This article discusses Smart Cap. Invs. I, LLC v. Hawkeye Ent., LLC (In re Hawkeye Ent., LLC), 49 F.4th 1232 (9th Cir. 2022).
There are several definitions of an executory contract. Generally, it refers to something (often a contract) that has yet to be fully performed or was completed but considered imperfect or where full execution is unassured. The most commonly used definition is referred to as the “Countryman definition.” Under the Countryman test1, an executory contract is defined as “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.” A lease related to a bankruptcy can be a type of executory contract.
Can a Debtor Assume a Lease Over the Landlord’s Objection?
Hawkeye Entertainment LLC leased real estate from Smart Capital Investments for use as a dance club. In the bankruptcy of Hawkeye Entertainment, the Ninth Circuit Court of Appeals dealt with whether the debtor could assume a lease over the landlord’s objection.
A debtor may assume a lease only if it: (A) cures the default (or provides adequate assurances that it will); (B) provides compensation for any actual pecuniary loss resulting from the default (or provides adequate assurances that it will); and (C) provides adequate assurances of future performance under the lease. 11 U.S.C. § 365(b)(1)(A)–(C).
Adequate Assurance of Future Performance
Of note in Hawkeye Entertainment is whether the debtor could provide adequate assurance of future performance. Here, there appeared to be some non-material, non-monetary defaults. And for these reasons, the landlord objected. Some of these “non-material defaults” included (1) subletting a portion of the space to a church, (2) refusing to execute an estoppel certificate because there were problems with the premises, (3) being in violation of a beverage permit, and (4) being in violation of insurance provisions.
The debtor argued that it was current on its monetary obligations, and if there were non-monetary defaults, they were not material. Further, in some instances these non-monetary defaults had existed for years, i.e., the landlord was well aware of these non-monetary defaults and did not require the debtor to cure the default and that the landlord simply wanted to find an excuse to terminate the lease because it was now under market. The landlord, on the other hand, argued that no matter the materiality of the defaults, there were defaults and thus, debtor could not provide adequate assurance of future performance. For these reasons, the landlord urged the court to deny assumption of the lease.
The bankruptcy court permitted assumption of the lease finding that any such defaults were not material and thus did not affect the debtor’s ability to provide adequate assurance of future performance. On appeal, the district court affirmed. The landlord appealed to the Ninth Circuit Court of Appeals.
Adequate Assurance of Future Performance By Agreeing Not to Perform
What makes the Ninth Circuit’s opinion so interesting is that though it affirmed the bankruptcy court’s ruling allowing the debtor to assume the lease over the objection of the landlord, it found that the debtor provided evidence of adequate assurance of future performance. Because there appeared to be no current default, the court found that the “the only curative requirement at issue was ‘adequate assurance of future performance’ of the lease.” The debtor offered adequate assurance of future performance by agreeing not to do certain things, e.g., not placing banners on the façade of the building and not holding more than 50 events at the building. Because everything appeared to be in the negative (the debtor would not…), only the future would prove whether the promise held up. What adequate assurance of future performance could the debtor offer? The landlord certainly could not provide an answer. The Ninth Circuit pointed out that “adequate assurance” does not allow the landlord to improve its position and the landlord cannot use evidence of adequate assurance as a means to terminate the lease.
Nevertheless, even though the debtor was permitted to assume the lease, the Ninth Circuit disagreed with the bankruptcy court’s reasoning finding that it does not matter if the default is material for purposes of allowing a debtor to assume an executory contract. In examining the language of Section 365(b)(1), the Ninth Circuit noted that there was no reference to whether the default was material. A default is a default. No matter how immaterial the default may be, and no matter whether the default is monetary or non-monetary — a debtor is required to cure the default in order to assume the lease.
So, it appears that a debtor can assume a lease no matter the materiality of the non-monetary default, as long as the debtor cures the default and provides adequate assurance of future performance.
Arguably, this case may be limited on its facts as there appeared to be some concern with the landlord’s underlying motive to terminate an under-market lease. In other words, it appears that in some instances bankruptcy courts may examine the equities of the case. Here, the facts were that the bankruptcy filing was the result of the landlord’s actions to find a way to terminate the lease, the non-monetary defaults existed for a number of years, the landlord had refused to engage the debtor in discussing these non-monetary defaults — which to avoid termination, the debtor filed bankruptcy — the appearance of the building was more due the landlord’s failure to maintain the building than fault of the debtor and probably most relevant, the evidence showed that the debtor was not currently in default..
The outcome may be that even though a default is a default, no matter the materiality, bankruptcy courts being courts of equity may be inclined to view the equities of the case and allow assumption of an executory contract even though such assumption may not strictly comply with Section 365 of the Bankruptcy Code.
1. The “Countryman test” derives from law professor Vern Countryman, author of Executory Contracts in Bankruptcy: Part I, 57 MINN. L. REV. 439, 460 (1973). Some circuit courts have adopted this test, as noted in Spyglass Media Grp. v. Bruce Cohen Prods. (In re Weinstein Co.), 997 F.3d 497, 503 (3d Cir. 2021). , Other circuit courts instead rely on a “functional approach.” See U.S. Department of Justice – Civil Resource Manual, 59 “Executory Contracts in Bankruptcy – Introduction, Threshold Issues.”