Here’s a scenario which is all-too-common. The CEO of a small family business called me because he received in the mail Chapter 11 bankruptcy papers from his largest account. Every day – for months now – his wife and daughter and eventually the whole family have been waiting for the mail, hoping and praying for that big arrears check the controller keeps telling them is on the way.
The national corporate debtor has been placing larger and larger orders in the past few months and has accumulated a significant portion of the family’s rental equipment inventory as well as hundreds of thousands in unpaid invoices – representing the majority of this small family business’ operating capital. The CEO is worried he won’t get paid and won’t be able to lease out the equipment again either. This could drive his own business into bankruptcy and severely hurt his family and reputation. To say the CEO is angry with the controller for promising to pay and ordering lots more inventory while knowing a bankruptcy is looming is a vast understatement. But it happens all the time.
The story didn’t start out this way, however. After years of the account always paying on time, our client started to receive a late payment here or there. There was always an excuse: the company ran out of checks, the accounting staff was behind, or the payment got lost in the mail just to name a few. These invoices were always paid in the end, so the client wasn’t concerned. In fact, he took it as a positive sign when the company greatly increased their order for equipment.
Then, the bottom fell out. Our client received a notice of Chapter 11 bankruptcy from his customer instead of payment.
Thankfully, he called me.
Unfortunately for creditors, bankruptcy debtors have very specific lease protections written into the bankruptcy code. These debtors will have the opportunity to decide if they want to keep the lease in place or terminate it at no cost to them. What’s more, depending on the type of bankruptcy filing, it could be months before my client will get notice of whether or not the debtor corporation intends to affirm the lease or not.
While the protections for debtors are strong, creditors aren’t without options. With my help, a small business like this one will be able to pursue a number of options including having payments on the lease reinstated or even obtaining a court order requiring the return of the equipment.
[h3][/h3]
[h3]Leases in Bankruptcy[/h3]
First and foremost, when the debtor filed for Chapter 11 protection, it initiated what is known as the automatic bankruptcy stay. The most basic of bankruptcy protection, the automatic stay prevents a creditor from initiating any form of collection action against the lessor. What’s more, any actions that had already begun prior to the filing must now be put on hold. While the stay is in effect, the debtor is barred from any attempt to collect on the account or reclaim their leased equipment.
Once bankruptcy has been filed, a lessor will have some time to make a decision regarding the lease. For the first 60 days after filing, a creditor is entirely without recourse as the lessor is given this time to determine how they will proceed. In the case of my panicked client, I told him it is important to keep track of this 60-day deadline; once it passes, he can compel the lessor to resume payments on the lease and press for a decision on whether the lease will be assumed or rejected. In cases regarding leased equipment, Bankruptcy Code Section 365(d)(5) requires the lessor to meet their obligations under the lease after the initial 60 days are up. That includes abiding by any specific terms of the lease as well as timely making the lease payments. These lease payments will continue to accrue unless the lessor decides to abandon the lease. In the case of our small business creditor, while he might not get paid immediately, his customer will still have to start paying again if they intend to keep the lease.
One bit of good news for the creditor is that equipment lessees are treated slightly better than lessees of other items. After the initial 60-day period, any amount due on the lease is treated as an “administrative expense.” This is important because these expenses must be paid before the Chapter 11 bankruptcy plan may be confirmed. There are many details that can affect whether or not a debtor will be able to challenge the status of lease payments as administrative expenses; contacting a creditor’s rights attorney such as myself gives the best opportunity to learn about the rights and risks facing a lessee during bankruptcy.
[h3][/h3]
[h3]Is the lessor violating the terms of the lease?[/h3]
While the bankruptcy process is designed to protect the lessor, it does not absolve them of all requirements under the lease. If the debtor fails to meet a critical requirement of the lease like maintaining required insurance coverage or using the equipment in a manner barred by the lease, the court may grant the creditor relief from the automatic stay and allow them to recover the leased equipment. I let my clients know it is important to be diligent in these situations in order to avoid incurring more risk than is necessary.
[h3][/h3]
[h3]Motion for Relief from the Stay[/h3]
If a lessor decides to reject the lease or fails to uphold a material requirement of the agreement, a lessee has a path to regaining the equipment they had leased out. However, it’s not as simple as just going to pick up the equipment you own. Even if the debtor rejects the lease the automatic bankruptcy stay is still in effect until the bankruptcy judge rules otherwise. Removing property protected by the bankruptcy stay on their own would only cause the creditor headaches they can’t afford. Instead, we would have to start the process by filing a motion for relief from the stay.
A motion for relief from the automatic stay is a formal request from a creditor to the bankruptcy court to restart the collection process. Motions for relief are typically used in cases involving secured creditors or mortgages in foreclosure. However, a motion for relief is also necessary if a creditor has any hope of recovering their leased assets.
In cases where a lessor has rejected the lease, it is likely that they might not object to relief from the stay. One of the first things I would do on my client’s behalf in this kind of a case would be to discuss with the debtor’s attorney the possibility of voluntarily lifting the stay to allow for the return of the equipment. This may wind up being in the debtor’s best interest too, as it’s possible they don’t want to keep racking up bills for the leased equipment.
The same may not be the case when a lessor isn’t complying with the critical terms of the lease, especially in cases where the lessor intends to affirm the agreement. In these cases, I would need to put on evidence outlining the terms of the lease that have not been complied with. Ultimately, if the bankruptcy judge agrees, relief from the stay will be granted and my client will be allowed to pursue an action in state court to collect the leased equipment.
[h3][/h3]
[h3]Getting Equipment Back Through the Replevin Process[/h3]
The notion that a lessor can stop paying on the lease but continue to profit off of the use of the equipment is inherently unfair. That’s why most states have enacted “replevin” laws. A replevin action is a lawsuit where a secured creditor seeks the return of their property that is in the possession of someone else. Unfortunately, these actions can take time. That means while a replevin case unfolds, a lessor will be able to maintain possession of your equipment.
New York has developed a novel pre-trial remedy designed to protect the value of the leased commodity without trampling on the due process of the lessor. New York law allows for the court to take possession of the leased commodity during the course of the replevin case. Known as an Order of Seizure, this option allows for the commodity to be held and protected until trial.
[h3][/h3]
[h3]Steps to take to Protect Leased Equipment in a Bankruptcy Case[/h3]
It is understandable that having equipment tied up in bankruptcy court without being paid is frustrating. But like I tell clients, it’s imperative to stay vigilant during this process. In some instances, a mistake can actually cost a lessee their equipment without receiving any compensation for it. Here are three steps to prevent being treated unfairly as a lessee in bankruptcy court.
[h3][/h3]
[h3]Ensure leases are not technically purchase agreements[/h3]
The language of a lease is obviously important, but one thing many don’t consider is if the lease is technically a purchase agreement. Many leases are structured in a “lease to own” fashion, meaning that after leasing a piece of equipment for a set period of time the lessor will own it outright. While these agreements are described as leases, under bankruptcy law they are closer to an agreement to purchase the property. This is important because there are more protections for leased property compared to property that was sold through a security agreement. If a court determines a lease is not in fact a lease, a lessor will likely be able to pay the equipment owner pennies on the dollar in order to keep their inventory. That’s why I review the terms of the lease carefully in cases like this.
[h3][/h3]
[h3]Read notices carefully[/h3]
While it may seem obvious, it’s important to read every notice from the bankruptcy court. Many bankruptcy cases involve a non-stop barrage of letters and notices, and it is easy to start skimming over them. This is a mistake. The sad fact is that while lessees enjoy notable protections in the bankruptcy code, it is possible for a lesse to be taken advantage of if they aren’t careful. The risk stems from the fact that the bankruptcy trustee can sell assets of the debtor free and clear of any liens or interests. That means when the sale is completed, any interests in the assets held by other parties are severed. In a worst-case scenario, debtors have included equipment they had been leasing in their list of assets for sale. When the lessee failed to notice or object, the leased items were sold along with the other assets. In that case, the lessee would have no recourse against either the debtor or the person who now owns their leased equipment.
[h3][/h3]
[h3]Hire an Experienced Creditor’s Rights Attorney[/h3]
We’ve only scratched the surface of the issues that can arise for a lessee in bankruptcy court. Because of the court’s ability to sell a lessee’s assets out from under them, the best practice in these situations is to hire an experienced creditor’s rights attorney. An experienced attorney will protect your rights and counsel you on the best way to retrieve your assets as soon as possible. This business owner made a wise choice in contacting me as soon as he received the bankruptcy notice. If you find yourself in a similar position, don’t hesitate to call me as well.
