Every Default Counts: Ninth Circuit Rules Tenant Must Provide ‘Adequate Assurance of Future Performance’ to Assume a Lease Regardless of Materiality

A recent decision from the Ninth Circuit Court of Appeals illustrates the challenges faced by both bankrupt tenants and their landlords in the assumption of leases by tenants in bankruptcy proceedings. In In re Hawkeye Entertainment, LLC, the Ninth Circuit affirmed the holdings of the bankruptcy court and U.S. District Court allowing the debtor tenant to assume its lease over the objections of the landlord—but it did so despite finding that the lower courts had erred and only because the error was harmless.

Background

The tenant, Hawkeye Entertainment, LLC (Hawkeye), leased the first four floors and a portion of the basement of the Pacific Stock Exchange Building for use as a dance club. It was apparently undisputed that the lease was below market. The relationship between the parties deteriorated and Hawkeye refused to provide tenant estoppels as requested based on alleged problems with the premises. The landlord, Smart Capital, provided Hawkeye multiple notices of several non-monetary defaults, including the refusal to provide estoppel certificates as well as other defaults generally related to the upkeep and operation of the premises. Hawkeye filed bankruptcy to prevent termination of the lease.

In the bankruptcy, Hawkeye sought to assume the lease under Bankruptcy Code Section 365 which governs the assumption and rejection of leases and other executory contracts. Section 365 provides that “if there has been a default,” the debtor tenant must cure the default, provide compensation for any pecuniary loss resulting from the default, and provide “adequate assurance of future performance.” 11 U.S.C. § 365(b)(1)(A)-(C). Smart Capital objected to the proposed assumption based on the defaults and Hawkeye’s failure to provide adequate assurance of future performance. 

After a year of discovery, the bankruptcy court held a trial at which it found that the alleged defaults “appeared manufactured, and minor, and made-up, sometimes.” The court also held that, in order to be a “default” for purposes of Section 365, the default must be material under the applicable state law. In other words, the default must be serious enough that a landlord would be entitled to terminate the lease. Because the court found that the alleged defaults were not “material,” it found that Section 365 did not apply and, therefore, Hawkeye was not required to provide adequate assurance of future performance.

Ninth Circuit’s Ruling

The bankruptcy court was affirmed by the district court and ultimately by the Ninth Circuit, but only because the Ninth Circuit found the bankruptcy court’s error to be harmless. The Ninth Circuit held that the bankruptcy court had erred by holding that Section 365’s requirements for a lease in default was not triggered. Based on the plain language of the statute (“If there has been a default…”), any default is sufficient to trigger those requirements, including the provision of adequate assurance of future performance. The default does not need to be ongoing at the time of the assumption and it need not be a material default.

The Ninth Circuit affirmed the assumption of the lease, because adequate assurance of future performance could be satisfied by a simple promise by Hawkeye not to deviate from the lease terms again. Key to the Ninth Circuit’s ruling was that Smart Capital failed to identify what more Hawkeye could have provided to address its insecurity from the alleged past lack of performance. Rather, it seemed to the court that Smart Capital’s demands for adequate assurance stemmed from the fact that the lease was below market such that Smart Capital wanted a new tenant (or at least a new lease) at market rates.

Key Takeaways

There are several things commercial landlords and tenants can learn about the assumption of a lease from the Hawkeye decision:

• At least in the Ninth Circuit, any default under the lease will trigger Section 365’s requirement that tenant cure any defaults, compensate for any pecuniary loss and provide adequate assurance of future performance.
• Tenants seeking to assume a lease in bankruptcy should be prepared not only to cure any existing defaults but also to address how they will satisfy lease obligations in the future, even if that means a simple promise to comply with the lease going forward.
• Both prior to and during a tenant’s bankruptcy, a landlord should: (i) assess the impact of a default and, to the extent quantifiable, the amount of damages sustained by the landlord; (ii) if the default cannot be cured, be able to explain that is the case; and (iii) if the default is curable, specify the remedy the landlord requires to remedy the default (i.e., a security deposit to protect the landlord against costs associated with a future default).
• Although the Ninth Circuit relied on the statutory text to reach its decision, it was cognizant of the underlying market-driven dynamics of the lease and that the landlord may have been seeking to get out of a below-market lease based on minor defaults.

The Bankruptcy and Restructuring Group at Ballard Spahr advises on all facets of financial distress, including restructurings, workouts, the refinancing of debt, creditor-debtor litigation, asset dispositions and recapitalizations, reorganizations, and liquidations, both in and outside of formal proceedings. Ballard Spahr is one of the only firms in the country to have a leading national practice representing commercial landlords in Chapter 11 cases. For over two decades, we have represented landlords in the nation’s largest and most complex restructuring and bankruptcy matters. Please contact us for more information.

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