In 1994 Congress amended the Bankruptcy Code to provide greater protection for personal property lessors. The Bankruptcy Reform Act of 1994 added §365(d)(10) to the Code. This section requires the trustee or debtor-in-possession to timely perform all of the obligations of the debtor first arising from or after 60 days after the order for relief in a chapter 11 case.

In theory, §365(d)(10) grants the debtor 60 days to determine whether to assume or reject a lease of personal property. If the debtor is unwilling or unable to make this determination within the first 60 days of the case, the debtor must perform under the lease until the determination to reject or assume is made, thus granting additional protections to the personal property lessor. The obligation to perform includes, if provided for in the lease, maintaining and insuring the property, and most importantly, paying to the lessor the contractual lease payment.

Section 365(d)(10) represented a major shift from the law that existed prior to the enactment of the 1994 amendments. Under the prior law, the burden of proof was on the lessor of personal property to establish that some post-petition, pre-assumption benefit had been conferred upon the debtor in order to support an administrative expense. Transfer Corp v. Grigsby (In re White Motor Corp.), 831 F.2d 106,110 (6th Cir. 1987). By shifting the burden of proof from the lessor to the debtor, §365(d)(10) makes such a showing by the lessor unnecessary. After the expiration of the initial 60-day period, a personal property lessor's right to administrative rent is automatic. In re The Elder-Berman Stores Crop., et al., 201 B.R. 759 (Bankr. S.D. Ohio 1996).

Non-compliance by the Debtor

But what happens if the debtor cannot pay the contractual lease claims or seeks to assert that a lease is not a "true lease" but rather a secured transaction simply labeled a lease, and ignores the provisions of §365(d)(10)?

There are no provisions within §365(d) (10) addressing the consequences of non-compliance. Unlike §365(d)(3), which relates to leases of real property, §365(d)(10) contains no provision terminating the lease and granting the lessor the right to possession of the property. The rights of the lessor and the remedies for non-compliance have been left to the courts to determine.

One option is for the lessor to simply request an administrative expense. If the debtor does not timely object, or fails to object until after the obligation has been incurred pursuant to §365(d)(10), the claim will be allowed as an administrative expense and paid at the administrative expense level. See Elder-Berman, 201 B.R. at 762.

The down side to simply awaiting payment as an administrative expense claimant in a chapter 11 case is that the estate may become administratively insolvent and unable to pay administrative claims in full, or may be converted to a chapter 7 such that chapter 7 administrative claims prime chapter 11 administrative claims.

A better option for the lessor is to move the court to order the debtor to pay the lease payments and to comply with §365(d)(10). Such a motion under §365(d)(10) should be accompanied by a motion to compel the debtor to assume or reject the lease, or set a time by which the debtor must assume or reject the lease and demand that the debtor provide adequate protection pursuant to §363(e), or alternatively that the stay be lifted.

Adequate Protection for Lessor

Section 363(e) was amended in 1994 as part of the statutory scheme to provide greater protection to lessors of personal property. Before the 1994 amendments, §363(e) provided:

Notwithstanding any other provision of this section, at any time, on the request of an entity that has an interest in property used, sold or leased, or proposed to be used, sold or leased by the trustee, the court, with or without a hearing, shall prohibit or condition such use, sale or lease as is necessary to provide adequate protection of such interest.

The following language was added as part of the 1994 amendments:

This subsection applies to property that is subject to any unexpired lease of personal property (to the exclusion of such property being subject to an order to grant relief from the stay under §362).

The additional language makes clear that Congress intended to insure that personal-property lessors have the right to seek adequate protection for their interest in property that is the subject of an unexpired lease, modifying the general rule that existed prior to the enactment of the changes.

The Debtor's Response

The debtor may respond to these motions in a number of ways. The debtor may seek to modify the payment schedule in a counter-motion that the "equities of the case" favor a different result. Section 365(d)(10) gives the court the authority to modify the payment schedule pursuant to its equitable powers, but if it does so it must consider the lessor's right to adequate protection under the circumstances. As the burden of proof is now on the debtor to show the need for equitable relief, and as the pre-petition payment schedule most likely resulted from arm's-length negotiations between the lessor and the lessee, it is hard to imagine many circumstances where the court will grant the debtor the equitable relief it seeks.

The debtor may contend that the lease is not a lease at all, but rather a secured transaction. If the lease is not a "true lease" but rather a financing device, then the lessor is not entitled to payments under §365(d)(10).

The question of what constitutes a lease is a mixed question of fact and state law. In re Homeplace Stores Inc., 228 B.R. 88, 92 (Bankr. D. Del. 1998). Further, the method to determine whether a lease should be recharacterized is an adversary proceeding. Fed.R.Bankr.P. 7001.

While the debtor bears a substantial burden of proof to overcome the strong presumption that a document-denominated lease is not a true lease, In re Edison Bros. Stores Inc., 207 B.R. 801, 812 (Bankr. D. Del. 1997), the time it takes to resolve this issue may be quite lengthy. The debtor should not be permitted to avoid the lease obligations during this dispute. At least one court has held that the debtor must, at a minimum, escrow the contractual payment pending a resolution of the controversy. See Elder-Berman, 201 B.R. at 764.

Conclusion

Congress's modifications to §§365 and 363, and the increased protections afforded lessors of personal property, substantially increase the options available to lessors of personal property, and the debtor should not be permitted to avoid the obligations contemplated by Congress if the lessor's counsel acts with diligence and with resolve.