When is an agreement a true lease entitling the nondebtor lessee to possessory protections under section 365(h) of the Bankruptcy Code?  The United States Bankruptcy Court for the District of New Jersey addressed this issue in the decision IDEA Boardwalk, LLC v. Revel Entertainment Group, LLC (In re Revel AC, Inc.), holding that agreements entered into by the tenants for the operation of retail facilities on the debtor’s premises were true leases and not management or joint venture agreements.  As a result, the lessees, who each gave notice of their intent to exercise possessory rights under section 365(h), were entitled to retain those rights “that are in or appurtenant to the real property.” 

Laying the Groundwork

The debtors, owners and operators of a resort and casino, maintained retail stores, restaurants and bars on its premises.  A little over a month after their bankruptcy filing, the debtors moved to reject the agreements with the tenants, and, on a date the decision refers to as the “Shutdown Date,” ceased operating and barred the tenants from using the premises.  Each tenant gave its notice to continue exercising its possessory leasehold rights under section 365(h).

Around half a year later, the bankruptcy court entered an order approving the sale of the debtors’ assets to Polo North Country Club, Inc.  As a result of the sale, Polo North stepped into the shoes of the debtors and adopted the debtors’ position that the agreements were not true leases, but rather were management or joint venture agreements and, therefore, the tenants were not entitled to the protections of section 365(h).  Notably, the sale order provided that the sale was “subject to the possessory interests of the Tenants.

A day after the Shutdown Date, one of the tenants commenced an adversary proceeding against Polo North, now a defendant in the action as a result of the sale, asserting its agreement was a “true lease.”  The tenant sought a preliminary injunction against Polo North so that the tenant could continue to enjoy its possessory rights under its lease, which the defendant moved to dismiss.

The Agreements were True Leases

In holding that the agreements were true leases, the bankruptcy court first looked to New Jersey law:  “[A] lease exists when there is an agreement by the lessor to turn over specific premises to the exclusive possession of a lessee for a definite time period.  In return, the lessor receives a payment of rent from the lessee[,]”observing that whether an agreement is a lease depends on the parties’ intention, as determined by the words employed in the agreement, and, if doubt exists, by the circumstances surrounding the agreement and the parties’ course of conduct.  The bankruptcy court found that the terms of the agreements and the supporting affidavits demonstrated the parties’ “unequivocal intention” to enter into true leases.  Among other examples of the parties’ intent, the bankruptcy court cited the repeated use of the words “tenant,” “lease,” “landlord,” and “rent,” as well as inclusion of provisions regarding the lessee’s quiet enjoyment of the premises.

The bankruptcy court also cited to four factors supporting the conclusion that the agreements were true leases in the face of any ambiguity:  (i) although the rent payments were based on a percentage of revenue, “percentage rate leases have been accepted for over 100 years in New Jersey,” (ii) the agreements provided for a set term of years, with options to renew at the end, (iii) the agreements granted the tenants possessory interests and rights to exclusive use of the leased premises during the specified term, and (iv) the agreements were not revocable at any time by the landlord, but were revocable only upon certain events of default.

Application of Section 365(h)

A necessary consequence of finding that the agreements were true leases, according to the bankruptcy court, is the retention of the tenants’ possessory rights under section 365(h), despite the sale of the debtors’ assets “free and clear of any interest in such property” under sections 363(b) and (f) of the Bankruptcy Code.  Although the bankruptcy court noted that the sale order “was expressly made subject to the interests of the Tenants,” the court went further and ruled that a section 363 sale could not trump the tenants’ rights under section 365(h).

Section 365(h) of the Bankruptcy Code authorizes a lessee to retain its rights under the lease “that are in or appurtenant to the real property.”  Those rights include rights “relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation.”  In addressing the interplay between section 363 and section 365, the bankruptcy court pointed to a prior decision in Crumbs Bake Shop, in which the same court held that “nothing in § 363(f) trumps, supersedes, or otherwise overrides the rights of licensees under § 365(n),” and found no reason to depart from its conclusion in Crumbs with respect to tenants’ rights under section 365(h).  (You can read more about the Crumbs decision here.)

As a result of finding that the tenants retained their possessory rights under section 363(h), including the right of quiet enjoyment, the bankruptcy court enjoined Polo North from interfering with the tenants’ access to the premises.  The court was careful to note, however, that the section merely preserved and did not enhance a tenant’s rights under its agreement, and thus declined to grant an easement or license as part of the preliminary injunction.

Takeaway, Puh-lease?

An interested bidder in a section 363 asset sale involving the purchase of real property subject to a lease should consider the possibility that a lessee could opt to retain its possessory rights under section 365(h) of the Bankruptcy Code, and the potential purchaser would be taking the debtors’ property subject to such interests.  Potential 363 purchasers should bear in mind that the mantra “free and clear” may be subject to exceptions, and a well-advised potential purchaser should factor in its bid the possibility that a below-market lessee will seek to retain its rights under section 365(h).