When a bankruptcy case is dismissed for cause pursuant to section 1112(b) of the Bankruptcy Code, the effect of the dismissal on orders entered during the case is not always clear.  A recent District of Delaware decision, In re Scarborough-St. James Corporation, sheds some light on the effect of an 1112(b) dismissal on a lease rejection order.  The court ultimately found that a lease rejection terminates the debtor’s possessory rights in the leased premises and that section 349(b) does not revest those possessory rights to the debtor upon a dismissal.  The court also found that its stay relief/adequate protection order, which had given effect to a state court order, would also survive the dismissal.  

Background

The debtor was the lessee and sublandlord of a shopping center located in Richmond, Michigan.  The debtor, which managed the shopping center and collected rents from eight subtenants, became embroiled in a messy dispute over who was entitled to the rents generated from the subtenants – the debtor or the landlord.  On the eve of a state court hearing on an eviction action brought by the landlord, the debtor filed for chapter 11 protection, resulting in a stay of the state court litigation.

Following the commencement of the case, the bankruptcy court entered three substantive rulings: (i) an order granting the shopping center’s landlord relief from the automatic stay to allow the state court litigation to go forward, (ii) an order denying landlord’s motion for adequate protection, and (iii) an order directing the debtor to reject and surrender the shopping center lease.  The rejection/surrender order resulted from the debtor’s failure to assume or reject the lease within the time permitted to do so under section 365 of the Bankruptcy Code.

The debtor then filed a motion to dismiss its bankruptcy case for cause pursuant to section 1112(b), asserting that as a result of the relief granted by the bankruptcy court – the stay relief and rejection/surrender order – “there is no remaining purpose to be served by having the Debtor remain in the bankruptcy case.”  The landlord countered that cause did not exist to dismiss the case and that he would be harmed if the case was dismissed because of various rights he had gained through the orders granted in the case.  The landlord’s real concern was what the effect of the dismissal would be on the relief already granted during the case.

Analysis

As an initial matter, the bankruptcy court acknowledged the two-party nature of the dispute over the debtor’s only real asset – the shopping center lease and the rents it generated.  Important to the court’s “cause” analysis under 1112(b) was the fact that it had already granted the landlord stay relief to permit the state court litigation in Michigan to go forward and, in doing so, had already concluded that the landlord was likely to prevail in the litigation.  With that, the court held that cause existed to dismiss the case because the debtor was unlikely to be able to successfully rehabilitate if it lost the shopping center lease – its only real asset.

After deciding to dismiss the case for cause, the court addressed the parties’ disagreement regarding the effect of the dismissal, pursuant to section 349(b), on the orders already entered in the case – particularly whether the rejection/surrender of the shopping center lease survives the dismissal.  Section 349(b) provides “[u]nless the court, for cause, orders otherwise, a dismissal of a case . . . revests the property of the estate in the entity in which such property was vested immediately before the commencement of the case under this title.”

The bankruptcy court first explained that a debtor’s rejection of a contract is a debtor’s determination not to perform its obligations under the contract and, accordingly, rejection equates to breach of contract, not termination.  Noting the lack of authority on the application of section 349(b) to rejected leases, the court explored two decisions cited by the parties, which each concluded, although for different reasons, that a 365 rejection terminates a debtor’s possessory rights in the lease and those rights remain terminated notwithstanding a dismissal.  In In re Tri-Glied, Ltdthe court held that property that revests pursuant to 349(b) is only the property that is part of the estate at the time of dismissal and because the deemed rejection of a lease terminates a debtor’s possessory right, that possessory right is no longer property of the estate at the time of dismissal.  Accordingly, it cannot revest in a debtor.  In In re BSL Operating Corp.the court held that the dismissal of a case affects a previously entered order only if it was entered under one of the specific Bankruptcy Code provisions listed in section 349(b).  Section 365 is not enumerated in 349(b) and, therefore, orders entered thereunder are not affected by dismissal of a case.  Here, the bankruptcy court found that under both theories, the rejection/surrender order survived the dismissal of the case.

The court also addressed whether the stay relief/adequate protection order also survived the dismissal.  Following the reasoning in In Re Tri-Glied and In Re BSL Operating, the court held that it too was unaffected by the dismissal of the case for the following three reasons.  First, the stay relief/adequate protection order was not entered pursuant to the one of the enumerated sections in 349(b) (In Re BSL Operating).  Second, the “property of the estate” that will revest to the debtor will be that which was determined by the stay relief/adequate protection order.  In granting the stay relief and denying adequate protection, the court had already given effect to – over the debtor’s objection – one of the state court’s orders limiting the debtor’s rights to rents from the shopping center pending the outcome of the state court litigation.  As a result, the court held that the only property rights that could revest in the debtor are the rights that existed at the time of dismissal – the limited rights to the rents (In Re Tri-Glied).  Finally, the landlord would be prejudiced if the stay relief/adequate protection order was vacated because it would allow the debtor to again argue that the state court order limiting the rents was not effective.

Conclusion 

As the debtor in In re Scarborough-St. James Corporation quickly learned, the bankruptcy court has broad discretion to condition the effect of a dismissal and a bankruptcy court will not look favorably on a debtor’s attempt to use the filing and the dismissal of a case as strategic maneuvers to the detriment of other creditors.