Source: https://www.monitordaily.com/article-posts/walking-through-the-shadows-of-bankruptcy-financing-equipment-in-time-of-distress/
Timestamp: 2020-08-07 16:07:50
Document Index: 160116105

Matched Legal Cases: ['§1', '§365', '§503', '§365', '§365', '§1129', '§362']

Walking Through the Shadows of Bankruptcy: Financing Equipment in Time of Distress - Monitordaily
by Inez M. Markovich & Howard Brod Brownstein May/Jun 2020 2020
Howard Brod Brownstein,
The bankruptcy code provides for fundamentally different treatment of true leases versus secured financings; however, it does not define what constitutes a “true lease.” In determining whether an agreement styled as a lease may in fact be a disguised secured financing, bankruptcy courts apply state law to determine the substance of the underlying transaction.
According to the Uniform Commercial Code (UCC), which has been adopted in nearly the same form in every state, the facts of each case determine whether a transaction creates a lease versus a secured purchase. Typically, when a lease cannot be cancelled by the lessee, the term of the lease is equal to or exceeds the useful life of the leased equipment. In these situations, the lessee has an option to buy the equipment for a relatively small amount at the end of the lease term, and courts will re-characterize the agreement as a secured purchase or financing.1
Generally, a “true lessor,” as the owner of leased equipment, has greater leverage in a customer’s Chapter 11 case because it can compel the debtor to assume or reject an unexpired lease agreement and because it is entitled to administrative expense treatment — the highest payment priority — for the debtor’s use of its equipment during the bankruptcy case. After the initial 60 days following the commencement of a Chapter 11 case, the debtor must perform its obligations, including regular lease payments, under an unexpired lease.2
An equipment lessor also can seek an administrative claim for lease payments owed during the initial 60-day period and any other postpetition missed payments, if the debtor continues to use the leased equipment during such an initial period. To succeed, the lessor must show that the lease payments represented “actual, necessary costs and expenses of preserving the estate.”3
In a Chapter 11 case, the debtor may assume or reject any “executory contract,” defined as a contract wherein there is substantial performance remaining by both parties to the contract, or an unexpired lease of real or personal property. This right to assume or reject executory contracts and unexpired leases is designed to allow debtors to free themselves, where necessary, of long-term contracts that may impede a successful reorganization, as well as to assume contracts important to their future. This is one of the “social engineering” purposes of bankruptcy and, while opinions may vary regarding its fairness, it is the law.
A debtor-lessee may assume or reject an unexpired equipment lease at any time before the confirmation of a plan of reorganization. While Chapter 11 debtors certainly enjoy considerable latitude in deciding which leases to reject or assume, equipment lessors need not wait indefinitely for the debtor’s decision. Instead, lessors can force the issue by filing a motion compelling the debtor to assume or reject the equipment lease within a specified period of time.4
Where a debtor-lessee assumes a lease, it must cure all defaults — such as missed payments, including any that occurred prepetition — and provide adequate assurance of future performance. An unexpired equipment lease may be assumed only with court approval, but curing any defaults does not have to be immediate. The debtor must provide adequate assurance of a “prompt” cure. Even in cases where the debtor’s reorganization strategy depends on its ability to assume its equipment leases, litigation frequently ensues over the sufficiency of adequate assurance of a “prompt” cure and/or the amount of the proposed cure payment.
The bankruptcy code also allows debtors to assume and then assign leases to a third party.5 This right becomes particularly important when a debtor’s reorganization strategy contemplates a sale of the debtor’s business. In those cases, the debtor has to provide adequate assurance of the future performance by the proposed purchaser/assignee of the assumed lease.
One issue that frequently comes up in the context of asset sales is whether a debtor can cherry-pick particular schedules in a master lease agreement for assumption and assignment to a prospective buyer. As a general rule, the debtor must assume and assign an executory contract or unexpired lease in its entirety. However, some bankruptcy courts recognize that a contract divisible into several different agreements may be partially assumed or rejected without assuming or rejecting the entire contract. Whether an executory contract or unexpired lease is divisible is a question of applicable state law, so lessors in a master lease agreement may want to specify a “choice of law” in order to determine whether the master lease will be divisible.
While a lessor’s ability to recover its leased equipment is critical, if the lessee can no longer pay, the value of such used equipment — especially if it hasn’t been adequately maintained during the lessee’s financial deterioration and/or if market conditions have weakened — may have declined substantially. In a case like this, a lessor may want to work creatively with the debtor-lessee and its advisors to maximize the lessor’s recovery, even if this means consensually restructuring the lease for the debtor-lessee or a buyer of the debtor-lessee. The following will help to shed light on which party may have leverage when lease financing encounters distress.
Turning now to how a secured creditor fares in contrast to a lessor in a “true lease,” a secured creditor’s remedies are limited to seeking “adequate protection” payments for the debtor’s use of its collateral or, if adequate protection cannot be provided, relief from the automatic stay in bankruptcy to take possession of the equipment. Notably, the debtor is not obligated to make adequate protection payments in the full amount of regular payments under the financing agreement and, prior to the confirmation of a Chapter 11 plan, is not obligated to make any payments on the creditor’s pre-petition claim.
Instead, the bankruptcy code only requires the debtor to provide payments to compensate the secured creditor for the “depreciation” of the creditor’s collateral caused by the debtor’s use, which can be an elusive concept and subject to disagreement. Although the debtor has the burden of proof to show the secured creditor is “adequately protected,” this may not be a difficult burden to meet concerning equipment that does not depreciate quickly.
Furthermore, a creditor deemed “oversecured” may not receive any adequate protection payments. Thus, hearings on “stay relief” motions often become battles of valuation experts in which the secured creditor must walk a fine line between demonstrating how the debtor caused the decline in the value of its otherwise valuable collateral and avoiding a low collateral valuation, which the debtor may later use to “cram down” the secured creditor’s claim under a Chapter 11 plan.6
A secured creditor also may seek relief from the automatic stay if the creditor can demonstrate the collateral contains “no equity” and is not necessary to an effective reorganization.However, during the early stages of a Chapter 11 case, courts are likely to give the debtor the benefit of doubt in overcoming a secured creditor’s arguments that the creditor’s collateral is not necessary to an effective organization.
Notably, a secured creditor awarded adequate protection payments in an amount lower than regular loan payments may not be able to increase the amount of such payments prior to the confirmation of a Chapter 11 plan. A secured creditor that finds itself bound by an adequate protection order in a protracted case, in which the debtor appears incapable of forming a reorganization plan, should consider alternative strategies for forcing the debtor to release the creditor’s collateral. Such strategies may include filing a motion for dismissal of the Chapter 11 case, conversion to Chapter 7 or the appointment of a Chapter 11 trustee or examiner.
While the bankruptcy code creates significant disparity in the treatment of lessors and financiers of equipment, both lessors and financiers should take an active role in their customers’ Chapter 11 cases early on to determine the best strategy for maximizing their recovery.
Even when a bankruptcy proceeding has not been initiated, the decisions of a distressed lessee or secured debt borrower, as well as its lessor or secured lender, are made “in the shadow of bankruptcy,” with all parties measuring the distance to bankruptcy, and whether they would be better off in a proceeding. It is often said that “bankruptcy is a better sword than a shield.” •
UCC §1-203
Bankruptcy Code §365(d)(5)
Bankruptcy Code §503(b)
Bankruptcy Code §365(d)(2)
Bankruptcy Code §365(f).
Bankruptcy Code §1129(b)
Bankruptcy Code §362(d)
Inez M. Markovich is a partner in the Philadelphia office of the law firm of McCarter & English, LLP. Howard Brod Brownstein is president of The Brownstein Corporation, a turnaround management firm in Conshohocken, PA.