Pre-Bankruptcy Lease Termination: Overlooked Benefit?

by Robert S. Bernstein, Esquire
Bernstein-Burkley, P.C.

reprinted from The Monitor

Terminating a personal property lease is often overlooked as an option in the early stages of the collection process. When faced with a lessee in default of its lease agreement, an equipment lessor should aggressively pursue its default remedies with the idea that the lessee may ultimately resort to filing a bankruptcy. Properly terminating a lease prior to a lessee filing bankruptcy can make a significant difference in minimizing losses and avoiding the lease assumption and rejection provisions of the Bankruptcy Code.

One of the first actions usually taken against a delinquent lessee is to send a default notice demanding payment of the past due amounts. A form demand letter should not be sent without first reviewing the lease agreement in order to elect the best available remedies under the lease, such as accelerating the balance, demanding return of the equipment and terminating the agreement.

Most sophisticated lease agreements contain specific default terms and conditions which were placed in the lease to optimize the lessor’s remedies. Before a default remedy takes effect, proper notice is usually required. Failure to follow the notice requirements in the lease or as provided under the appropriate state law can result in loss of the right to elect certain remedies. Therefore, before sending any notices to a distressed lessee, a lessor needs to insure all notices are in compliance with the agreement or appropriate state law.

The Bankruptcy Code is filled with provisions which give a bankrupt lessee considerable powers and time to make decisions regarding leases. The Code provides that unexpired leases and executory contracts are considered property of the bankruptcy estate. (1) The Code further provides that, with some exceptions and subject to court approval, a trustee may assume or reject any executory contract or unexpired lease of the debtor, (2) or even assume and assign such agreements. (3) In contrast to the 120 day time limit to assume non-residential real estate leases, the Code does not limit the time period in which to decide to assume or reject personal property leases. (4) Consequently, the lessee can delay long past 60 days, unless the lessor demands a decision by filing a motion with the bankruptcy court. Moreover, Chapter 11 now allows a debtor 60 days after the bankruptcy before it is required to make post-bankruptcy personal property lease payments. (5)

An executory contract or lease which expires before the Debtor files bankruptcy is not part of the estate. (6) Similarly, a lease which is terminated before the filing of a bankruptcy petition is also not considered property of the estate. (7)

In determining whether a lease has been terminated prior to bankruptcy, courts tend to look at what constitutes termination under the state law which governs the lease. (8) One court has, however, held that in a commercial real estate lease relationship, the parties are permitted to terminate the lease in accordance with the provisions of the lease contract. (9) An analogy can be made to a person property lease in which the parties may terminate the lease pursuant to its terms. There are only a handful of published decisions on the effect of pre-petition termination of equipment leases, but the analogy seems appropriate. Thus, if a lease is properly terminated under its provisions or under state law, the lessor can pursue return of the equipment and prevent a bankrupt lessee from assuming the lease in bankruptcy.

Unfortunately, terminating a lease prior to bankruptcy does not necessarily mean a bankrupt lessee has no interest in the leased equipment. Two situations can arise to cause the lessor difficulty. First, the lessee will likely have a possessory interest which will, at a minimum, require a lessor to seek relief from the Bankruptcy Code’s automatic stay. Second, if the lease is not a true lease, but rather a financing or conditional sale agreement, then the lessee may assert an ownership interest in the equipment, thereby making it property of the estate.

State law governs whether a document is regarded as a true lease or purchase agreement. (10) As a general rule, payment of nominal consideration for the equipment upon expiration of a lease is indicative of purchase agreement rather than a true lease. Nominal consideration is a sum being so trifling so as to be consideration in name only. (11) If the agreement is not a true lease, then the lessor’s rights are the same as a secured lender, assuming the lessor has a security interest in the equipment. Those rights include seeking relief from the automatic stay if “adequate protection” is not provided to the lessor. Adequate protection includes the lessee making monthly post-petition payments and maintaining insurance and service for the equipment so its value is not at risk or diminished. (12) A hearing on relief from the automatic stay is required within 30 days from filing the appropriate motion. (13) Obviously, having a lease treated as a purchase agreement and relying on a security interest raise issues of perfection of that security interest. That is a subject best left for another day.

Pre-bankruptcy lease termination can save a lessor time and money. It can also prevent the lessee from invoking certain bankruptcy provisions favorable to its position. Complete review of the lease, with the assistance of legal counsel, is imperative when navigating through these nuances of bankruptcy law.

1. See, 11 U.S.C. §365(a) and §541(a).

2. See, 11 U.S.C. §365(a).

3. See, 11 U.S.C. 365(a) and §365(k).

4. See, 11 U.S.C. §365(d)(4).

5. See, 11 U.S.C. §365(d)(5).

6. Gloria Mfg. v. Intern. Ladies Garment Workers , 734 F. 1020, 1022 (4th Cir. 1984).

7. See, In re: Pogoda Intern., Inc. , 26 B.R. 18, 20 (Bankr. Md. 1982); In re: Opus Corp. , 89 B.R. 9, 10 (Bankr. D.Md. 1988); Robinson v. Chicago Housing Authority , 54 F.3d 316, 319-22 (7th Cir. 1995); In re: Mako, Inc. , 102 B.R. 814, 817 (Bankr. E.D. Okl. 1988).

8. See, In re: Gant , 201 B.R. 216, 220 (Bankr. N.D. Ill. 1996); In re: Boll Weevil, Inc. , 202 B.R. 762, 764 (Bankr. S.D. Cal. 1996).

9. See, In re: Mako, Inc. , supra .

10. See, In re: Larson , 128 B.R. 257, 260 (Bankr. D.N.D. 1990).

11. Id. at 261.

12. See, 11 U.S.C. §362(d).

13. See, 11 U.S.C. §362(e).

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