11 May CALIFORNIA’S LAWYER’S ASSOCIATION – CASES OF INTEREST
South Bay Law Firm is proud to profile select “Cases of Interest” and other legislative developments, prepared by members and colleagues of the California Lawyers Association Business Law Section’s Insolvency Law Committee, and posted here by kind permission of the California Lawyers Association:
When is a breach of lease insufficient to trigger Section 365(b)(1)’s cure, compensation, and future performance requirements? In Smart Capital Investments I, LLC v. Hawkeye Entertainment, LLC (In re Hawkeye Entertainment, LLC), 2021 WL 4974038 (C.D. Cal. October 26, 2021), the District Court for the Central District of California affirmed the Bankruptcy Court’s decision holding that Bankruptcy Code Section 365(b)(1) did not apply because the alleged breaches were not sufficiently material so as to allow the landlord to terminate the lease under applicable state law.
Smart Capital leased a portion (the Premises) of a building in Los Angeles, California (the Property), to Hawkeye which it primarily used to operate a dance club and event venue. Shortly after Smart Capital served Hawkeye a notice of default, identifying numerous breaches of the Lease, Hawkeye commenced its Chapter 11 bankruptcy case. Hawkeye subsequently filed a motion to assume the Lease in the bankruptcy case (Lease Assumption Motion).
Under Bankruptcy Code Section 365(b)(1), if a “default” has occurred under an executory contract or unexpired lease, then the trustee (which includes a debtor in possession in a Chapter 11 case) must cure such default, compensate the counterparty for any actual pecuniary loss resulting from such default, and provide adequate assurance of future performance in order to assume the contract or lease.
Smart Capital opposed the Lease Assumption Motion, asserting Hawkeye had breached the Lease, that Hawkeye had caused damages that had not been cured, and that Hawkeye had not shown adequate assurance of future performance. After conducting a lengthy evidentiary hearing, the Bankruptcy Court granted the Lease Assumption Motion. The Bankruptcy Court determined that Hawkeye was not required to make a showing of cure or adequate assurance of future performance because Smart Capital failed to demonstrate a material default under the Lease. Smart Capital timely appealed.
The District Court affirmed the Bankruptcy Court’s legal conclusion that, to constitute a default under Section 365(b), a breach of an unexpired lease agreement must be sufficiently material to warrant the lease’s termination under applicable state law. The District Court cited Superior Motels, Inc. v. Rinn Motor Hotels, Inc., 195 Cal.App.3d 1032, 1052 (1987) and NIVO 1 LLC v. Antunez, 217 Cal.App.4th Supp. 1, 5 (2013) as California authorities for the principle that only a material breach gives a plaintiff landlord the right to terminate a lease. In doing so, the District Court rejected Smart Capital’s contention that any breach of a lease agreement, whether material or not, constitutes a default under Section 365(b)(1).
The District Court then comprehensively discussed and affirmed the Bankruptcy Court’s findings on each of Smart Capital’s theories of default: (1) Hawkeye’s failure to timely pay certain prepetition rent; (2) Hawkeye’s failure to sign an estoppel certificate; (3) Hawkeye’s entry into a contract with a religious group for use of the premises; (4) Hawkeye’s failure to hold insurance policies of certain minimums provided in the Lease; and (5) Hawkeye’s sale of alcohol on the Premises in violation of the Lease.
The District Court ruled that the Bankruptcy Court did not err in finding that Hawkeye’s late payment of April 2020 rent was not a material breach of the Lease, in view of the uncertainty regarding its liability due to a recently-imposed local moratorium on certain rent payments in the early stages of the COVID-19 pandemic. The Court noted that Hawkeye had made the rent payment (and applicable late fee) less than one month after the due date, soon after losing a motion to determine its liability. The District Court also cited EDC Associates, Ltd. v. Gutierrez, 153 Cal.App.3d 167, 170 (1984) for the “general rule that the right of a lessor to declare a forfeiture of the lease arising from some breach by the lessee is waived when the lessor, with knowledge of the breach, accepts the rent specified in the lease.”
The District Court also determined that the Bankruptcy Court did not err in finding Hawkeye did not breach a Lease provision requiring the Premises to be used as an “entertainment venue” by subletting it to a religious group. Based on evidence that the group performed religious worship with rock-and-roll music, large stereo equipment, and dancing, the District Court agreed with the Bankruptcy Court’s conclusion that this was consistent with the “entertainment venue and related business use” requirement of the Lease. The Court also approvingly noted that the group had used the premises for many years without any complaint by Smart Capital.
The District Court further ruled that the Bankruptcy Court did not err in finding that Hawkeye’s failure to sign an estoppel certificate was not a breach of the Lease. Although Hawkeye had refused to sign a form of estoppel certificate prepared by Smart Capital which it believed contained inaccurate information, it returned, within the period required under the Lease, an edited copy with language that Hawkeye believed to represent accurately its compliance with the Lease. The District Court refused to reverse the Bankruptcy Court’s determination that this did not constitute a default under the Lease, noting that it would be against public policy to compel Hawkeye to sign an estoppel certificate that misrepresented facts or to sign a document that would effectively waive known claims.
The District Court additionally ruled that the Bankruptcy Court had not erred in concluding that Hawkeye was not in breach of local governmental conditional use beverage provisions incorporated into the Lease, by serving alcohol in a portion of the premises where it was not generally permitted. The District Court cited with approval the Bankruptcy Court’s reliance on testimony on Hawkeye’s behalf that, on each occasion when alcohol was served in such location, Hawkeye had secured a daily permit for such service, and Smart Capital’s failure to present contrary evidence.
Finally, the District Court found no error with the Bankruptcy Court’s rejection of Smart Capital’s claim that Hawkeye failed to comply with the insurance requirements of the Lease. Although the Lease required Hawkeye to carry at least $7 million of specified liability coverage, Smart Capital contended Hawkeye had only provided documentation reflecting $6 million of coverage. However, the Bankruptcy Court found credible testimony on Hawkeye’s behalf that it actually possessed the required insurance coverage, and noted Smart Capital’s lack of contrary evidence. The Bankruptcy Court also observed that Smart Capital had belatedly raised this issue, having not previously requested proof of insurance from Hawkeye nor cited this in its prior default notice. The District Court declined to reverse the Bankruptcy Court’s determination in such regard.
As the Ninth Circuit has noted, “the purpose behind [Bankruptcy Code Section 365] is to balance the state law contract right of the creditor to receive the benefit of his bargain with the federal law equitable right of the debtor to have an opportunity to reorganize.” In re Circle K Corp., 127 F.3d 904, 909 (9th Cir. 1997). The District Court applied this principle in its decision in Hawkeye Entertainment. The Court appropriately rejected the landlord’s attempt to use non-material breaches of a lease as pretext to prevent the debtor-tenant from assuming the lease. Recognizing that the landlord’s financial interests were not actually impaired by the debtor’s alleged breaches, the Court properly preserved the value of the debtor’s leasehold interest for the benefit of the bankruptcy estate. Landlords and other contract counterparties should accordingly tread lightly in seeking to utilize technical lease or contract breaches to deprive a debtor of its established rights and powers under bankruptcy law.
These materials were prepared by ILC member Gary M. Kaplan, a partner at Farella Braun + Martel LLP in San Francisco (firstname.lastname@example.org), with editorial contributions from Ed Hays of Marshack Hays LLP in Irvine (email@example.com).