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When it Comes to Assuming Executory Contracts, a Default is a Default; But the Equities Still Matter

The recent decision of the Ninth Circuit in In re Hawkeye Entertainment, LLC contains a few important takeaways with respect to the treatment of executory contracts and unexpired leases under section 365 of the Bankruptcy Code. First, for purposes of section 365(b)(1), the Ninth Circuit has established that a default does not need to be a material default to trigger the requirements for a debtor’s assumption of a contract or lease which includes providing adequate assurance of future performance. [1] Second, even a non-monetary default triggers the requirements. And third, notwithstanding the above rules, equitable considerations, whether expressed as such, still influence courts to rule in favor of the party the court thinks should win. 

In Hawkeye, the debtor tenant, Hawkeye Entertainment, LLC (the “Debtor”) had leased four floors of the Pacific Stock Exchange building in Los Angeles (the “Lease”) from landlord Smart Capital (the “Landlord”). The Debtor was found to be current on rent but the Landlord asserted a number of non-monetary defaults. According to the Debtor’s allegations, among other things, the Landlord had been non-responsive when the Debtor sought to communicate with the Landlord about remedying certain of these non-monetary defaults and was forced to file Chapter 11 to avoid forfeiture of the Lease after receiving a three-day notice to pay rent or quit. [2]

The Debtor sought to assume the Lease and the Landlord objected. The Debtor emphasized that it was current on its monetary obligations, and alleged that the non-monetary defaults had either been cured or were manufactured by Landlord, despite the Landlord’s knowledge that some of these default conditions had existed for years without objection. The Debtor argued that the Landlord simply wanted to terminate the Lease because it was now under market. The Landlord argued that under section 365(b)(1) of the Bankruptcy Code, the Debtor was in default, had failed to demonstrate adequate assurance of future performance, and thus could not assume the Lease.

The Bankruptcy Court granted the Debtor’s motion to assume the lease, finding that any defaults that existed were non-material and, therefore, did not trigger the requirement that the Debtor provide adequate assurance of future performance. On appeal, the District Court looked at each of the following alleged defaults and affirmed the Bankruptcy Court’s determination with respect to each one (either on the basis that there was no default or that such default was not material enough to constitute reversible error): (1) a partial sublet of the space to a church for religious services in alleged violation of the Lease; (2) failure to sign an estoppel certificate; (3) failure to comply with a conditional use beverage permit, and (4) failure to abide by insurance provisions. The Landlord appealed to the Ninth Circuit.

In its opinion, the Ninth Circuit disagreed with the reasoning of the Bankruptcy Court and District Court; suggesting a reversal was in the offing. The Ninth Circuit determined the Bankruptcy Court was wrong, ruling that it does not matter whether a default is material for purposes of section 365(b)(1). The Ninth Circuit looked at the language of the statute which did not contain the term “material”, as well as other portions of the Bankruptcy Code which made that distinction and concluded that Congress knows how to reference material defaults when it wants to do so. In so ruling, the Ninth Circuit also made clear that even a non-monetary default triggered the requirement that the Debtor provide adequate assurance of future performance. Nevertheless, the Ninth Circuit affirmed the Bankruptcy Court’s decision (authorizing assumption of the Lease), holding the Bankruptcy Court’s misinterpretation of the law was a harmless error because, in this case, the Debtor provided adequate assurance of future performance by simply agreeing to assume the Lease

As a result, this Ninth Circuit decision is a mixed bag. While it establishes that any default -- whether big or small, monetary or non-monetary – precludes a debtor from assuming a lease without satisfying the requirements of section 365(b)(1), by finding a debtor’s duplicative promise to comply with non-monetary obligations satisfies the requirement of providing adequate assurance of future performance, it may have gutted the significance of that requirement in the context of a non-monetary default. Notably, however, when questioned about it at the hearing, Landlord’s counsel could not articulate how the Debtor should actually provide such adequate assurance. So, if the Ninth Circuit’s decision is to be interpreted as being limited to the facts of this case, then it has failed to provide any real guidance as to what constitutes adequate assurance of future performance of a non-monetary default. 

The Ninth Circuit (and the lower courts) seemed to be swayed by what appeared to be the Landlord’s underlying motive – to take back this under market lease. And it certainly appears – from the fact that the courts took two entirely different legal approaches to reach the same practical result – that the Bankruptcy Court and District Court were also heavily influenced by the equities, which they viewed in the Debtor’s favor. At least according to the Debtor’s allegations in its motion to assume (the Landlord’s opposition to the motion appears not to directly address each such allegation), the bankruptcy filing and a prior Debtor bankruptcy were each precipitated by the Landlord’s aggression. Also, according to the Debtor’s allegations, a number of the alleged non-monetary defaults were in existence for years, the Landlord was non-responsive when the Debtor tried to engage in discussion to address some of the non-monetary defaults, some of the asserted non-monetary defaults related to the appearance of the building – which appeared contrived due to the Landlord’s non-maintenance of the rest of the building, and the Landlord had recently attested to the fact that there were no existing defaults under the Lease.

In sum, this case establishes some important rules interpreting section 365; however, the underlying facts and perceived equities still matter to the outcome.

[1] The full text of the statute reads:

(b)(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 nonmonetary obligations under an unexpired lease of real property, if it is impossible for the trustee to cure such default by performing nonmonetary 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.

[2] The Debtor had also filed a Chapter 11 several years earlier - also in response to the Landlord’s default notice. The earlier Chapter 11 was resolved through a settlement among the Debtor and the Landlord.