Default Under Assumed Lease Need Not Be Material or Ongoing to Trigger Landlord's Entitlement to Adequate Assurance of Future Performance

The ability of a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") to assume, assume and assign, or reject executory contracts and unexpired leases is an important tool designed to promote a "fresh start" for debtors and to maximize the value of the bankruptcy estate for the benefit of all stakeholders. However, the Bankruptcy Code establishes strict requirements for the assumption or assignment of contracts and leases. Among them are the requirements that, if the debtor has defaulted under an executory contract or unexpired lease, the default must be "cured" upon assumption of the contract or lease by the trustee or DIP and that the non-debtor party must be provided with "adequate assurance of future performance."

The adequate assurance requirement was recently examined by the U.S. Court of Appeals for the Ninth Circuit. In Smart Capital Investments I LLC v. Hawkeye Entertainment LLC (In re Hawkeye Entertainment LLC), 49 F.4th 1232 (9th Cir. 2022), the Ninth Circuit ruled that, even though a default under an unexpired lease already had been remedied prior to assumption or was immaterial, the landlord is nonetheless entitled to adequate assurance of future performance. The Ninth Circuit concluded that a bankruptcy court erred in ruling otherwise, but that the error was harmless because the defaults either had been cured prior to the debtor's request to assume the lease or were "minor deviations" from the lease terms, and "any adequate assurance responsive to the alleged defaults would be little more than simple promises not to deviate from the contract terms again." 

Assumption, Assumption and Assignment, and Rejection of Executory Contracts and Unexpired Leases in Bankruptcy

Section 365(a) of the Bankruptcy Code provides that, with certain exceptions delineated elsewhere in the statute, "the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor." The trustee's power to assume or reject contracts or leases (among other powers) is conferred upon a DIP under section 1107(a) of the Bankruptcy Code. Rejection results in a court-authorized breach of the contract, with any claim for damages treated as a prepetition claim against the estate on a par with the claims of other general unsecured creditors (unless the debtor has posted security). 11 U.S.C. § 365(g). Assumption of a contract requires, among other things, that if there have been defaults under the contract, the trustee or DIP cure all existing monetary defaults and provide "adequate assurance of future performance."

In particular, section 365(b)(1) provides as follows:

(1) If there has been a default in an executory contract or unexpired lease of the debtor, the trustee may not assume such contract or lease unless, at the time of assumption of such contract or lease, the trustee—

(A) cures, or provides adequate assurance that the trustee will promptly cure, such default other than a default that is a breach of a provision relating to the satisfaction of any provision (other than a penalty rate or penalty provision) relating to a default arising from any failure to perform non-monetary obligations under an unexpired lease of real property, if it is impossible for the trustee to cure such default by performing non-monetary acts at and after the time of assumption, except that if such default arises from a failure to operate in accordance with a nonresidential real property lease, then such default shall be cured by performance at and after the time of assumption in accordance with such lease, and pecuniary losses resulting from such default shall be compensated in accordance with the provisions of this paragraph;

(B) compensates, or provides adequate assurance that the trustee will promptly compensate, a party other than the debtor to such contract or lease, for any actual pecuniary loss to such party resulting from such default; and

(C) provides adequate assurance of future performance under such contract or lease.

11 U.S.C. § 365(b)(1).

The cure obligations set forth in section 365(b)(1) do not apply to defaults triggered by the debtor's financial condition (including its bankruptcy filing) and certain other breaches. See 11 U.S.C. § 365(b)(2). 

Special rules govern what constitutes adequate assurance of future performance under shopping center leases. See 11 U.S.C. § 365(b)(3). However, for other kinds of contracts and leases, the Bankruptcy Code does not specify what constitutes "adequate assurance of future performance." Courts have considered various factors in examining the issue, including the debtor's payment history, the existence of a guarantee or a security deposit, evidence of profitability, a chapter 11 plan earmarking money exclusively for the landlord, the general outlook in the debtor's industry, and whether an unexpired lease is at or below market. See Collier ¶ 365.06[3][a] (16th ed. 2022) (citing cases and noting that courts apply the adequate assurance requirement "based upon the facts and circumstances of each case"). 

The trustee or DIP may not assume or assign any executory contract or unexpired lease, whether or not such contract or lease prohibits or restricts an assignment of rights or delegation of duties, if: (i) applicable law excuses the non-debtor party from accepting performance from or rendering performance to an entity other than the debtor or the DIP, and the non-debtor party does not consent to assumption or assignment; (ii) the contract is one "to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor"; or (iii) the lease is a nonresidential real property lease that was terminated under applicable non-bankruptcy law prior to entry of the order for relief. 11 U.S.C. § 365(c).

Bankruptcy courts will generally approve a proposed assumption or rejection of a contract or lease if presented with evidence that either course of action is a good business decision. See Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652, 1658 (2019) ("The bankruptcy court will generally approve [the] choice [to assume or reject], under the deferential 'business judgment' rule.").

Upon assumption, most kinds of executory contracts may also be assigned by the trustee or DIP to third parties under the circumstances specified in sections 365(c) and 365(f). In chapter 11 cases, except with respect to certain kinds of contracts (such as nonresidential real property leases, aircraft lease agreements, and commitments to a federal depository institutions regulatory agency), the trustee or DIP may decide to assume or reject at any time up to confirmation of a chapter 11 plan. However, any non-debtor party to a contract may seek to compel the trustee or DIP to assume or reject the contract prior to confirmation, in which case the bankruptcy court must decide what period of time is reasonable to make the decision. 11 U.S.C. § 365(d)(2). Pending the decision to assume or reject, the trustee or DIP is generally obligated to keep current on most obligations that become due under the contract postpetition. 11 U.S.C. §§ 365(d)(3) and (d)(5).

In Hawkeye, the Ninth Circuit considered the "adequate assurance of future performance" requirement in section 365(b)(1).

Hawkeye

In 2014, Smart Capital Investments I, LLC and its affiliates (collectively, the "landlord") leased several floors of an office building in Los Angeles to Hawkeye Entertainment, LLC (the "debtor") under a significantly below-market-rate lease. The debtor sublet a portion of the premises to its affiliate, WERM Investments, LLC. After the relationship between the landlord and the debtor soured, the landlord asked the debtor to sign estoppel certificates to assist in refinancing the landlord's mortgage on the property. However, the debtor refused, claiming that there were problems with the premises giving rise to claims against the landlord under the lease.

In August 2019, the landlord notified the debtor that it had defaulted under several non-monetary default provisions in the lease by, among other things, failing to provide adequate emergency infrastructure, violating a conditional use permit for the premises, improperly subletting a portion of the premises, failing to provide estoppel certificates, and refusing to subordinate its leasehold interest to any future mortgage. The landlord later notified the debtor that it would take steps to terminate the lease. The debtor, however, filed for chapter 11 protection in the Central District of California in August 2019 before the termination was effected.

The debtor moved to assume the lease and the sublease in October 2019. It also asked the bankruptcy court to defer rent payments under the lease for two months in light of Los Angeles's April 2020 COVID rent moratorium. The court denied the motion, concluding that the moratorium did not apply. The debtor did not timely pay its April 2020 rent (but ultimately paid such rent) and timely paid the rent due after April 2020. The late April rent triggered a late-fee penalty under the lease, which the debtor paid in October 2020. 

Shortly afterward, the bankruptcy court granted the debtor's motion to assume the lease and the sublease. Among other things, the court found that: (i) a sound business rationale existed for the debtor's decision to assume the lease and the sublease; (ii) assumption of the lease and the sublease was in the best interests of the estate; and (iii) many of the debtor's alleged breaches of the lease had been ongoing for years and appeared to be "manufactured, and minor, and made-up, sometimes."

Addressing section 365(b)(1)'s adequate assurance of future performance requirement in cases where "there has been a default" under an unexpired lease, the bankruptcy court concluded that a "default" must be something that is "material" in that it would warrant forfeiture or termination of the lease under applicable non-bankruptcy law (here, California law). Because the landlord failed to demonstrate that the alleged non-monetary breaches of the lease were either ongoing or material, the court held that "the Debtor was not required to make a showing of cure or adequate assurance of prompt cure, compensation or adequate assurance of prompt compensation, or adequate assurance of future performance as a condition of assumption of the Lease and Sublease pursuant to Bankruptcy Code § 365(b)(1)(A), (B) and (C)." In re Hawkeye Entertainment, LLC, No. 1:19-bk-12102-MT (Bankr. C.D. Cal. Oct. 27, 2020) (unpublished order) p. 3 [Doc. No. 230]. According to the bankruptcy court, the adequate assurance requirement in section 365(b)(1) is not triggered by minor, immaterial, or previously cured defaults.

The district court affirmed, and the landlord appealed to the Ninth Circuit.

The Ninth Circuit's Ruling

A three-judge panel of the Ninth Circuit ruled that the bankruptcy court erred in concluding that section 365(b)(1) did not apply, but that the error was harmless.

Writing for the panel, U.S. Circuit Judge Danielle Jo Forrest explained that, if there has been no default under an unexpired lease, "section 365(b)(1)'s requirements—cure, compensation, and adequate assurances of future performance—are not triggered." Hawkeye, 49 F.4th at 1236.

However, she noted, the plain language of section 365(b)—"[i]f there has been a default"—indicates that lawmakers intended for the provision to be triggered upon the occurrence of a default prior to assumption, "regardless of whether that default has been resolved or is ongoing." Id. at 1237 (emphasis added). Although "a debtor that has previously cured a default need not provide cure as a condition of assumption under section 365(b)(1)(A)," Judge Forrest wrote, "the other two requirements—compensation for pecuniary loss and adequate assurances of future performance—may nonetheless still apply, depending on the circumstances." Id. (citing Collier at ¶ 365.06[2] (stating that a landlord is "entitled to insist that any defaults, whenever they may have occurred, be cured, that appropriate compensation be provided, and that, a past default having occurred, adequate assurance of future performance is available") (emphasis added)).

Therefore, the Ninth Circuit reasoned that the bankruptcy court's finding that there was no active default when it granted the debtors' motion to assume the lease "did not render section 365(b)(1)'s curative requirements inapplicable." Id.

Next, the Ninth Circuit determined that the bankruptcy court erred by narrowly construing "default" to mean only "defaults that are sufficiently material to warrant forfeiture of the lease under California law because there is nothing in section 365(b)(1) to support this interpretation." Id. at 1239. According to Judge Forrest, section 365(b)(1), unlike several other provisions of the Bankruptcy Code, does not explicitly require that a default be material, suggesting that Congress did not intend a materiality analysis in connection with the unexpired lease cure and adequate assurance requirements. Id. (citing 11 U.S.C. § 1112(b)(4)(N) (cause for conversion or dismissal of a chapter 11 case includes "material default by the debtor with respect to a confirmed plan"); § 1208(c)(6) (substantially the same for chapter 12); § 1307(c)(6) (substantially the same for chapter 13). Moreover, Judge Forrest explained, "section 365(b)(2) specifically exempts certain types of defaults involving ipso facto and forfeiture clauses; nonmaterial defaults are not one of the exempted categories." Id. 

Despite its determination that the bankruptcy court had erred, the Ninth Circuit concluded that the bankruptcy court's failure properly to analyze section 365(b)(1)'s "curative requirements" was harmless error under Fed. R. Civ. P. 61, which provides that "the court must disregard all errors and defects that do not affect any party's substantial rights" (made applicable to bankruptcy cases by Fed. R. Bankr. P. 9005).

According to Judge Forrest, the only outstanding issue was the landlord's alleged right to "adequate protection of future performance" under section 365(b)(1)(C), because any existing breaches had been cured or had been found by the bankruptcy court to be "only minor deviations from the contract terms." Therefore, she wrote, "any adequate assurance responsive to the alleged defaults would be little more than simple promises not to deviate from the contract terms again." Furthermore, Judge Forrest noted, the landlord "has not explained how any additional assurance of future performance would have substantively impacted its right to full performance of the lease terms." Id. at 1240.

The Ninth Circuit ultimately ruled that any error committed by the bankruptcy court was "harmless." Noting the below-market nature of the lease, Judge Forrest wrote that the landlord "made the deal" and "is not entitled to use section 365(b)(1) as a means to get out of a bad deal so that it can make a better one." Id. at 1240-41.

Outlook

The key takeaway from the Ninth Circuit's decision in Hawkeye is that a default under an executory contract or an unexpired lease need not be material or ongoing to trigger the obligation of the DIP or trustee to provide adequate assurance of future performance to the non-debtor counterparty as a condition to assumption of the contract or lease. The materiality of any breach may, however, impact the court's determination as to the extent of adequate assurance required to assume a contract or lease.

In Hawkeye, for example, because the payment default under the lease had been cured prior to assumption and the remaining alleged lease defaults were viewed as immaterial, the Ninth Circuit concluded that the bankruptcy court's imposition of a materiality trigger on the adequate assurance obligation was harmless error and that little or no adequate assurance was necessary. The court also perceived that the landlord was objecting to assumption on the basis of lack of adequate assurance in a ploy to get out of a bad lease. On different facts, the court might have ruled otherwise.