From the Editor

CERCLA Safe Harbor for Lenders Revived

Perfecting Security Interests in Treasury Securities

Must a Debtor Cure Its Nonmonetary Defaults Prior To Assuming a Lease?

Must a Debtor Cure Its Nonmonetary Defaults Prior To Assuming a Lease?

Edward K. Gross, Randall L. Hagen, and Monique D. Almy

Many of you are aware that there were significant changes made by the Bankruptcy Reform Act of 1994 (the "Reform Act") to the provisions of the United States Bankruptcy Code (the "Bankruptcy Code") that affect equipment lessors. Most of these changes were considered to be lessor favorable, or at worst, innocuous. Lessors naturally have had a keen interest in the changes to Section 365 of the Bankruptcy Code, which governs the rights and duties of a bankruptcy trustee or debtor-in-possession concerning executory contracts and leases. This article discusses two recent cases in which the Reform Act changes to Section 365 were adversely interpreted, and recently proposed legislation that will, if passed, resolve lessors’ concerns raised by these cases.

Section 365
Section 365 allows a debtor to either assume or reject leases, including equipment leases. However, Section 365 also prohibits a lessee/debtor from assuming a lease without first curing, or providing assurance that it will promptly cure, all existing defaults under the lease, with certain exceptions. The lessee must also compensate, or provide adequate assurance that it will compensate, the lessor for actual losses resulting from any default and provide adequate assurance of its future performance under the lease.

Prior to the changes made by the Reform Act, the only defaults the debtor did not need to cure prior to assuming a lease were those that arose as a result of the lessee’s having filed its bankruptcy case (e.g., automatic "bankruptcy defaults"). However, the Reform Act amended Section 365 to excuse a lessee from curing a default that stemmed from "the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the . . . unexpired lease." Many commentators read the word "penalty" as modifying both the words "rate" and "provision," thereby excusing the lessee only from having to cure a penalty rate and other penalty provisions in the unexpired lease. However, two courts, addressing executory contracts, have interpreted this amendment to mean that the debtor need not cure any nonmonetary default prior to assumption.

The Cases
In re Claremont. This less favorable interpretation was first introduced in In re Claremont Acquisition Corp., 186 B.R. 977 (C.D. Cal. 1995), where a federal district court upheld a bankruptcy court’s holding that a debtor need not cure any nonmonetary default prior to assumption. The Claremont case involved an automobile dealership agreement between Ford and a debtor. The court held that Ford could neither terminate nor prevent the assumption of that executory contract merely because the debtor had violated a "lights out" clause in the dealership agreement by closing prior to filing bankruptcy. The court read the new amendment to Section 365 to mean "that a trustee or debtor-in-possession is not required to cure nonmonetary defaults inorder to assume" executory contracts and leases. 186 B.R. at 990. In so holding, the court noted that the legislative history to the Reform Act was insufficient to defeat what the court viewed as the plain language in the amendment.

The Claremont holding created great concern in the equipment leasing community, because a lessee might now argue that it was relieved from curing all defaults under a nonmonetary provision prior to assuming a lease, thereby leaving the lessor without remedies for the nonmonetary default, whether pre- or post-assumption or during the 60-day "no free ride" period established by the Reform Act, now codified at Section 365(d)(10).

In re GP Express Airlines, Inc. The controversial holding in Claremont recently was revisited by a bankruptcy court in In re GP Express Airlines, Inc., 200 B.R. 222 (Bankr. D. Neb. 1996), where the bankruptcy court also addressed the cure of nonmonetary obligations prior to the assumption of an executory contract. There, the debtor was an airline with several executory contracts with Continental Airlines. The debtor airline had breached these contracts by failing to meet certain performance standards concerning the completion of flights, the timely arrival of flights, and the utilization of specified accounting services. The bankruptcy court recognized that the debtor’s curing these several nonmonetary defaults would be "impossible," and ruled that the debtor could assume the contracts without curing the defaults of the nonmonetary obligations. 200 B.R. at 233.

The court commented that its holding was consistent with Claremont, reasoning that because many nonmonetary defaults are historical in nature, and therefore can never be cured, to require the debtor to cure nonmonetary defaults prior to assumption would frustrate the debtor’s right to assume.

However, the court also ruled that its decision did not excuse the debtor from performing nonmonetary obligations after assumption. To assume the contracts, GP Express had to provide adequate assurance that it could perform the nonmonetary obligations post-assumption; if GP Express could not provide such assurance, then the contracts could not be assumed.

Proposed Legislation
The adverse precedent of the holdings of Claremont and GP Express may not be permanent. On January 7, 1997, the Bankruptcy Law Technical Corrections Act of 1997 was introduced in the U.S. House of Representatives. As part of that bill, Section 365(b)(2)(D) would be modified and would separately address the exemption for the debtor’s having to satisfy "penalty rate" provisions and the exemption for the debtor’s having to satisfy "nonmonetary" defaults. However, one proposed subsection, as presently drafted, expressly provides that the nonmonetary default exemption is not applicable to "an unexpired lease of personal property." If passed as drafted, this statutory amendment would eliminate lessors’ concerns regarding the Claremont and GP Express decisions, with respect to any bankruptcy cases filed after its effective date. However, there is some concern regarding the effect of this proposed legislation regarding a lease of fixtures and other executory contracts affecting lessors.

Conclusion
The decision in GP Express is troublesome because it adopts the reasoning in Claremont. However, the GP Express case also narrows the application of Claremont because it requires debtors to provide assurance that they will perform post-assumption nonmonetary obligations under a lease as a condition to assuming that lease. Although the decisions are troubling, to date they are the only courts that have come to this conclusion. They are not binding beyond their district. These cases will no longer be relevant to equipment leases if the proposed statutory amendment is passed. However, until the Bankruptcy Code is revised, lessors must take into account a possible adverse interpretation of the Section 365 exceptions, when determining strategy in connection with an anticipated assumption of an unexpired lease.

Copyright© 1997, Ober, Kaler, Grimes & Shriver