Nina B Matis August 15 2003 Obligation to Other Party when Rejecting Leases in Bankruptcy Katten Muchin Rosenman LLP | Real Estate - USA Nina B Matis Real Estate Introduction Cases Comment IntroductionUnder the US Bankruptcy Code, a lease in the estate of a debtor in bankruptcy is governed by deceptively simple rules. Under the terminology of the Bankruptcy Code, a real property lease is akin to an 'executory contract'. Under Section 365 of the Bankruptcy Code, if the debtor in bankruptcy is reorganizing rather than liquidating, an executory contract can be assumed or rejected by the debtor in bankruptcy. If the debtor in bankruptcy is the tenant under the lease, it is not entitled to assume the lease unless it cures all defaults and remains current on its obligations under the lease during the course of the bankruptcy proceedings. If a lease is rejected by a debtor in bankruptcy who is a lessee under a lease, the lease terminates; but if the debtor in bankruptcy is the lessor, the lessee is entitled to remain on the property until the term of the lease expires, as long as the tenant continues to perform its obligations under the lease. However, two recent bankruptcy cases - one involving a lease with a tenant in bankruptcy and one involving a lease with a landlord in bankruptcy - show that the rules in bankruptcy are rarely so simple. There is, after all, a party on the other side of the executory contract whose rights are affected when the lease is rejected. That party will have its own opinion as to how its claim should be handled. Both of these cases involved a rejected lease and in both cases the party not in bankruptcy challenged the court's disposition of its claim. CasesThe Solow Case In the first case, Solow v PPI Enterprises (US), Inc 324 F3d 197 (3rd Cir 2003), a tenant abandoned its lease after the first year of a 10-year term and ceased to pay rent. As provided in the lease, the tenant provided a letter of credit in lieu of a cash security deposit and the landlord drew down on the letter of credit for nine months to pay the then-current rent until the letter of credit was completely drawn down. Thereupon, the landlord sued the tenant for damages equal to the rent the landlord would have received for the duration of the term of the lease. Settlement negotiations ensued, but after four years without a settlement the landlord moved for a trial date, whereupon the tenant filed for bankruptcy.Section 502(b)(6) of the Bankruptcy Code caps a lessor's damages for claims of defaulted rent owed by a bankrupt lessee at the greater of one year's rent or 15% of the rent due during the remaining term of the lease, but not in excess of three years' rent. Section 502(b)(6) of the Bankruptcy Code provides that, in calculating damages, the 'remaining term' of the lease begins on the earlier of (i) the date of filing for bankruptcy, or (ii) the date the lessor recovers possession. Here, the then-remaining term began when the landlord recovered possession - that is, after the first year of the lease, and not when the tenant filed for bankruptcy four years later. The bankruptcy plan provided for the landlord to receive the full amount of damages (three years' rent, less the amount received by the landlord under the letter of credit) permitted under Section 502(b)(6).The landlord sought to be treated as an impaired creditor. Under Section 1124 of the Bankruptcy Code, an 'impaired creditor' is one which does not receive the full amount of its claim. Pursuant to Section 1129 of the code, if an impaired class objects to the confirmation of a bankruptcy plan, the requirements for creditor approval of confirmation are more difficult for the debtor to achieve. Although the landlord would receive the full 'capped' amount under the tenant's reorganization plan, the landlord argued that he would not receive the full amount of damages provided for in the lease and, therefore, was 'impaired'.The court rejected the landlord's claim, holding that the landlord was not entitled to be treated as an impaired creditor merely because the Bankruptcy Code set a limit to its recovery. As the landlord received the full amount to which he was entitled under the code, the court treated the landlord as a fully satisfied creditor.The court made two other rulings of note. First, the landlord argued that because the letter of credit was an obligation of the issuing bank, and not a direct obligation of the tenant, the proceeds of the letter of credit should not be subtracted from the landlord's recovery under the plan. Once the Section 502(b)(6) calculation was complete, security deposits must be deducted from the landlord's maximum Section 502(b)(6) claim. Although the court found some authority to support the landlord's contention that payments by a third party are not deducted from landlord's damages under Section 502(b)(6), the court did not believe that authority to be persuasive in the present case, for two principal reasons. First, the tenant was ultimately responsible for amounts paid under a letter of credit. Second, the lease provided that the letter of credit was in lieu of a deposit and the tenant had an obligation under the lease to replenish any drawdown on the letter of credit, making the amounts drawn under the letter of credit to be deemed the equivalent to a payment by the tenant.The other noteworthy point made by the court was that the landlord's claim was not reduced by his mitigation efforts. Although the landlord found a replacement tenant two years after the original tenant abandoned the property, the landlord was entitled to receive an amount equal to the rent for the full three years (less the amount received from the security deposit), as permitted under Section 502(b)(6).Solow illustrates that the bankruptcy law establishes liquidated damages for a landlord, but it has no sympathy for a landlord seeking more than the damages provided by the code. Although Solow involved a lease which was repudiated prior to the bankruptcy filing, the outcome would have been the same had the tenant filed for bankruptcy and then rejected the lease under Section 365 of the code.The Precision Industries Case Precision Industries, Inc v Qualitech Steel SBQ, LLC 327 F 3rd 537 (7th Cir, 2003) also involved a repudiated lease, this time by a bankrupt landlord. In this case the disposition of the property by the landlord made a great difference to the tenant's remedies. The tenant, Precision Industries, was tenant of a warehouse under a lease with Qualitech Steel Corporation (the second defendant), as landlord. Qualitech Steel Corporation filed for bankruptcy and, pursuant to a sales order authorized by the bankruptcy court, its assets were sold to a party of senior lenders who became the owners of a new entity know as Qualitech Steel SBQ, to which the assets of the bankrupt entity were assigned. As part of the reorganization plan, the warehouse leased to Precision Industries was included in the sales order as one of the assets transferred to Qualitech Steel SBQ, the purchaser. When the purchaser of the property changed the locks and otherwise denied Precision Industries access to the property, Precision Industries sued Qualitech Steel SBQ, the purchaser of the subject property, and the case was remanded to the bankruptcy court. The bankruptcy court and the district court disagreed with each other and an appeal was taken to the US Seventh Circuit. Although the court could have denied Precision Industries relief based on its failure timely to object to the sales order, the court chose to address the issue on the merits. Precision Industries argued that there was a contradiction between two provisions of the Bankruptcy Code. Section 365(h) of the Bankruptcy Code provides protection for a lessee when a bankrupt lessor rejects a lease of the bankruptcy estate's property: it allows the tenant under a rejected lease to continue to occupy the property for the duration of the lease term, provided that the lessee continues to pay rent and fulfils its other obligations under the lease. The bankrupt lessor is absolved from providing any ancillary obligations to the lessee, but must honour the lessee's continued occupation.In contrast, Section 363(f) permits a debtor in bankruptcy to sell property of the estate, pursuant to a sales order of the bankruptcy court, free and clear of all other interests, including the interests of a lessee. In the case at hand Qualitech sold the subject property to the new entity pursuant to a sales order by the bankruptcy court, which removed all other claims to the property, including those of the tenant. Asked to reconcile seemingly contradictory provisions, the Seventh Circuit found no contradiction to reconcile. Rather, the court found that if a landlord sells the property, rather than retaining the property while rejecting the lease, it does not have to permit the tenant to remain on the property. While Section 363(e) of the Bankruptcy Code requires that the bankrupt landlord provide adequate protection to other interests in property to be sold, the court found that such 'adequate protection' did not require the landlord to accept the continued presence of the tenant on the property and that monetary damages would be sufficient to compensate the tenant.The significance of this case is that it provides a bankrupt landlord with alternate strategies. If the tenant's rent is close to current market rates, it may choose to allow the tenant to remain on the property, whether by assuming or rejecting the lease. On the other hand, if the property has alternative uses more valuable than the rent being paid by the tenant, the property can be sold out of the bankruptcy estate, which can have the effect of removing the tenant.CommentBoth cases demonstrate that the rejection of a lease in bankruptcy is not just a matter of moving the tenant out of the space. The rights of the party which is not in bankruptcy must be respected and the court will ensure that damages are paid to such party. The rules governing such damages can be fairly complex and any debtor (or potential debtor) in bankruptcy would be wise to familiarize itself with such rules so that it can accurately assess the effect such rules will have on the bankruptcy estate. For further information on this topic please contact Nina Matis or Tom Bernerat KMZ Rosenman by telephone (+1 312 902 5200) or by fax (+1 312 902 1061) or by email ([email protected] or [email protected]). 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