Ninth Circuit Court of Appeals Rules that Debtor in Possession’s Burden to Provide Adequate Assurance of Future Performance is Not Dependent on Whether the Default was “Material” Under California Law

In a published opinion on September 23, 2022, the Ninth Circuit Court of Appeals determined that the debtor in possession’s burden to provide adequate assurance of future performance is not dependent on whether the default was “material” under California law such that it warranted forfeiture of the entire lease. In publishing the opinion, the Ninth Circuit Court of Appeals settled a legal issue that has significant consequences beyond the particular case.

The September 23 decision is the latest ruling in the case In re Hawkeye Entertainment, LLC, a dispute that traces back to 2014. Hawkeye leased the first four floors of the Los Angeles Stock Exchange building in 2009 from Pax America Development, LLC (“Pax”). Hawkeye subleased the space to a nightclub operator.  At some point after entering into the lease, Pax defaulted to Hawkeye and also fell into default under Pax’s mortgage loan with Pax’s lender. Following a number of serial bankruptcy filings by Pax and related entities which were determined to be in bad faith, New Vision Horizon, LLC (“NVH”) purchased Pax’s mortgage note from Pax’s lender and then foreclosed on Pax’s interest in the building. NVH acquired the building through the foreclosure sale. NVH was the predecessor to Smart Capital. After purchasing Pax’s interest in the building, NVH attempted to terminate the lease and the parties eventually settled their dispute resulting in a settlement agreement and a 2014 amendment to the lease, which, among other things, increased the rental rate paid to NVH. Thereafter, Smart Capital (which is owned by a former member of NVH) acquired the interest of NVH in the building. After acquiring MVH’s interest, Smart Capital again attempted to terminate the lease. After trying to terminate the lease, Smart Capital testified that the nightclub was paying a price that was “significantly” under market value. After Hawkeye filed for bankruptcy, Smart Capital presented the bankruptcy court with allegations that the nightclub operator had not honored its end of the lease agreement. After a five-day trial, the bankruptcy judge disagreed with Smart Capital and ruled in favor of Hawkeye.

In publishing the September 23 opinion, the Ninth Circuit affirmed the decision of the Bankruptcy Judge and U.S. District Court Judge, ruling that Hawkeye can keep its space in the downtown Los Angeles Pacific Stock Exchange building, dismissing the landlord’s attempt to prove defaults and terminate its lease.

The Ninth Circuit Court of Appeals determined the debtor in possession must provide adequate assurance of future performance under Bankruptcy Code § 365(b)(1) even if a default is cured as of the time of assumption and even if the default is non-material and would not warrant forfeiture or termination of the lease under California law; and the Ninth Circuit Court of Appeals further found that the Bankruptcy Court erred in holding that Section 365(b)(1) was not triggered because the alleged defaults were non-material.

However, the Ninth Circuit Court of Appeals nevertheless affirmed the Bankruptcy Court’s decision regardless of its failure to consider adequate assurance on the basis of the secondary argument that if error occurred, it was harmless error. The Bankruptcy Code does not specify what constitutes “adequate assurance of future performance.” Instead, courts apply this requirement “based upon the facts and circumstances of each case.” The Ninth Circuit Court of Appeals reasoned that adequate assurances under Section 365(b)(1)(C) are only appropriate and necessary where the counterparty has reasonable grounds for insecurity with respect to the debtor’s ability to fully perform its obligations under the contract. Here, the Court of Appeals found that the record established that the Bankruptcy Court determined that any default was cured as of the time of assumption, and that many of the alleged defaults were either not defaults in the first place or were only minor deviations from the contract terms. Thus, the Court of Appeals found that any adequate assurance responsive to the nature of the alleged defaults in this case would be little more than simple promises not to deviate from the contract terms again.

Significantly, the Court of Appeals pointed out that although Section 365 provides protection for a landlord from having to be saddled with a debtor that may continue to default and return to bankruptcy, it does not allow a landlord to improve its position by escaping the bargain it made in pursuit of an opportunity to rent the premises to others at a higher amount.

The Court of Appeals further determined that requiring further assurances would serve only to assist the landlord in its attempts to avoid continuance of an under-market lease, and that this is not a right or benefit afforded under section 365. Therefore, the Court of Appeals ruled that the Bankruptcy Court’s failure to analyze whether the debtor in possession satisfied section 365(b)(1)’s curative requirements before granting its assumption motion was harmless error, and it affirmed the decision of the Bankruptcy Court.

Leech Tishman’s Business Restructuring & Insolvency Practice Group regularly assists clients in bankruptcy and bankruptcy litigation matters. If you have any questions about the case outlined above, or what they might mean for bankruptcy proceedings, please contact Sandford L. Frey.

Sandy is a Partner with Leech Tishman and Co-Chair of the Business Restructuring & Insolvency Practice Group, where he co-leads the Bankruptcy Chapter 11 Debtor and Bankruptcy Chapter 11 Subchapter V Debtor Groups. Sandy is based in the Los Angeles office and can be reached at 626.796.4000 or sfrey@leechtishman.com.

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Leech Tishman Fuscaldo & Lampl is a full-service law firm dedicated to assisting individuals, businesses, and institutions. Leech Tishman offers legal services in business restructuring & insolvency, construction, corporate matters, employment & labor, estates & trusts, intellectual property, litigation & alternative dispute resolution, and real estate. In addition, the firm offers a wide range of legal services to clients in the aviation & aerospace, cannabis, emerging cyber technologies, energy & natural resources, healthcare, and hospitality industries. Headquartered in Pittsburgh, PA, Leech Tishman also has offices in Chicago, Los Angeles, New York, Philadelphia, Sarasota, and Washington, D.C.