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Financial distress persists in the commercial real estate market, raising the prospects that property owners and landlords could seek relief under chapter 11 of the Bankruptcy Code. The Bankruptcy Code contains numerous provisions that apply to commercial real property
leases — in Bankruptcy Code parlance, a lease of “nonresidential real property” — but only one provision relates specifically to unexpired leases of nonresidential real property where the lessor is in chapter 11. As a result, the Bankruptcy Code leaves open certain questions that arise in lessor chapter 11 cases, such as the tenant’s right to retain possession when the underlying property is sold and the impact of rejection by a debtor that is both a lessee and sublessor on the rights of the subtenant. This note summarizes those issues and their treatment in the courts, which has not been uniform or provided clear guidance to lessors and lessees.
Chapter 11 Options Generally
Virtually all commercial property leases contain a provision allowing the landlord to terminate upon a tenant bankruptcy; some leases contain a reciprocal provision benefitting the tenant. In neither case can the non-debtor party seek any remedy based on a default arising from the chapter 11 filing. The Bankruptcy Code renders such provisions unenforceable and until the landlord rejects the lease, the tenant is obligated to pay rent.
Most leases also provide that a security deposit remains the lessee’s property and that the lessee is entitled to its return when the lease expires (after any damages recoverable from the security deposit are paid). The landlord, therefore, should not be able to use the security deposit to pay the claims of its creditors.
As with any unexpired lease or executory contract, the Bankruptcy Code gives the bankrupt lessor three options for ultimately disposing of the lease. The landlord has the right to assume, assume and assign, or reject its lease with the tenant. Assumption is the lessor’s agreement to continue performing under the lease in exchange for retaining its rights. A landlord may opt to assume a lease that, for example, pays above-market rent or provides strategic benefits to its business. If the landlord wishes to assume (or assume and assign), the lease, it must first cure, or provide adequate assurance that it will promptly cure, all monetary defaults and any nonmonetary defaults that can be cured. The landlord also must provide adequate assurance that it will continue to perform under the lease. If the landlord wishes to assume and assign the lease to a third party, the assignee must provide the adequate assurance of future performance.
Lease Rejection and Section 365(h)
The more challenging issues arise, though, when the landlord rejects the lease. Rejection constitutes a breach and not a termination, but the tenant can treat the lease as terminated and vacate the premises if the breach would entitle it to terminate under applicable non-bankruptcy law. The tenant also would have the right to file a proof of claim for rejection damages.
Section 365(h) of the Bankruptcy Code gives the tenant another option. If the lease term has begun, then the tenant can retain its rights under the rejected lease (and rights in or appurtenant to the real property) for the entirety of the remining lease term plus any renewal or extension period to the extent such rights are enforceable under applicable non-bankruptcy law. The tenant also is entitled to its rights of use possession, quiet enjoyment, subletting, assignment, and hypothecation.
But Section 365(h) limits and conditions the tenant’s right to remain in possession. The tenant must continue to pay rent and other amounts owed under the rejected lease. If the premises are in a shopping center and the lessee elects to remain in possession, the lessee must continue to abide by non-monetary restrictions on radius, location, use, exclusivity or tenant mix, as must the tenant’s successors, assigns or lenders. The tenant cannot file a proof of claim for rejection damages, seek specific performance or enforce any right against the debtor’s estate arising from nonperformance after the date of rejection. The tenant’s only right is to offset the value of any damage caused by the lessor’s nonperformance against its rent payments. The inability to enforce any rights means, for example, that the tenant cannot compel the landlord to make repairs or provide services.
Tenant’s Rights if Lessor Sells Property “Free And Clear”
Companies operating in chapter 11 often sell assets to raise cash to pay creditors. Section 363(f) of the Bankruptcy Code gives a debtor the right to sell assets of its bankruptcy estate “free and clear of any interest in property” if certain conditions are met. The Bankruptcy Code neither limits the phrase “interest in property” to liens nor defines the scope of those interests, but a tenant’s leasehold rights undoubtedly are an interest in property.
The conditions for a free and clear sale include the situation where applicable non-bankruptcy law allows a sale free and clear of such a property interest. For example, in many jurisdictions a foreclosure sale to satisfy a senior mortgage terminates a subsequent lease recorded on the mortgaged property. Because such a foreclosure sale permits a transfer free and clear of the leases, a leasehold interest may be subject to the debtor’s rights to sell its property free and clear under Bankruptcy Code section 363(f). As a result, courts have had to determine whether a debtor-lessor can sell the underlying real estate “free and clear” and divest the tenant of its leasehold interest in the property and its right to remain possession.
In its much-discussed opinion in Precision Industries, Inc. v. Qualitech Steel SBQ (“Qualitech”), United States Court of Appeals for the Seventh Circuit held that a lease is an interest in property that can be extinguished in a free and clear sale of the underlying property under Section 363(f). Qualitech reversed a district court ruling which found that section 363(f) conflicted with the tenant’s right to remain in possession under Section 365(h) and there was no statutory basis for allowing the lessor to terminate the lessee’s right of possession by selling the property out from under it. The Seventh Circuit found no such statutory conflict. It determined that the where one of the criteria permitting a free and clear sale existed, the right to sell free and clear of “any interest” in property under section 363(f) was sufficiently broad to encompass a lessee’s possessory interest.
Qualitech found no conflict between Section 363(f) and Section 365(h). Nothing in Section 363(f)’s text subjected it to any limit Section 365(h) might impose. Further, section 365(h) applies only where the lessor rejects the lease but in Qualitech the debtor in the first instance sold the property without rejecting the lease. Section 365(h), therefore, applied to a set of circumstances that did not exist. Qualitech also notes that Section 363(e) of the Bankruptcy Code offers the tenant a remedy other than remaining in possession: the tenant can seek adequate protection of its leasehold interest.
The reaction to Qualitech has been mixed. A Ninth Circuit opinion concurred with Qualitech’s analysis that Sections 363(f) and 365(h) do not conflict but referred to it as the “minority approach.”The Fifth Circuit refused to issue a writ of mandamus to stay a sale of real property free and clear of a tenant’s leasehold because the sale satisfied the criteria of section 363(f), but criticized the bankruptcy court’s reliance on Qualitech as a “mistake” because of the Seventh Circuit’s “excessively broad proposition that sales under Section 363 override, and essentially render nugatory, the critical lessee protections against a debtor-lessor under Section 365(h).” A bankruptcy court in New York concluded that nothing in Section 365(h) mandates a contrary result where the debtor can sell free and clear, but that Section 363(f) will rarely permit a sale free and clear of a lessee’s appurtenant rights to the property and those rights will generally be enforceable against the buyer.
Qualitech also is not a case in which the lease was rejected. Instead, the debtor moved to sell the property free and clear before any order had been entered as to assumption or rejection. Courts have often protected tenant’s rights under 365(h) to remain in possession under a rejected lease when assets are sold free and clear. For example, a Virginia bankruptcy court held that where a debtor, as tenant, assumed and assigned a prime lease in a 363 free and clear sale but, as sublessor, rejected its sublease, the subtenant retained its rights to possession under section 365(h). That decision relied, in part, on a Massachusetts bankruptcy court which ruled that “where the Debtor is rejecting the lease with [tenant], under its Liquidating Plan, [tenant] has, at its option, the right to remain in the premises in accordance with § 365(h). [Tenant] cannot be compelled to accept money for its rejected lease under § 363(f)(5) in view of the provisions of § 365(h).” Under the reasoning in these cases, the right to remain in possession set forth in section 365(h) survives rejection of a lease or sublease as part of a free and clear sale of the underlying real property under section 363(f).
Subtenant’s Rights if Sublessor Rejects Its Lease as Lessee
Section 365(h) also may create issues where a debtor that is both a lessee under a prime lease and a sublessor under a sublease rejects both agreements. Where the debtor, as sublessor, rejects just the sublease, the tenant could assert a right to remain in the premises under section 365(h). But where the debtor also rejects the prime lease for the same space and the prime lease is no longer in effect then, the Bankruptcy Code requires the debtor to “immediately surrender that nonresidential real property to the lessor.” This creates a situation where the debtor’s obligation to surrender the premises and the subtenant’s right to continue possession both apply. Various courts have addressed whether the subtenant’s right to possession continues after its sublessor rejects, as lessee, the prime lease with its landlord.
For example, in the chapter 11 case of the A&P supermarket chain, the bankruptcy court ruled that Section 365(h) does not give the subtenant a meaningful election to remain in its former subtenancy when the debtor rejects the prime lease prior to or simultaneously with rejection of the sublease. The debtor, as lessee, is required to surrender the premises under the rejected prime lease to its landlord, so the subtenant lacks any meaningful right to possession from a debtor that can no longer confer it. The court recognized that Section 365(h) allows the subtenant to assert it may have under applicable non-bankruptcy law against the landlord, such as a continued right to possession under common law, but continued possession under the sublease was not possible where the debtor no longer had a possessory interest to convey.
Other courts find that because Section 365(h) allows a lessee enforce its rights “to the extent that such rights are enforceable under applicable non-bankruptcy law,” the debtor’s rejection of a prime lease does not determine the outcome. Instead, any continued right of possession by the sublessee turns entirely on state law. For example, the Fifth Circuit has held that where a debtor-tenant has not timely decided whether to assume the lease and it is deemed rejected as a matter of law, that lease is merely breached, not terminated, and does not affect an implied forfeiture of the rights of third parties to the lease. Other courts have looked entirely to the sublessee’s rights under state law to determine the continued viability of the sublease. The sublease may still exist (when the prime lease has been terminated) but third party rights therein survive only if mentioned explicitly therein and/or to the extent recognized under pertinent non-bankruptcy law.
Conclusion
While the Bankruptcy Code and reported cases don’t provide definitive guidance on outcomes, tenants can best protect themselves by filing pleadings and carefully monitoring activity in their lessors’ bankruptcy case. The tenant should consider hiring counsel and enter an appearance to ensure that it receives notices of all motions and other pleadings. If the premises are subject to a free and clear sale, the tenant can negotiate with the debtor and buyer for adequate protection of its leasehold via the right to remain. If those negotiations are not productive, the tenant can seek relief with the bankruptcy court. Where the issue is protecting a subtenant under a rejected prime lease, the tenant may have to rely on its rights under applicable state law to protect its possessory interest.
Andrew Tenzer is a partner in Nutter’s Corporate Department and a member of the Bankruptcy, Restructuring and Workout practice group. Andrew focuses his practice on advising lenders, troubled companies, and buyers and sellers of distressed assets in chapter 11 reorganization and in out-of-court and cross-border restructurings. In addition, he frequently handles non-insolvency related syndicated financings, securitizations, and structured finance transactions. Andrew has extensive experience serving as a trusted legal adviser to domestic and multinational companies in a wide range of industries, including financial services, technology, manufacturing, energy, and retailing. Andrew’s email is atenzer@nutter.com.
