Smart Capital Investments I, LLC v. Hawkeye Entertainment, LLC (9th Cir.)

The following is a case update written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), analyzing a recent decision of interest:

SUMMARY

The United States Court of Appeals for the Ninth Circuit (the “Circuit Court”) recently ruled that a default under an executory contract need not be material in order to trigger the application of § 365(b)(1) of the Bankruptcy Code when the contract is assumed by a Chapter 11 debtor, a ruling contrary to the decision of the bankruptcy court which allowed the assumption. However, the Circuit Court concluded that the bankruptcy court’s misapplication of the law in this circumstance was harmless error, and the underlying decision was affirmed. Smart Capital Investments I, LLC v Hawkeye Entertainment, LLC, 2022 WL 4393579 (9th Cir. Sept. 23, 2022).

To view the opinion, click here.

FACTS

In 2014 Smart Capital Investments (and related entities referred to collectively as “Smart Capital”) leased real property in Los Angeles to Hawkeye Entertainment for use as a dance club. According to Smart Capital, the lease was substantially under market. The parties had a rocky relationship for years, with Hawkeye refusing to provide estoppel certificates to assist Smart Capital in obtaining refinancing, among other points of contention. In 2019 Smart Capital sent Hawkeye a notice of default, enumerating asserted nonmonetary defaults under the lease pertaining to the operation of the club and stating that Hawkeye had 15 days to remedy the defaults. Two weeks later Smart Capital sent a follow up notice threatening to terminate the lease in three days. Hawkeye countered with correspondence asking for a meeting and asserting no default had occurred. When Smart Capital did not respond, Hawkeye filed a chapter 11 petition. In April 2020, Hawkeye moved to defer rent for two months due to the Covid-19 moratorium, instead paying its April rent into trust. When the court denied the deferment, Hawkeye promptly tendered the April rent, which by then was late, generating a late fee which it paid when it became aware it was due in October 2020.

Hawkeye moved to assume the lease under § 365. After lengthy discovery, the bankruptcy court held a trial and stated findings on the record. It concluded that the testimony of the Smart Capital witness was suspect and that the asserted defaults appeared to be made up or were minor. It found there were no uncured defaults and that the earlier alleged defaults were not material under the lease. Analyzing California law, the bankruptcy court decided there could only be a material default if it warranted forfeiture of the lease, and none existed here. Although Smart Capital argued that any default would trigger the requirement that Hawkeye comply with § 365(b)(1), which among other things compels a debtor in possession (DIP) to provide adequate assurance of future performance if a default has occurred, the bankruptcy court rejected that assertion. It allowed Hawkeye to assume the lease without providing such adequate assurance because Smart Capital had failed to demonstrate “a material default under the Lease,” making § 365(b)(1) inapplicable.

Smart Capital appealed to the district court, which affirmed, then further appealed to the Circuit Court, which disagreed with the need for a material default to trigger § 365(b)(1) but found the error harmless.

REASONING

The Circuit Court first noted that § 365(b)(1) provides that “[i]f there has been a default in an….unexpired lease,” three conditions must be met in order for a DIP to assume the lease: (1) the DIP must promptly cure any default; (2) the DIP must compensate the other party for any actual pecuniary loss caused by the default or provide assurance that such compensation will be paid; and (3) the DIP must provide adequate assurance of future performance under the lease. Here, there were no uncured defaults at the time of the assumption and no actual pecuniary loss was at issue. The Circuit Court ruled, however, that just the lack of uncured defaults did not automatically mean § 365(b)(1) did not apply. Therefore, compliance with the third provision was still at issue.

The Circuit Court then focused on the lack of modifiers to the word “default” in the statute, noting that Congress knew how to designate that a default must be material in other parts of the statute, but had not done so here. Moreover, the dictionary definition of “default” was simple: “[a] failure to perform a task or fulfill an obligation,” citing the American Heritage Dictionary for the plain meaning. It also found that California law did not lay any materiality element on its use of “default” when referring to the performance of real property leases. Thus, the Circuit Court concluded that “the bankruptcy court erred in narrowly interpreting ‘default’ to refer only to defaults that are sufficiently material to warrant forfeiture of the lease….”

That did not end the inquiry, however. The Circuit Court was mindful of Federal Rule of Civil Procedure 61, which instructs courts to “disregard errors and defects that do not affect any party’s substantial rights.” It reasoned that the alleged defaults by Hawkeye really amounted to not performing its nonmonetary obligations under the lease; therefore, adequate assurance of further performance “would be little more than simple promises not to deviate from the contract terms again.” Such promises, made redundant by Hawkeye’s assumption of the lease, did not implicate Smart Capital’s substantive rights. Consequently, the bankruptcy court’s error on the materiality element did not create reversible error.

AUTHOR’S COMMENTS

The takeaway from this case is that the materiality of a default is not in play when a debtor in possession desires to assume an executory contract. Any default, cured or not, brings the three requirements of § 365(b)(1) for assumption into play. Counsel for chapter 11 debtors should make certain they assert compliance with all three whenever they move for assumption. However, the closing paragraph of the Circuit Court’s opinion, quoted below, shows the real reason it found no reversible error:

…[I]t seems that requiring further assurances would serve only to assist Smart Capital in its attempts to avoid continuance of an under-market lease. But this is not a right or benefit afforded under section 365…. Smart Capital made the deal it made with Hawkeye. And while it is entitled to assurance that Hawkeye will comply with the terms of that deal, it is not entitled to use section 365(b)(1) as a means to get out of a bad deal so that it can make a better one. 

This review was written by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.