In a recent decision, Bankruptcy Judge Christopher S. Sontchi addressed the question of whether a Chapter 11 debtor, the tenant under a commercial lease, could exercise an option to renew the lease during the bankruptcy proceedings, even though the debtor was in default under the lease and the lease specified that it could not be renewed if defaults existed at the time the option was exercised. When the debtor attempted to assume and assign the lease, the landlord argued that the debtor had failed to properly exercise the option because of pre- and post-petition defaults, and as a result, the debtor could only assume and assign the lease to the extent of its remaining term without regard to the option period.

In In re Fresh-G Restaurant Intermediate Holding, Case No. 16-12174 (CSS) (Del. Bankr. Dec. 20, 2017), Sontchi held that the debtor had validly exercised the renewal option, and any defaults that existed at the time the debtor exercised the option did not prevent its right in the option from vesting. Since the lease was subsequently cured of any post-petition defaults and was a vested right, the option could be relieved from forfeiture pursuant to California law, which governed the lease. Sontchi declined the landlord's invitation to apply the court's equitable powers to amend the substantive state law rights of the parties outside bankruptcy, and rejected the landlord's argument that Section 365(d)(3) of the Bankruptcy Code preempted the state anti-forfeiture law. Sontchi held that the California anti-forfeiture law sufficiently balanced the interests of debtors and creditors and did not conflict with the rationale of Section 365(d)(3).

The debtor, Garden Fresh Restaurant Corp., filed for Chapter 11 along with its affiliates in October 2016. The following month, the debtor moved to assume and assign the lease between the debtor and the landlord, DK Connections, in connection with a motion to sell certain assets. The initial lease term was still in effect at the time of the motion. The lease contained an option to extend the term for two additional five-year periods, but provided that the debtor/tenant's right to exercise the option for any extended period was conditioned on the tenant not being in default when notice of the exercise of the option was given. While the landlord and debtor were engaged in negotiations over the proposed assumption and assignment of the lease, the debtor purported to exercise the first option before the deadline for doing so. The landlord rejected the renewal, because the debtor was in default of the lease for failure to pay rent and other charges, both from before and after the filing of the bankruptcy petition. The post-petition defaults were later cured by the debtor.

Sontchi focused on two competing legal principles of California law. The first principle was that the acceptance or exercise of an option must be in strict compliance with its terms. The second principle, buttressed by California's anti-forfeiture statute, Cal. Civ. Code Section 3275, was the equitable doctrine that a party to a contract should not suffer a forfeiture as the result of a minor or trivial breach of that contract.

Sontchi construed the principle that the holder of an option must strictly comply with the terms of the option to mean that strict compliance was required with respect to the timing and manner in which the option was exercised. Other terms barring exercise of the option due to material or immaterial defaults are not strictly enforced. California courts have applied equitable principles to allow the curing of lease renewal options where the loss amounts to a forfeiture. Sontchi concluded that under California law, a court may take a less restrictive interpretation of a renewal option's conditions relating to defaults for the purposes of equity, particularly in situations where the parties adhere to the remaining requirements of the contract, the optionor receives the benefit of the bargain intended in the original agreement, and the defaults are relatively minor or waived. Where the investment of the tenant is great and the defaults are minimal, the failure to renew a lease would work a forfeiture and be subject to the protections of the state's anti-forfeiture statute.

In the instant case, the debtor timely exercised the option. Sontchi found that valuable consideration was provided by the debtor to the landlord that created a vested right in the option, including the payment of over $2 million throughout the prior nine-year course of the lease and more than $795,000 in post-petition payments. Sontchi also noted that a majority of the defaults—the pre-petition defaults—were not payable or due at the time the renewal was exercised because of the bankruptcy proceedings. Stub-rent payments for the month in which the Petition was filed, charges billed retroactively after the option was exercised, and late charges and interest were not immediately due under bankruptcy law. The remaining defaults were otherwise de minimis, constituting less than 2.5 percent of the total amount paid to the landlord post-petition. The continued post-petition performance of obligations, the settlement of adequate assurance claims, the minimal size of the payment defaults, and the ultimate economic position of the parties favored the application of California's anti-forfeiture law. The option was revived based upon the cure of the post-petition defaults that existed at the time the option was exercised.

The landlord argued in the alternative that the state anti-forfeiture law conflicted with, and was preempted by, Section 365(d)(3) of the Bankruptcy Code. Section 365 allows the debtor to maximize the value of the estate by assuming those contracts that are beneficial to the estate and rejecting those that are not. Section 365(d)(3) requires the debtor to timely perform all obligations under any unexpired lease until the lease is assumed or rejected. However, there is no express language in Section 365(d) that supports the preemption of state anti-forfeiture laws under these circumstances. Sontchi construed Third Circuit case law interpreting Section 365(d)(3) to allow the parties to enforce their preexisting contractual lease rights under the governing state law. It did not displace that law. Accordingly, the obligation created by the option in the lease, that there be no existing default when the option was exercised, was governed by and subject to the ability to be cured under the state anti-forfeiture law. Given his decision on the state law claim, Sontchi declined to address the Section 365 argument and found the state anti-forfeiture law to not be preempted in this case.

In the end, Sontchi had no need to invoke federal bankruptcy law to validate the debtor's exercise of the option, relying instead on the state anti-forfeiture statute. Sontchi did apply federal bankruptcy law to evaluate and minimize the debtor's defaults under the lease. However, Sontchi's introductory remark, declining in this case to apply the court's equitable powers to amend the substantive state contract rights of the parties outside bankruptcy, suggests that the outcome would have been the same even if there were no state anti-forfeiture law to apply, although the rationale would have been different. The key factor may be gleaned from the court's comment in its subsequent legal discussion that preventing the renewal of the lease, after the settlement of the adequate assurance objection and the post-petition cures, would have resulted in a windfall to the landlord.

Barry M. Klayman is a member in the commercial litigation group and the bankruptcy, insolvency and restructuring practice group at Cozen O'Connor. He regularly appears in Chancery Court.

Mark E. Felger is co-chair of the bankruptcy, insolvency and restructuring practice group at the firm.