United States: No Cuts, No Buts, No Coconuts: The Second Circuit Limits Who May Assert Priority Cure Claims In Bankruptcy

A fundamental concept underlying the Bankruptcy Code is the "absolute priority rule," which generally provides that creditors of lower priority may not be paid until higher priority creditors are paid in full. One exception to the absolute priority rule is for "cure claims" related to a debtor's assumption of an executory contract or unexpired lease.

To assume (or assume and assign) an executory contract or unexpired lease, the debtor must cure all monetary defaults through the date of assumption. Consequently, a debtor's assumption of a contract or lease gives rise to a "cure claim" for all amounts then due under the contract or lease, and those amounts must be paid in full before assumption can occur, irrespective of whether secured or general unsecured creditors will receive distributions on account of their claims or when they will be received. Thus, "cure claims" effectively cut to the front of the priority line, often resulting in creditors attempting to shoehorn their otherwise lower priority claims into the category of "cure claims."

In In re George Washington Bridge Bus Station Development Venture LLC,

the United States Court of Appeals for the Second Circuit addressed the scope of those who may assert priority "cure claims" and held that a creditor asserting such a "cure claim" under the Bankruptcy Code must have a contractual right to payment under the assumed executory contract or unexpired lease at issue, but suggested that being an intended third-party beneficiary to such contract or lease under state law might suffice to satisfy this requirement. This article explores the Second Circuit's decision in George Washington Bridge and addresses its go-forward impact.

Facts

George Washington Bridge Bus Station Development Venture LLC (the Debtor) was the developer on an approximately US$183 million project to renovate and improve a Port Authority bus station at the Manhattan end of the George Washington Bridge. In 2011, the Debtor and the Port Authority initiated a public-private venture to improve the facility by constructing a large retail mall on the same site. In July 2011, the Debtor and the Port Authority memorialized the terms of their arrangement in a ground lease (the Ground Lease), which obligated the Debtor to arrange for necessary renovations to the bus station and, in exchange, the Port Authority promised a substantial monetary contribution toward the costs of construction, plus it awarded the Debtor the right to operate and manage the retail center for up to 99 years.

The Ground Lease contemplated that the Debtor would retain a general contractor to perform the construction work and further specified that the Debtor, not the Port Authority, would be responsible for paying the general contractor. More specifically, the Ground Lease provided that, "the Port Authority shall have no obligations or liabilities in connection with the performance of any Construction Work or the contracts for the performance thereof entered into by the [Debtor]," and that, "the [Debtor] shall pay all claims lawfully made against it by its contractors, subcontractors, material-men and workmen ... arising out of or in connection with or because of the performance of the Construction Work."

In 2013, the Debtor and Tutor Perini Building Corporation (Tutor Perini) entered into a construction contract (the Construction Contract) under which the latter agreed to serve as general contractor for the redevelopment project. Tutor Perini commenced work, but the project was plagued by delays and disputes between the Debtor and Tutor Perini. In 2015, the Debtor commenced an arbitration proceeding against Tutor Perini and Tutor Perini countered with a claim for US$113 million in damages. Eventually, the project opened to the public, but the delays and extra costs, including those related to the arbitration, caused the Debtor to file for Chapter 11 protection in October 2019.

Tutor Perini's Asserted Cure Claim

In its bankruptcy, the Debtor proposed a sale of substantially all of its assets, including its most valuable asset: the Ground Lease. That sale required, among other things, the Debtor to exercise its ability under the Bankruptcy Code to assume the unexpired Ground Lease (but not the Construction Contract), and then assign it to a buyer. Tutor Perini, however, asserted the right to bring a "cure claim" against the Debtor even though it was not party to the Ground Lease, i.e., Tutor Perini demanded that the Debtor cure its purported default under the Ground Lease,

that default being the Debtor's failure to pay US$113 million to Tutor Perini as allegedly required by the terms of section 5.7(c) of the Ground Lease, before the lease could be assumed and assigned.

Tutor Perini advanced two legal theories to support its demand that the Debtor cure its alleged default before assuming the Ground Lease. First, Tutor Perini argued that it was a third-party beneficiary of the Ground Lease, with rights to enforce it. Second, Tutor Perini asserted that, even if it were not a third-party beneficiary, its economic interest in the Debtor's performance under the Ground Lease entitled it to bring a cure claim because section 365 of the Bankruptcy Code does not contain an express limitation on who may bring such a claim.

The Bankruptcy Court for the Southern District of New York held that Tutor Perini was not a third-party beneficiary of the Ground Lease and had no cure rights thereunder.

On appeal, the District Court for the Southern District of New York affirmed.

Tutor Perini appealed to the Second Circuit.

The Second Circuit's Decision

First, George Washington Bridge rejected Tutor Perini's contention that section 365 does not limit who may assert a "cure claim." Instead, the Second Circuit held that, "to receive priority under § 365(b)(1)(A), a creditor asserting a default must have some right to pursue a breach of contract claim under the executory contract or unexpired lease a debtor assumes under § 365(a)." More particularly, the court noted that section 365 of the Bankruptcy Code was intended to ensure that contracting parties receive the full benefit of their bargain and "that intent is effected where an actual party to the Ground Lease — here, the Port Authority — seeks cure claim treatment ...," but not when someone not party to the Ground Lease seeks such treatment.

Second, George Washington Bridge rejected Tutor Perini's alternative argument that it did have contractual rights in the Ground Lease sufficient to pursue a cure claim, "either by virtue of [the] Debtor's delegation to and Tutor Perini's assumption of [certain] Ground Lease obligations, or by being a third-party beneficiary."

In determining whether Tutor Perini was a third-party beneficiary of the Ground Lease, the Second Circuit considered whether Tutor Perini qualified as an intended third-party beneficiary under New York law on the basis that the Ground Lease provided that the Debtor was required to make payments to the contractors and subcontractors hired by the Debtor to complete the project. The Second Circuit held that this obligation in the Ground Lease simply allocated payment responsibilities to the Debtor instead of the Port Authority, rather than creating a promise by the Debtor to perform any obligation for the benefit of any contractor, including Tutor Perini.

In further support of its holding that Tutor Perini was not a third-party beneficiary of the Ground Lease, the Second Circuit pointed to a specific provision in the Ground Lease that specified certain third-party beneficiaries, but did not list Tutor Perini as one of these beneficiaries. According to the Second Circuit, these facts taken together indicated that Tutor Perini was not a third-party beneficiary under the Ground Lease and therefore not entitled to any cure payment on that basis.

The Second Circuit did not expressly decide whether an intended third-party beneficiary of an assumed contract or unexpired lease may assert a priority cure claim under section 365 of the Bankruptcy Code, but noted in dicta that, "there are sound reasons to think that Congress would have wanted third-party beneficiaries to be able to assert cure claims. After all, a third-party beneficiary is one who has a right to performance under a contract because the intention of the parties to that contract was to afford the third party such a right."

Conclusion

The Second Circuit's decision will impact contractors, subcontractors, and other real estate project vendors throughout the country, particularly those in New York City where project developments are often structured as ground leases. In light of George Washington Bridge, contractors, subcontractors, and vendors should carefully evaluate development contracts and ground leases to determine whether the applicable agreement includes a provision that requires the developer to pay all claims made against it by its contractors, subcontractors, and other vendors, and if so, request that they be named in the agreement as an intended third-party beneficiary. Doing so may increase the likelihood of successfully asserting a priority cure claim in the developer's bankruptcy should the ground lease or development contract be assumed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.