Alliotts Bankruptcy Article Bankruptcy Law

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  • 8/14/2019 Alliotts Bankruptcy Article Bankruptcy Law


    ection 365 of the Bankruptcy

    Code addresses the assumption

    (and perhaps assignment) and

    rejection of unexpired leases andexecutory contracts. Though 365

    is generally considered the most convoluted

    section of the Bankruptcy Code, due in

    part to amendments prompted by special

    interests, this article focuses on the specific

    provisions of 365(h). These provisions are

    implicated when the debtor in bankruptcy

    seeks to reject an unexpired lease in which

    the debtor is the lessor (as opposed to the

    lessee) of real property.

    Commonly, a debtor will be the lessee of

    real property and will assume or reject the

    lease if the contract terms are more or less

    advantageous than prevailing market rates. If

    the debtor rejects the lease, there are three

    important consequences. First, the debtor

    must vacate the premises in order to avoid

    the continued accrual of administrative

    rent by the bankruptcy estate. Second, the

    debtors rejection will be deemed to have

    occurred just prior to the filing of the

    bankruptcy case, the lessor will be left with a

    general unsecured claim for the damagesarising from the debtors rejection and such

    claim will be paid on a pro rata basis with

    other general unsecured creditors. Third, any

    claim for rejection damages by the lessor will

    be limited by the cap on lease-rejection

    damages set forth in 502(b)(6).

    When the debtor is the lessor of real

    property, however, the consequences of

    rejecting the lease are significantly different

    in two respects. First, 365(h) gives to the

    nondebtor lessee the right to remain in

    possession of the premises for the balance of

    the lease term and any extensions thereof,

    even though the debtor will no longer be

    required to fulfill its other obligations under

    the lease. Second, while the lessees claim for

    rejection damages will be a prepetition

    general unsecured claim, the 502(b)(6) cap

    will not apply because, by its express terms, it

    is limited to situations where the debtor is

    the lessee and not the lessor.

    Addressing a nondebtor

    lessees possessory rightA nondebtor lessees residual possessory

    right under 365(h) can be a nettlesome

    issue for the bankruptcy estate. If a sale of

    the real property is necessary, it would

    behoove a nondebtor lessee to assert its

    rights under 365(h) even if only to extract

    more advantageous treatment of its claims in

    the case. As the 7th U.S. Circuit Court of

    Appeals recently pointed out, a debtor must

    provide adequate protection of a nondebtor

    lessees interest in the real property when

    selling free and clear of residual possessory

    rights under 365(h). See In re Precision

    Industries Inc., 327 F.3d 537 (7th Cir. 2003).In Precision Industries, the debtor sold real

    property to a buyer under 363(f). Howev-

    er, the real property was the subject of a lease

    to a certain lessee. Nine months after the

    sale, the buyer changed the locks and

    excluded the lessee. The principal question

    before the court was whether 363(f)

    authorized a sale free and clear of a lessees

    rights under 365(h). The 7th Circuit ruled

    that 363(f) does authorize such a sale.

    The 7th Circuit went on to state, howev-

    er, that the nondebtor lessees residual

    possessory right constitutes an interest in

    the real property for purposes of 363(f) and

    that the lessee is entitled to adequate

    protection of such interest pursuant to

    363(e). Unfortunately, the nondebtor

    lessee in that case did not object to the

    proposed sale and, as a result, the issue of

    adequate protection was not addressed

    squarely. Nonetheless, the 7th Circuit

    suggested that adequate protection under

    363(e) could be in the form of a cash pay-ment from the proceeds, which would neces-

    sarily involve issues over the relative value o

    the residual possessory interest as against the

    overall sales price of the real property.

    While the 7th Circuit held that 363(f)

    authorizes a sale free and clear of rights under

    365(h), the outcome for the nondebtor

    lessee in Precision Industries seems a bit

    harsh. In denying the lessee any relie

    under 363(e), the court certainly seemed

    persuaded by the fact that the lessee did not



    By Craig Rankin and Christopher Alliotts

    is a partner at Los Angeles-based

    bankruptcy boutique Levene, Neale, Bender,

    Rankin & Brill. is of

    counsel in the Menlo Park, Calif., office of Los

    Angeles-based SulmeyerKupetz.

  • 8/14/2019 Alliotts Bankruptcy Article Bankruptcy Law


    object to the sale until nine months after-

    ward. One might question this conclusion

    given the fact that the debtor never sought

    to reject the lease and the lessee could easily

    have thought the sale was subject to, as

    opposed to free and clear of, its lease.

    Regardless, the practice tip appears to be: Do

    not let a sale of real property in which a

    client has an interest get approved without

    completely understanding how the sale will

    affect the clients rights.

    Unlike the situation in Precision Indus-

    tries, if a nondebtor lessee demands adequate

    protection of its residual possessory interest

    in the real property, the debtor will have to

    pay off the lessee for its residual possessory

    right essentially as a secured or administra-

    tive claim. This favored treatment could

    have a material negative impact on the

    outcome of the case, particularly if it relates

    to the payment of unsecured claims. Good

    practitioners should thus look for creative

    ways to avoid implicating 365(h)s

    provisions: They should consider a three-

    pronged approach.

    First, counsel for the debtor should

    determine whether there is any basis for ter-

    minating the agreement by its own terms.

    An agreement could contain provisions for

    terminating the contract upon writtennotice, or the debtor could have the right to

    terminate the lease for a breach by the

    nondebtor lessee. Of course, this approach

    will succeed or fail based on the agreements

    provisions, and there is no suggestion that

    a pretextual breach would carry the

    day. Nonetheless, the point is to know

    the documents, as they may contain the

    simplest solution.

    Second, counsel should ask this question:

    Is the lease a true lease or some other execu-

    tory contract dressed up as a lease? The resid-

    ual possessory rights set forth in 365(h)

    apply only to true leases and not other

    executory contracts. In Butner v. United

    States, 99 S. Ct. 914 (1979), the U.S.

    Supreme Court held that the nature of prop-

    erty interests should be based upon the state

    laws under which they arose, absent a clear

    and manifest federal interest. Under the law

    of most states, a valid real property lease

    must set forth, at a minimum, a definite

    description of the premises being leased, the

    rent to be paid and the grant of exclusive

    possession of the premises. While creative

    drafting may obscure the matter, courts will

    look beyond the terminology of the agree-

    ment to its economic substance.

    Finally, if the agreement qualifies as a true

    lease under state law, the issue is not neces-

    sarily settled. In In re PCH Assocs. Inc., 804

    F.2d 193 (2d Cir. 1986), and In re Morreggia

    & Sons Inc., 852 F.2d 1179 (9th Cir. 1988),

    the 2d and 9th circuits concluded that the

    leases at issue were financing and joint ven-

    ture agreements, and not the type of lease

    covered by the protections of 365(d). They

    reasoned that [s]imply meeting the state law

    definition of a lease will not necessarily

    mandate the mindless application of

    section 365. Rather, the economic realities

    of the particular agreement must properly

    fall within the scope of the type of agreement

    anticipated by Congress in enacting section

    365. 852 F.2d at 1183.

    Is there a true landlord/

    tenant relationship?Based upon PCH and Morreggia, a

    nondebtor lessee must show that, in addition

    to having a true lease under applicable state

    law, its lease fits within the intended purview

    of 365. Courts will consider a wide range of

    factors, such as the intended scope of the

    statutory provision at issue, whether the

    parties intended a true landlord/tenant

    relationship, whether there are any executory

    obligations, the relative value given for the

    lease, the balancing of risks between the

    parties and other indicia of ownership.

    Such considerations are not exhaustive

    by any means. Indeed, the reasoning ofPCH

    and Morreggia can be applied to other sub-

    sections of 365, such as the residual posses-

    sory rights set forth in 365(h). Thus, when

    faced with a nondebtor lessee that is assert-

    ing a right to remain in possession of the rea

    property under 365(h), a debtor can argue

    that the lease at issue is not the type of lease

    to which 365(h) should apply.

    It would be impossible to catalog all the

    types of leases that would qualify as leases

    under 365(h). Consideration of certain

    contracts may provide a sense of the statutes

    intended scope. For instance, standard

    residential leases would most probably fal

    within the purview of 365(h), given the

    presumption of uniqueness of such property

    Certain commercial leases where location is

    important would probably also qualify.

    On the other hand, PCH and Morreggia

    strongly suggest that leases lacking a

    traditional landlord/tenant relationship

    such as disguised secured financing transac

    tions and joint ventures, are outside the

    statutes intended scope. Other contracts

    that grant possession of the real property as

    an incident to an agreement to provide otherservices or to acquire personal property, such

    as harvesting and mining agreements, would

    also not qualify because the economic

    substance of the transaction is not one of

    landlord/tenant. Such interests could be

    satisfied with money damages.

    The precise scope of 365(h) will be

    established by future cases. With interest

    rates on the rise, there is the potential for

    more bankruptcy filings by debtors who are

    lessors of real property. A spate of such cases

    would do much to develop what would

    essentially be a separate federal common law

    on the issue of what is a true lease for

    purposes of 365, and arguably other

    provisions of the Bankruptcy Code.


    This article is reprinted with permission from theDecember 20, 2004 edition of THE NATIONALLAW JOURNAL. 2004 ALM Properties, Inc. Alrights reserved. Further duplication without permission is prohibited. For information, contact ALMReprint Department at 800-888-8300 x6111 #005-05-06-0018

    Section 365(h) givesnondebtor lesseesthe right to remainin possession of the

    premises for thebalance of the

    lease term.