lease. The debtor asserted that the holding in Circle K permitted it to exercise the option without first curing its defaults.
The bankruptcy court held that, as a matter of law according to the holding in Circle K, the debtor had the right to renew the lease irrespective of any prepetition or postpetition defaults in payment. Accordingly, the bankruptcy court determined that the debtor had validly exercised the option to renew the lease, and it denied the lessor's motion for relief from the automatic stay.
Postpetition v. Prepetition Defaults
The Bankruptcy Appellate Panel of the Ninth Circuit disagreed with the bankruptcy court's interpretation of Circle K and declined to affirm the order denying relief from the stay because it could not determine what effect the bankruptcy court's erroneous interpretation of Circle K had on its decision to deny the lessor's motion for relief from the stay. Accordingly, it vacated the decision and remanded the case to the bankruptcy court. The Appellate Panel focused on the fact that the alleged defaults in payment were primarily defaults in postpetition payments rather than in prepetition payments, as was the case in Circle K. Postpetition defaults, unlike prepetition defaults, violate the "timely performance" requirement of section 365(d)(3). The Appellate Panel noted that, although section 365(d)(3) requires a debtor to perform timely the obligations under a lease until the lease is assumed or rejected, section 365(d)(3) neglects to prescribe the consequence of noncompliance. Thus, according to the Appellate Panel, there was only one issue in the Leisure Corp. case: Could a debtor who had defaulted on a lease postpetition in violation of section 365(d)(3) nevertheless exercise a renewal option in order to preserve its right to assume the lease, even though the lease prohibited renewal if there were outstanding defaults?
In answering this question, the Appellate Panel relied on the Ninth Circuit's decision in In re Southwest Aircraft Services, Inc. In that case, the Ninth Circuit considered whether a debtor's failure to comply with the "timely performance" requirement of section 365(d)(3) should render a lease rejected so that the debtor has no lease to consider assuming or rejecting. In rejecting that argument, the Ninth Circuit held that "the failure to make payments under subsection (d)(3) constitutes simply one element to be considered, along with all the other relevant factors."
In reliance on the holding in Southwest Aircraft, the Appellate Panel found that the Ninth Circuit's decision in Circle K does not compel a court to allow renewal when there is a postpetition default; nor does section 365(d)(3) prohibit renewal in the same circumstance. Rather, the Appellate Panel held that postpetition defaults in violation of section 365(d)(3) should be one factor for the court to consider in deciding whether a debtor may renew a lease. In reviewing postpetition defaults, the Appellate Panel directed the bankruptcy court to consider, among other things, the scope of the default, the cause of the default, any subsequent cure of the default, and whether the significance of the lease to the reorganization is sufficient to outweigh the policy underlying section 365(d)(3) that the landlord has a right to timely payment postpetition.
Cannery Row Co. v. Leisure Corp. (In re Leisure Corp.), 234 B.R. 916 (B.A.P. 9th Cir. 1999).
Coleman Oil Co. v. Circle K Corp. (In re Circle K Corp.), 127 F.3d 904 (9th Cir. 1997), cert. denied, 140 L. Ed. 2d 176 (1998).
In re Southwest Aircraft Services, Inc., 831 F.2d 848 (9th Cir. 1987).