§ 136.10 — Leases and Executory Contracts before BAPCPA
Revised: June 30, 2004
Payments due at the petition under a lease, rental contract or other executory contract are ordinary prepetition claims in the Chapter 13 case but typically get special treatment through the plan. If the debtor assumes a prepetition lease or executory contract under §§ 365(a) and 1322(b)(7),1 the prepetition defaults must be cured “promptly” (or faster) consistent with § 365(b)(1).2 If the debtor rejects the lease or contract, the claim from that rejection is allowed or disallowed as if it arose before the filing of the Chapter 13 petition under § 502(g).3
Unexpired leases and executory contracts can produce nasty administrative expense problems in Chapter 13 cases. For example, if the debtor assumes an automobile lease after filing a Chapter 13 case and then has a change of heart and rejects the lease, any postpetition charges or damages for breach of the lease can be an administrative expense under § 365(g)(2)(A).4
Chapter 13 debtors too often just roll along living in a rented apartment or using rented personal property without assuming or rejecting the lease or rental agreement. If a rented apartment or a rented refrigerator is an “actual, necessary cost and expense of preserving the estate,” then postpetition rent can become an administrative expense under §§ 507(a)(1) and 503(b)(1). Although there is some dispute whether the contract rental payment is controlling as the use-value of a rented apartment or of rented personal property prior to assumption or rejection,5 whatever actual, necessary cost accrues after the petition is entitled to administrative status under § 503(b). In In re Freeman,6 the bankruptcy court refused a residential landlord’s request for an administrative expense for unpaid postpetition rent, finding that the debtor’s occupation of the rental property as a holdover tenant during the Chapter 13 case was not an actual and necessary expense for § 503(b)(1) purposes:
For a claim to qualify as an actual and necessary expense two elements must be present. First, the debt “must arise from a post-petition transaction with the estate. Second, the goods or services giving rise to the debts must benefit the estate in some demonstrable way.” . . . Finding whether property is necessary to an effective reorganization requires a showing by a debtor of (1) his or her intent, (2) “the anticipated integration of the property at issue in the production of future income” and (3) “the nature and extent of the property involved.” . . . Debtor has made no showing of his intent to use the property as part of his reorganization efforts. Further, there is no evidence of any effect the property will have on future income of the debtor. Finally, the extent to which the property will be involved in the reorganization is not clear. Debtor cannot show that this property was necessary to an effective reorganization. In fact, movant sought relief from stay . . . . Debtor offered no defense and the motion was granted . . . . This court . . . finds no basis in the present case to award administrative expense priority for post-petition rental arrears under a pre-petition residential lease. . . . Movant . . . has not shown that debtor’s estate received an actual benefit by debtor continuing to reside on the subject rental property.7
Chapter 13 debtors engaged in business are especially likely to be parties to leases and executory contracts that need attention under §§ 365 and 1322(a)(7). Debtors engaged in business are more likely than ordinary debtors to be parties to nonresidential lease agreements that must be “timely” performed until assumed or rejected under 11 U.S.C. § 365(d)(3).8 Failure of a Chapter 13 debtor to act quickly with respect to a lease of nonresidential real property results in a “deemed” rejection 60 days after the filing of the Chapter 13 case under § 365(d)(4), followed by a battle with the landlord whether the postpetition rent is an administrative expense under § 503(b)(1)(A). Several reported Chapter 13 decisions hold that postpetition, pre-rejection lease payments for nonresidential real property are an administrative expense measured at the full contract rate.9
Other contractual obligations of a debtor engaged in business can generate administrative expenses that have been granted priority and full payment under § 1322(a). For example, in In re Carney,10 the debtors operated a muffler and brake shop franchised by Meineke Discount Muffler Shops, Inc. The debtor assumed the franchise agreement with Meineke but failed to pay all postpetition weekly franchise fees. The confirmed plan called for full payment of priority claims, and with respect to postpetition claims under § 1305, provided, “Claims allowed for post-petition debts incurred by debtors may be paid in full and in such order and on such terms as the trustee, in his sole discretion, may determine.”
Meineke moved for allowance of an administrative expense for all unpaid postpetition franchise fees. The trustee opposed on the ground that the fees were postpetition claims under § 1305. The bankruptcy court found that Meineke’s claim did not fit the definition of a postpetition claim in § 1305 because the franchise fees were not incurred for a personal, family or household purpose.11 Instead, the court found that Meineke’s claim was an administrative expense under § 503(b)(1)(A), was entitled to priority under § 507(a)(1) and was entitled to full payment under § 1322(a)(2).
Similarly, in Kwik-Kopy Corp. v. Klein (In re Klein),12 the debtor rejected a franchise agreement with Kwik-Kopy Corporation that contained a covenant not to compete for two years. Although the debtor rejected the franchise agreement, the court found that continued operation of a copying business at the same location constituted a violation of the covenant not to compete. On the complaint of Kwik-Kopy, the debtor was held obligated to pay royalties for breach of the covenant, and the royalties were an actual and necessary expense to preserve the estate for purposes of § 503(b)(1)(A). As a result, rejection generated an administrative expense for the royalties that had to be paid in full through the plan under § 1322(a)(2).
Neither of these courts considered critically whether administrative expenses in a Chapter 13 case are necessarily priority claims entitled to full payment under § 1322(a)(2). There is no clear reference to administrative expenses in § 1322(a)(2); but many reported decisions and most Chapter 13 plans treat administrative expenses as priority claims, entitled to full payment (without interest).13
The message in Klein and Carney is that debtors engaged in business must be particularly attentive to the administrative expenses that can be generated by the mismanagement of executory contracts used in the operation of the business. If the debtor is going to reject a lease for a business location, a franchise agreement or some other contract used in the business, the debtor should do so right away at the beginning of the Chapter 13 case because almost any continued operation using the contract will generate an administrative expense that may be entitled to priority and full payment through the plan. Contracts must be carefully examined for noncompete and other ongoing restrictions that even if rejected may generate postpetition damages claims that are administrative expenses. Negotiating the rejection of a lease or executory contract to include elimination of administrative expenses can save the Chapter 13 case.
The Bankruptcy Reform Act of 1994 enhanced the rights of lessors of personal property in Chapter 13 cases.14 The 1994 Act amended § 363(e) to permit lessors of personal property to request adequate protection in Chapter 13 cases.15 In Chapter 13 cases filed after October 22, 1994, on motion of the lessor, the debtor may be required to adequately protect a lessor of personal property prior to confirmation by, for example, making periodic payments or granting a lien on other property.16
When a Chapter 13 debtor fails to make court-ordered adequate protection payments to a lessor of personal property, the lessor is likely to clamor for an administrative expense under § 503(b). Section 361 of the Code specifically excludes administrative expense treatment as a form of adequate protection.17 Although there are reported Chapter 13 decisions that seem to grant an administrative expense remedy to a creditor asserting failed adequate protection,18 it is a long-shot argument for a lessor with a prepetition contract. The lessor will have difficulty proving a postpetition transaction with the estate. This will be especially true when the Chapter 13 debtor rejects the lease at or before confirmation of a plan. The more likely remedy for a lessor when adequate protection has been ordered but not paid in a Chapter 13 case is a motion for relief from the stay.19
The new adequate protection rights of lessors of personal property in § 363(e) should not produce “superpriority” problems for Chapter 13 debtors. Section 507(b) entitles lienholders to superpriority treatment when adequate protection fails and the creditor is left with a claim that qualifies as an administrative expense under § 503(b).20 Though lessors of personal property now have adequate protection rights under § 363(e), the superpriority in § 507(b) is only available to the “holder of a claim secured by a lien on property of the debtor.”21 Lessors of personal property typically are not also lienholders.
1 See § 51.3 Assume, Reject or Assign Leases, Rental Agreements and Executory Contracts and discussion beginning at § 102.1 Debtor Can Assume, Assign or Reject Executory Contracts. BAPCPA made changes to § 365 of the Bankruptcy Code that will affect claims arising from leases and executory contracts in all bankruptcy cases, as well as some changes that are specific to the treatment of leases and executory contracts in Chapter 13 cases. See § 136.11 Leases and Executory Contracts after BAPCPA; see also § 51.4 Preconfirmation Assumption and Rejection of Leases and Executory Contracts after BAPCPA, § 57.4 Preconfirmation Rights of Landlords and Lessors after BAPCPA, § 102.3 Leases and Executory Contracts after BAPCPA and § 136.13 Failed Adequate Protection after BAPCPA.
3 See § 174.2 [ Rejection Generates Unsecured Claim ] § 102.5 Rejection Generates Unsecured Claim.
4 In re Pearson, 90 B.R. 638 (Bankr. D.N.J. 1988). Accord In re Masek, 301 B.R. 336, 342 (Bankr. D. Neb. 2003) (Acknowledging conflicting authority, balance of lease payments is entitled to administrative priority when Chapter 13 debtor assumed car lease, and defaulted, and lessor repossessed. “The negotiation between the parties that resulted in the stipulated assumption of the lease created, in essence, a new agreement, as both parties made concessions . . . . If Ford Motor Credit were not permitted to recover the payments it is otherwise entitled to, then the lease assumption caused only a detriment with no concomitant benefit . . . . This is an outcome that debtors and their attorneys will have to seriously consider when weighing the costs and benefits of lease assumption.”); In re Wright, 256 B.R. 858, 859–60 (Bankr. W.D.N.C. 2001) (Abandonment of a truck lease after assumption through confirmed plan generates a priority administrative expense. Plan confirmed in June assumed unexpired lease of a trailer. In October, debtors moved to modify the confirmed plan to “abandon” the trailer. Court permitted the modification subject to a determination of the priority of the resulting claim of the lessor. “Section 365(g)(2) . . . states that where an assumed lease is later rejected, the resulting damages are construed as arising postpetition at the time of such breach. . . . [P]ostpetition damages resulting from the breach of a previously assumed lease are entitled to priority as an administrative expense.”).
5 See, e.g., In re Dant & Russell, Inc., 853 F.2d 700 (9th Cir. 1988).
6 297 B.R. 41 (Bankr. E.D. Va. 2002).
7 297 B.R. at 43–45.
8 See § 51.3 Assume, Reject or Assign Leases, Rental Agreements and Executory Contracts, § 51.4 Preconfirmation Assumption and Rejection of Leases and Executory Contracts after BAPCPA, § 102.1 Debtor Can Assume, Assign or Reject Executory Contracts, § 102.2 Debtor Must Cure Defaults and Assure Future Performance and § 102.3 Leases and Executory Contracts after BAPCPA.
9 See In re Schnitz, 293 B.R. 7, 11 (Bankr. W.D. Mo. 2003) (Landlord gets administrative expense claim under § 365(d)(3) for postpetition, pre-rejection rent of business property without meeting benefits and necessity test in § 503(b)(1)(A); administrative rent claim can be paid pro rata with other priority claims over the life of the Chapter 13 plan. “Great Plains is entitled to an administrative expense claim . . . pursuant to § 365(d)(3), without the necessity of meeting the ‘benefits test’ of § 503(b)(1)(A). . . . Administrative expense claims are entitled to first priority in payment under § 507. 11 U.S.C. § 507(a)(1). There is nothing in Chapter 13 that provides for the immediate payment of any claim or class of claims, and the concept of superpriority claims is foreign to Chapter 13 proceedings. . . . Because the claims in Chapter 13 are to be paid from the debtor’s future income, it necessarily follows that those claims are not to be paid immediately, but instead are to be paid over time in the order of priority established by § 507. . . . That claim may and should be paid pro rata with other administrative expense claims.”); In re Kirsch, 242 B.R. 77, 79 (Bankr. M.D. Fla. 1999) (Debtor is bound by § 365(d): rent for nonresidential real property is an administrative expense for the period between the petition and rejection or expiration of the lease. “Though Section 365(d) provides that the trustee is permitted to assume or reject unexpired leases, courts interpret the Bankruptcy Code as to allow chapter 13 debtors to assume or reject leases under this Section. . . . Accordingly, chapter 13 debtors must perform their obligations ‘under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title.’ . . . Debtors’ lease with Regency did not expire until the lease was rejected by law in accordance with 11 U.S.C. § 365(d)(4) sixty days after Debtors filed their petition. Accordingly, Debtors are required to pay as an administrative expense the full lease payment for the sixty-day postpetition period that the lease remained unexpired.”); In re Brewer, 233 B.R. 825, 828–29 (Bankr. E.D. Ark. 1999) (“Among a chapter 13 debtor’s duties under section 365 is the performance of ‘all the obligations of the debtor . . . arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title.’ 11 U.S.C. § 365(d)(3) (1994). . . . The majority view interpreting this section is that a lessor bound by an unexpired, nonresidential lease is entitled to allowance of an administrative claim for rent without regard to the section 503 demonstration of benefit to the estate. . . . Rent paid during the pre-rejection period pursuant to section 365(d)(3) is to be paid at the full contract rate.”);.
10 No. 93-01065-H13 (Bankr. S.D. Cal. July 15, 1993).
12 218 B.R. 787 (Bankr. W.D. Pa. 1998).
14 See § 47.1 Adequate Protection of Lienholders before Confirmation, § 47.2 Preconfirmation Adequate Protection after BAPCPA, § 57.2 Adequate Protection Rights, § 57.3 Preconfirmation Adequate Protection Rights after BAPCPA, § 57.4 Preconfirmation Rights of Landlords and Lessors after BAPCPA and § 102.6 Lessor Can Demand Adequate Protection.
15 11 U.S.C. § 363(e), as amended by Bankruptcy Reform Act of 1994, Pub. L. No. 103-394, § 219, 108 Stat. 4106 (1994).
16 See § 174.3 [ Lessor Can Demand Adequate Protection ] § 102.6 Lessor Can Demand Adequate Protection.
17 11 U.S.C. § 361(3) describes potential forms of adequate protection with this exception: “other than entitling such entity to compensation allowable under section 503(b)(1) of this title as an administrative expense.” See § 47.1 Adequate Protection of Lienholders before Confirmation, § 47.2 Preconfirmation Adequate Protection after BAPCPA, § 57.2 Adequate Protection Rights, § 57.3 Preconfirmation Adequate Protection Rights after BAPCPA, § 57.4 Preconfirmation Rights of Landlords and Lessors after BAPCPA and § 64.1 Lack of Adequate Protection for further discussion of adequate protection in Chapter 13 cases.
19 See 81.1 [ Lack of Adequate Protection ] § 64.1 Lack of Adequate Protection for discussion of lack of adequate protection as a ground for relief from the stay.
21 11 U.S.C. § 507(b) (emphasis added).