FEATURE ARTICLE, OCTOBER 2005

BREAKING THE BANK
The 2005 Amendments to the Bankruptcy Code can positively affect business bankruptcy cases involving real estate.
Paul Hoffmann

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (2005 Amendments) constitutes the first set of material amendments to the Bankruptcy Code in approximately 10 years. These amendments primarily affect consumer bankruptcy cases. However, many of the amendments also affect business bankruptcy cases. Two sets of amendments in particular are affecting business bankruptcy cases involving real estate.

Under the current Bankruptcy Code, unexpired real estate leases are deemed rejected unless they are assumed within 60 days after the filing of the case, unless the deadline is extended. There is no limit on the number or length of extensions of this deadline. In fact, many bankruptcy courts routinely extend this deadline until the effective date of a confirmed plan, which often constituteds an indefinite extension.

The 2005 Amendments double the initial time frame for a debtor to assume or reject an unexpired non-residential real estate lease to 120 days after the filing of the case. More importantly, the 2005 Amendments only allow the court to extend this deadline by a maximum additional amount of 90 days, unless the landlord consents in writing to a further extension. Thus, debtors that are lessees of non-residential real estate must assume or reject the lease within approximately 7 months after filing bankruptcy, unless the landlord consents in writing to a further extension. The 2005 Amendments attempt to ameliorate this 7-month time limit through a provision that suggests a debtor may subsequently reject a lease that previously has been assumed, with the landlord's claim for any unpaid rent to be bifurcated between an administrative expense claim limited to no more than unpaid rent for 2 years after rejection, and a general unsecured claim for the balance of rent due.

How these amendments play out in actual cases remains to be seen. In this regard, consider the following situations.

First, consider the situation of a debtor holding a long-term lease at rental rates that are significantly below market. Presumably, the landlord would love the opportunity to have this lease rejected and re-let the premises at market rates. For this reason, the landlord is unlikely to consent to an extension of the deadline to assume the lease beyond the 7-month period provided in the 2005 Amendments. This will put pressure on debtors to assume these leases within this timeframe. However, most debtors will readily agree to assume such a lease knowing that they can subsequently reject it with the landlord having no material damages for such a rejection under relevant non-bankruptcy law (because the landlord will be able to re-let the premises at a higher rental rate).

On the other hand, a debtor holding a lease with rent that is significantly above market will not want to assume the lease any earlier than necessary. In fact, most debtors will not even wait the 7 months provided by the 2005 Amendments because they do not want to pay the above-market rent during this 7-month period. Instead, most debtors will immediately commence negotiations with landlords about modifying the lease to reflect market rates and thereby avoid the 7-month limitation. However, depending upon the leverage in a given situation, a debtor may negotiate interim modifications to the lease during the 7-month period and get the landlord's consent to an extension of the 7-month period while other issues in the bankruptcy case are resolved.

Some commentators feel that the only practical effect of the 2005 Amendments will be to limit the debtors' ability to market leases for sale to the 7-month period provided in the 2005 Amendments. However, many debtors will may be able to effectively extend the time period for marketing a lease by assuming it within the 7-month period and reserving the right to assign the lease after the 7-month period. The temporal distinction between assuming and assigning a lease was largely ignored under the prior Bankruptcy Code because a debtor could extend the deadline to assume a lease. With the amendments, debtors may now explore separating the time period for performing these two functions. In the end, the 2005 Amendments may not make a material difference in the assumption or rejection of non-residential real estate leases.

After the Tax Reform Act of 1986, the tax benefits of many forms of real estate ownership were eliminated. Many real estate partnerships became uneconomic, and the partnerships filed bankruptcy to delay the adverse tax consequences of a foreclosure for as long as possible. This resulted in some rather weak amendments to the Bankruptcy Code to address single asset real estate cases.

The amendments contain changes intended to minimize abuses in this area. However, most of these cases have worked their way through the system by now, and Congress may be too late in adopting these changes.

Nevertheless, single asset real estate owners should note the following changes in the 2005 Amendments. First, the definition of single asset real estate under the amendments has been modified to delete the previous $4 million cap. Any debtor that generates substantially all of its gross income from real property constituting a single property or project is subject to these rules, whether the property is worth less than $4 million or more than $400 million.

Second, the 2005 Amendments provide that a mortgagee of such a debtor may obtain relief from the automatic stay to complete a foreclosure 90 days after the bankruptcy case is filed, unless the debtor has either filed a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time, or commenced monthly payments in an amount equal to interest at the applicable non-default contract rate of interest with the creditor. This differs from the current Bankruptcy Code by obligating the debtor to pay the contract rate of interest instead of a fair market rate of interest.

A separate 2005 Amendment allows any real estate mortgagee to obtain relief from the automatic stay if the court finds that the debtor filed the bankruptcy case as part of a scheme to delay, hinder and defraud creditors that involved either (a) transfer orf all or part ownership of, or other interest in, such real property without the consent of the secured creditor or court approval, or (b) multiple bankruptcy filings affecting such real property. Moreover, a mortgagee may record an order granting relief from the automatic stay under this provision in the relevant real estate records and thereby prevent a debtor from filing a new bankruptcy case to stop a subsequent foreclosure for up to 2 years after the date of entry of the stay relief order, subject to the debtor proving changed circumstances or good cause shown in the subsequent bankruptcy case for not enforcing the previous order. These changes are intended to address many of the abuses by real estate debtors under the current Bankruptcy Code. Many courts under the current Bankruptcy Code already were creating remedies similar to this, and the 2005 Amendments should now strengthen a mortgagee's ability to obtain this relief.

The amendments discussed in this article will be effective for bankruptcy cases filed on or after October 17, 2005. Consequently, any business with real estate that may be adversely affected by these amendments should consult with an attorney about the possibility of filing a bankruptcy case before October 17th. On the other hand, parties benefited from these amendments should consider holding off on pursuing aggressive activity until these amendments are effective.

Paul Hoffmann is partner in the bankruptcy and creditors rights practice division of Stinson Morrison Hecker LLP in Kansas City, Missouri. Nothing in this article should be construed as legal advice for a particular situation.

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