Leases: Is Rejection the Same as Termination and Who is the Tenant Anyway?

John Hilsman Inv., LLC v. Quality Properties, LLC, 500 B.R. 105 (N.D. Ala. 2013) –

A Chapter 11 debtor sought to assume a lease that had been assigned to it.  The landlord contended that rejection of the lease in a prior bankruptcy by the debtor’s assignor caused the lease to terminate so that there was nothing for the current debtor to assume.  The bankruptcy court rejected the landlord’s arguments and approved assumption of the lease; and the landlord appealed to the district court.

This case involves a series of three bankruptcies.  In the first bankruptcy case, Bruno’s, Inc. assigned a ground lease to Bruno’s Supermarkets, Inc. (Supermarkets), which immediately reassigned the lease to Quality Properties, LLC (Quality).  The landlord objected to the assignment.

While the landlord and Quality were still litigating the validity of the assignment in state court, Supermarkets filed a Chapter 11 bankruptcy.  In this second case, the bankruptcy judge determined that Supermarkets had a continuing contractual obligation to pay rent if Quality failed to do so.  So, the lease was treated as an executory contract that was deemed rejected in Supermarkets’ bankruptcy.

A little over a year later, Quality filed its own bankruptcy and sought to assume the lease as assigned to it.  The landlord objected based on the argument that Supermarkets’ rejection in its bankruptcy caused Quality to lose the leasehold estate it obtained through the assignment.  However, the Quality bankruptcy judge decided that at the time the lease was deemed rejected in the Supermarkets case (which had the effect of avoiding its contingent contractual obligations), Supermarkets was no longer the tenant under the lease since it retained no reversionary rights.  Consequently, the Quality bankruptcy judge concluded that all rights were vested in Quality, Supermarkets retained only liabilities, and Supermarkets’ rejection did not affect Quality’s leasehold interests.

The district court began by focusing on a distinction between §365(a) and §365(d)(4) of the Bankruptcy Code.  Section 365(a) is the general section that states that a lease or executory contract may be assumed or rejected, while §365(d)(4) relates specifically to leases of nonresidential property.  Under §365(d)(4), if a debtor fails to take action to assume or reject by designated deadlines then “an unexpired lease of nonresidential real property under which the debtor is the lessee shall be deemed rejected, and the trustee shall immediately surrender that nonresidential property to the lessor” (emphasis added).

The district court concluded that the reference to “lessee” in §365(d)(4) means a debtor with a possessory interest.  Under applicable state law, the effect of Supermarkets’ assignment was to transfer all of its rights, including its possessory interest, to Quality without retaining any reversionary right.  (This is in contrast, for example, to a sublease for less than the full term of the lease – which would result in the premises reverting to the original tenant before the prime lease expired.)  Consequently, the district court concluded that §365(d)(4) was not applicable in this case, and instead rejection was governed by §365(a).  Under §365(a), there is no mandate for immediate surrender of the leased premises (with its implication that the lease is no longer in effect).

Besides, the court found that regardless of which section applies, rejection does not operate to terminate the lease, but rather constitutes a breach.  As articulated in an 11th Circuit case involving §365(a):  “[R]ejection does not embody the contract-vaporizing properties commonly ascribed to it. . . .  Rejection merely frees the estate from the obligation to perform; it does not make the contract disappear.”

The court went on to discuss a variety of additional aspects of the issue, including (1) the point that other sections of §365 specifically refer to treatment of an executory contract as terminated (§365(h), (i), and (n)), and (2) the distinction between a sublease (in which the subtenant’s rights are derivative of the prime tenant’s rights) and an assignment in which the original tenant transfers all of its rights to its assignee.

The court also concluded that the Quality bankruptcy was the proper forum for determining the effect of Supermarkets’ rejection of the lease on the rights of Quality (as opposed to the Supermarkets bankruptcy court).  Since the Supermarkets’ rejection did not terminate the lease, Quality retained its assigned leasehold rights; and from the perspective of the Supermarkets bankruptcy, the extent of those rights was to be determined outside the Supermarkets bankruptcy.  When Quality filed its own bankruptcy, the assigned lease became an unexpired lease of the debtor that could be assumed or rejected in its own case.

Consequently, the district court affirmed the bankruptcy court order granting Quality’s motion to assume the assigned lease.  (This decision is being appealed to the 11th Circuit.  So, this may not be the last word on the issue.)

In many circumstances all of the parties treat rejection of a lease (or executory contract) as the equivalent of termination.  However, as evidenced by this case, that is not a foregone conclusion.  So, it behooves a landlord to obtain explicit recognition of termination in an order dealing with rejection if that is what is intended.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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