EDITOR’S NOTE: In this piece reprinted from the American Bankruptcy Institute’s September 2024 Real Estate Committee Newsletter, Timothy W. Brink examines one of the Bankruptcy Code’s most important, yet underutilized protections for landlords when their tenants file for chapter 11 bankruptcy protection.
Section 365(l) of the Bankruptcy Code (“section 365(l)”), which entitles a landlord to “require a deposit or other security for the performance of the debtor’s obligations under the lease substantially the same as would have been required by the landlord upon the initial leasing to a similar tenant” when a tenant seeks to assume and assign a lease, is an important landlord protection, yet it is one that seems to have been underutilized by landlords facing lease assignments. With the challenges facing commercial real estate generally and the significant year-over-year increases in commercial bankruptcy filings in 2023 and 2024, 1 the need for commercial landlords to act to protect their interests when a tenant files a chapter 11 bankruptcy case and the opportunity to obtain the protections afforded by section 365(l) are greater than ever.
When a tenant files bankruptcy to reject above-market leases and close unprofitable locations, the commercial landlord’s concerns will include payment of post-petition/pre-rejection rent, rejection of the lease and surrender of possession of the leased premises, and recovery from pre-bankruptcy security deposits and non-debtor guarantors. When the purpose of a tenant’s bankruptcy filing is to sell its business as a going concern and assume and assign its leases to a new owner, however, the commercial landlord’s focus typically will shift to the landlord protections in sections 365(b) and 365(f) of the Bankruptcy Code, which require as a condition to assumption and assignment of a lease that existing defaults under the lease be cured and adequate assurance of future performance under the lease by the proposed assignee be provided.
Whether the “adequate assurance of future performance” condition to assumption and assignment of a lease has been met frequently is the subject of litigation between and among the landlord, the tenant, and the proposed assignee. 2 However, the same cannot be said of section 365(l), which has generated almost no case law and has barely been discussed by legal commentators. 3
The only reported decision concerning section 365(l) does little more than acknowledge a landlord’s right to require a new security deposit when its lease is assigned. In In re Hathaway, 401 B.R. 477 (Bankr. W.D. Wash. 2009), a chapter 13 debtor moved to assume and assign his lease to the buyer of his restaurant business. To resolve the landlord’s objection, he negotiated an agreed order fixing the amount of the cure payment. Before closing, the landlord informed the parties that the debtors’ security deposit had been applied to amounts due under the lease and requested a new security deposit, which the buyer deposited into escrow. After the sale closed and the agreed cure amount was paid to the landlord, the debtor filed a motion to recover the amount of his security deposit from the escrow. The court denied the debtor’s motion, finding that his claims were precluded by the order fixing the cure amount. In dicta, the court explained that while a similarly-situated landlord “can and should insist on the setting of a new security deposit in the order assigning the lease, as permitted by § 365(l),” the landlord’s failure to do so did not affect its rights. Id. at 487.
Orders entered in connection with various bankruptcy sales are more instructive, in that they suggest that even when a landlord asserts its section 365(l) rights, its entitlement to a new deposit or other security is subject to challenge. For example, in the Delphi Behavioral Health Group cases, the landlord objected to the debtor-tenant’s proposed lease assignment and sought an unlimited parental guaranty from the proposed assignee similar to that provided by the debtor-tenant. After the court set the objection for an evidentiary hearing, the parties resolved the landlord’s objection by entry of an agreed order directing the assignee to provide a cash security deposit and the parent of the assignee to provide a new lease guaranty subject to limitations not found in the original guaranty, including a cap and an early termination provision. See Agreed Order Resolving Objection to Lease Assumption and Assignment in Connection with Sale of Debtors’ Assets, ECF No. 382, In re Delphi Behavioral Health Group, LLC, et al., Case No. 23-10945-PDR (Bankr. S.D. Fla.) at ¶¶ 3, 4. 4 A landlord in the Décor Holdings, Inc. cases similarly objected to the debtor-tenant’s proposed lease assignment and sought an unlimited parental guaranty from the proposed assignee similar to that provided by the debtor-tenant. To resolve the landlord’s objection, the parties agreed that the parent of the assignee would provide a new unconditional lease guaranty but subject to limitations including the guarantor’s right to terminate the guaranty and replace it with a letter of credit. See Order Confirming Plan and Approving Sale of Substantially all of the Debtors’ Assets, ECF No. 303, In re Décor Holdings, Inc., et al., Case No. 19-71020-REG (Bankr. E.D.N.Y.) at ¶ 49.
With so little guidance from courts and commentators, counsel representing landlords and proposed new tenants are free to advance sharply contrasting interpretations of section 365(l) when negotiating and litigating proposed lease assignments.
To take full advantage of section 365(l), landlords should consider:
- objecting to the proposed lease assignment if the proposed assignee has not agreed to provide new security.
- requiring that that new security be the same as the security provided by the original tenant — for example, if the original tenant’s obligations were secured by an unlimited parental guaranty, the landlord should require an unlimited guaranty from the proposed assignee’s parent.
- preparing to prove that security the same as that provided by the original tenant would have been required upon leasing to a similar tenant — this may be done by reference to the landlord’s internal leasing practices and procedures, underwriting and credit requirements for new tenants, and the actual lease and security negotiations with the original tenant.
Proposed new tenants hoping to minimize the impact of section 365(l) should consider:
- if supporting evidence can be adduced, challenging the landlord’s contention that it would have required security upon initial leasing to a tenant similar to proposed assignee — this may be done by, for example, demonstrating the proposed assignee’s strong financial condition or probing the landlord’s leasing practices and procedures, underwriting and credit requirements for new tenants, and the actual lease and security negotiations with the original tenant.
- if this challenge is unsuccessful, arguing that the form of security the proposed assignee is willing to provide (for example, a parental guaranty) is “substantially the same” as the form of security provided by the original tenant or required by the landlord (such as a letter of credit or cash security deposit).
- asserting that section 365(l) does not establish an independent condition of lease assignment but is simply another form of adequate assurance — while this argument has not found support in any reported decisions, a leading bankruptcy treatise has stated (without citing to any authority) that a section 365(l) deposit may satisfy the adequate assurance requirement of section 365(f). See 3 Collier on Bankruptcy 365.09[1] (Richard Levin and Henry J. Sommers eds. 16th ed.).
While it may be necessary to develop and present evidence to successfully prosecute or oppose an objection to a proposed lease assignment on section 365(l) grounds, the payoff for the prevailing party — be it landlord or proposed new tenant — can be significant. At the same time, the tenuous state of the commercial real estate market and the increasing number of chapter 11 filings involving commercial real estate make it certain that opportunities for landlords to take advantage of section 365(l) will abound. This combination of “motive” plus “opportunity” suggests that we may see development in the law concerning section 365(l) in the near future.
Reprinted with the permission of the American Bankruptcy Institute. Copyright © 2024. All rights reserved.
1 According to data provided by Epiq, commercial chapter 11 filings increased 72 percent to 6,569 in calendar year 2023 from 3,819 in calendar year 2022. Commercial Chapter 11 Filings Increase 72 Percent in Calendar Year 2023, American Bankruptcy Institute (January 3, 2024), https://www.abi.org/newsroom/press-releases/commercial-chapter-11-filings-increase-72- percent-in-calendar-year-2023. This trend continued in the first quarter of 2024, with commercial chapter 11 filings increasing by 43 percent to 1,894 from 1,325 in 1Q23. Bankruptcy Filings Increase Across All Chapters in First Quarter 2024, American Bankruptcy Institute (April 2, 2024), https://www.abi.org/newsroom/bankruptcy-headlines/bankruptcy-filings-increase-across-all-chapters-in-first-quarter-2024.
2 While the results vary depending on the exact search terms used, Westlaw searches concerning objections to proposed assignments of contracts and leases on adequate assurance of future performance grounds produce hundreds of reported decisions.
3 Section 365(l) was added to the Bankruptcy Code as part of the Bankruptcy Amendments and Federal Judgeship Act of 1984, which corrected constitutional errors in the Bankruptcy Reform Act of 1978, partially overturned the Supreme Court’s Bildisco decision concerning rejection of collective bargaining agreements, and made major changes to section 365 in response to shopping center industry lobbying efforts. Little light is shed on the addition of section 365(l), however, with the legislative history being limited to Senator Hatch’s floor statement that it would “permit the landlord to get his usual, reasonable security deposit from an assignee tenant.” Sen. Orrin Hatch, 98th Cong., 2nd Sess., 130 Cong. Rec. 8895 (daily ed. June 19, 1984).
4 The author represented the landlord in the Delphi Behavioral Health Group chapter 11 cases.