Section 365 of the Bankruptcy Code allows debtors to “assume” unexpired leases, recommitting themselves and their counterparties to the existing lease terms, subject to approval by the Bankruptcy Court.  If there are existing defaults under the lease, section 365(b) appears to require that the debtor provide the counterparty with adequate assurance of prompt cure of defaults, compensation for losses resulting from the defaults, and adequate assurance of future performance under the lease, ensuring that the landlord enjoys the full benefit of its bargain going forward.

Oral argument was held last month between appellant-landlord and appellee-debtor in the Ninth Circuit Court of Appeals regarding the hotly contested assumption of an office building lease and nightclub sublease in a Central District of California bankruptcy case.  The outcome may alter conventional thinking and the balance of power in connection with the process of lease assumption and cure of defaults in the bankruptcy context.  At issue is whether a debtor must satisfy the cure and adequate assurance requirements of section 365(b) at all when assuming an unexpired lease if none of the alleged defaults are “sufficiently material to result in the termination of the lease under state law.”

Affirmation of the District and Bankruptcy Court rulings may significantly impair landlord leverage to negotiate the terms of lease assumptions in the Ninth Circuit.

Hawkeye, the debtor, subleases the first four floors and part of the basement of the Pacific Stock Exchange Building in Los Angeles to a related entity, W.E.R.M. Investments, LLC which operates a successful nightclub and entertainment venue on the leased premises.  Shortly after commencing its bankruptcy case, Hawkeye moved to assume the lease and the landlord objected.  Extensive discovery, briefing, and a five-day bench trial followed.  It did not go well for the landlord.

Bankruptcy Judge Tighe found that none of the alleged on-going defaults were material enough to warrant forfeiture of the lease and explained that “I just cannot read 365 to say any teeny, tiny infraction means a Debtor-In-Possession loses the very valuable asset. That would be not in keeping with state law…”  Hawkeye’s assumption of the lease was approved without the need to provide the landlord with adequate assurance of future performance as required under section 365(b)(1)(A), (B) and (C) of the Bankruptcy Code, including prompt cure of defaults and compensation for pecuniary loss resulting from such defaults.

On appeal, District Court Judge Fernando L. Aenlle-Rocha agreed with the Bankruptcy Court and in an unpublished decision found that technical breach of the terms of a lease must be material under state law to be considered a default under section 365(b).  In addition, the District Court found no clear error in the Bankruptcy Court’s findings that the five separate alleged lease defaults were not in fact existing defaults at all (neither material nor “teeny tiny”).

Accordingly, if the Ninth Circuit agrees, Hawkeye will assume the lease under section 365(a).  Existing breaches, if any, that would not lead to termination of the lease would not need to be cured and the landlord will not be entitled to adequate assurance.  Assuming there was some identifiable breach, not only would this result appear to be out of step with the restorative policy of section 365(b), but the landlord will be left out in the cold with respect to outstanding non-material defaults.  So much for maintaining the ‘benefit of the bargain’ for non-debtor contract counterparties. Please check back for further developments.