The risk associated with rejecting a previously assumed real property lease will be greatly reduced under the new Code amendments which will take effect on Oct. 17, 2005. Specifically, in the circumstance where a debtor assumes a real property lease in its bankruptcy and later rejects that lease, the liability associated with that bonehead decision will be limited under the new amendments. In the past such a post-assumption rejection would have meant that the debtor was still on the hook for the lease payments for the entire remaining term of the lease, as the whole lease was assumed in the post-petition time period when all new debts are assigned a priority status. However, as a favor to large tenants (think K-Mart or another large retailer who may file for chapter 11) this liability is now limited to two years of the lease term, even if that assumed lease would have by its terms continued for another ten years or more. The new Section 503(b)(7) states:

with respect to a nonresidential real property lease previously assumed under section 365, and subsequently rejected, a sum equal to all monetary obligations due, excluding those arising from or relating to a failure to operate or a penalty provision, for the period of 2 years following the later of the rejection date or the date of actual turnover of the premises, without reduction or setoff for any reason whatsoever except for sums actually received or to be received from an entity other than the debtor, and the claim for remaining sums due for the balance of the term of the lease shall be a claim under section 502(b)(6).

What does this mean in layman’s terms? Let’s say XYZ Inc., a company selling widgets out of several leased locations, files for Chapter 11 bankruptcy protection. XYZ assumes a nonresidential real estate lease with 5 years remaining on a downtown Fort Worth location, but 6 months into the bankruptcy, that store’s sales reverse and XYZ rejects the lease. The lessor is entitled to a priority claim for all obligations due for the next 2 years from date of rejection and the remaining 2 and Ω years’ obligations will be an unsecured claim.

NOTE: Under amended Bankruptcy Section 365(d)(4), a debtor has 120 days after the order for relief is granted to assume or reject nonresidential real property leases. The deadline can be extended for 90 days on the motion of the trustee or lessor for cause. Any further extensions may only be granted by the court upon prior written consent of the lessor. The more stringent deadlines will require greater planning for debtors who are party to leases affected by these provisions.

Ray