In an opinion that’s good for lessors, the U.S. Court of Appeals for the Third Circuit has ruled that the lower courts were incorrect to hold that the approval of a lease-rejection request included the implicit right to prorate the last lease payment.

In In re Federal-Mogul Global Inc., 2007 WL 777061 (3rd Cir. March 15, 2007) (not precedental), the lessor, Computer Sales International, Inc., appealed a ruling by the bankruptcy court permitting proration of the last month’s payment as of the date of the rejection of the lease. Federal-Mogul Corporation was a large automobile parts supplier, which, together with 156 of its U.S. and U.K. subsidiaries, had filed for chapter 11 bankruptcy relief and continued to operate as a debtor-in-possession.

Prior to Federal-Mogul’s bankruptcy filing, Computer Sales International entered into a Master Lease Agreement with Federal-Mogul, which established lease terms covering hundreds of pieces of equipment leased under some 70 leasing schedules. The Master Lease Agreement called for Federal-Mogul to pay monthly rental payments in advance on the first day of each month.

As debtor-in-possession, Federal-Mogul negotiated a new computer leasing arrangement with IBM, and asked the bankruptcy court to allow it to approve the new leases and reject the CSI leases. Federal-Mogul planned to replace more than 4,200 pieces of equipment in 60 locations, and sought to minimize costs by replacing the equipment over a period of time, and by rejecting the lease as each item was replaced.

CSI and other computer lessors opposed Federal-Mogul’s motion to reject its leases as proposed.

The bankruptcy court held a hearing and granted permission to reject the CSI leases "with such rejection taking effect upon the Debtors giving notice to the applicable Computer Equipment Lessor."

When Federal-Mogul began replacing the leases, it did not make payments on the first of the month for equipment covered by leases which the company chose to reject mid-month. Rather, the debtor later remitted a prorated payment reflecting the portion of the month it had held the equipment before rejection.

CSI objected, arguing that the Master Lease Agreement still controlled, and the entire monthly payment was due on the first of the month. CSI asked the bankruptcy court to compel payment for the entire month in which each lease was rejected.

Both the bankruptcy court and the district court held that CSI had waived any argument against proration by failing to raise the issue before the bankruptcy court when Federal-Mogul moved for permission to reject the CSI leases, and by failing to appeal the order approving lease rejection. The district court found that proration was "implicit" both in the motion to reject and the bankruptcy judge’s order "even if not explicitly stated in either," the Third Circuit noted.

On appeal, the Third Circuit considered whether the order allowing rejection of the leases had determined the issue of proration. The court concluded it had not.

The Third Circuit cautioned against confusing the power to assume or reject a lease under section 365(a) of the Bankruptcy Code with the ability to request a lease modification under section 365(d)(5). Federal-Mogul’s motion to reject the leases under section 365(a) did not include a request for modification of its lease obligations under section 365(d)(5), the court stated.

Rather, the bankruptcy judge later found the right to prorate implicit in the order approving lease rejection: "[T]he order rejecting the lease[s] says that they’re rejected the date we tell you they’re rejected, and the order, the motion specifically said that means you get paid up to that date."

But the Third Circuit disagreed that the reference to rejection of the leases "as of a certain date" implied that the lease payments were to be prorated.

"[P]roration of sums owing prerejection can only be affected by modifying the lease to the extent the Bankruptcy Code permits," the court stated. "[D]ebtors should make their requests to modify lease obligations explicit by invoking the Court’s § 356 (d)(5) authority…. [T]hey should not conflate the § 365(a) power to assume or reject with the § 365(d)(5) power to modify, as those powers are distinct."

The Third Circuit was unpersuaded by the argument that the equities were in the debtors’ favor because the debtor should not be compelled to make payments on equipment it already had surrendered. The debtors could have requested proration at the outset or rejected the leases at or near the end of the month, the court noted.

"[T]here is nothing in this case inequitable about holding the Debtors to their bargain," the court stated.

Nonetheless, the court did go as far as CSI urged. The Third Circuit determined it would not follow the U.S. Court of Appeals for the Fourth Circuit in holding that retroactive modification is prohibited by section 365(d)(5). "We decline here to make a bright line rule, but we do note that § 365(d)(5) is structured so that vigilant debtors should not need a retroactive remedy," the court stated.

This article is presented for informational purposes only and is not intended to constitute legal advice.