Lease Termination: Say It Like You Mean It (Or Else)

Franklin Advisors LLC v. Sherwood Mgmt. Corp. (In re Whyco Finishing Technology, LLC), 500 B.R. 517 (Bankr. E.D. Mich. 2013) –

A landlord filed an amended proof of claim for ~$700,000 based on a chapter 11 debtor’s breach of a real estate lease.  The debtor’s plan liquidation trustee brought an adversary proceeding seeking to disallow or reduce the claim, and moved for summary judgment.

The debtor’s first argument was that the lease terminated after its initial term, and did not automatically renew for an additional term.  The lease provided:

Unless the LESSEE provides the LESSOR written notice One Hundred Eighty (180) days prior to a renewal period, this LEASE will automatically extend in one (1) year increments after the INITIAL PERIOD.  During any occupancy after the INITIAL PERIOD, all the same terms and conditions as set forth in this LEASE shall apply, except the rent during any months will be Five Hundred Dollars ($500.00) more than the corresponding month twelve (12) months prior.

The property was actually occupied by one of the debtor’s subsidiaries.  (The debtor claimed that it assigned the lease to its subsidiary, and that the landlord consented – although this was disputed by the landlord.)  The debtor’s subsidiary sent a March 20, 2008 letter noting that based on changes in the economic climate of the area, market rents had gone down so that the rent for the initial period was above market, much less the increased rent for a renewal period.  As a result (emphasis added):

We would like to open a discussion with you to re-examine the rent following this initial 5-year period in the hope of lowering the rent and remaining in the building.  If you feel this is not possible, I would appreciate it if you would let me know and in that event you may consider this letter your 180-day notice (per the lease agreement) that we will be forced to vacate 18074 Sherwood by the end of September.

The term actually ended at the end of January 2009, rather than September 2008 as indicated in the letter, so the tenant actually had several more months to give its notice.  But regardless, the landlord immediately responded by asking for a lease modification proposal, noting that it would be receptive to reducing the rent.  The parties negotiated, but did not reach agreement.

At the end of July 2008, the landlord sent an email to the tenant asking it to sign the last proposed lease modification if it was acceptable.  Otherwise, “I can only assume the original property lease is still effective and governing.”  The tenant responded that it was negotiating an extension of a major contract that would make it essential that it remain in the building.  However, it would not have an answer on the contract until September 30, and it was not able to determine if it was going to extend until it received an answer.

Although the debtor argued that the letter was a conditional notice of nonrenewal, the court concluded that based on the facts before it, the condition (e.g., refusing to discuss lowering rent) was not met, so that the notice to terminate was not effective.  The court concluded that the e-mail also did not serve as a notice of nonrenewal since its message was that the tenant could not make a decision until after the 180-day period expired.  Consequently, the court found that for purposes of denying summary judgment, it appeared that the lease automatically renewed for an additional year.

The debtor also argued that it had assigned the lease to its subsidiary with the consent of the landlord.  Putting aside whether the landlord did consent (which it disputed), a permitted assignment of the lease did not release the debtor from liability under the lease after the assignment.  So, even if the lease was properly assigned, that did not affect the landlord’s claim against the debtor.

Alternatively, the debtor argued that if the lease automatically renewed, it did not receive “reasonably equivalent value.”  Consequently, the lease renewal should be avoided as a constructive fraudulent transfer (i.e., the debtor received less than reasonable equivalent value in exchange for the obligation and was insolvent on the date the obligation was incurred).

Considering the potential outcomes of the arguments after trial:  If the tenant prevailed on the argument that the lease was not automatically renewed, then it did not incur an obligation and there was nothing to avoid.

Even assuming it incurred an obligation, there was a question of fact about when the debtor’s subsidiary vacated the premises and the value to the debtor of the subsidiary’s occupancy.  The court specifically noted that a parent can benefit indirectly from economic benefits to its subsidiary.

Under applicable circuit court cases, a bankruptcy court should first determine if there is any value, and if so, whether the value was reasonably equivalent.  The value must be economic and must be concrete and quantifiable.  Given that the occupant was a 100% subsidiary of the debtor, the court did not rule out that the landlord might be able to establish reasonably equivalent value.

The debtor next argued that the lease was deemed rejected 120 days after the bankruptcy was filed because it was neither assumed nor rejected.  Although the landlord argued that rejection actually occurred at a later date as provided in the confirmed plan, the court concluded that under Section 365(d)(4) of the Bankruptcy Code, it was automatically deemed rejected at the earlier date (assuming the lease was still in effect).  However, the court pointed out that rejection was not a termination of the lease, but rather was deemed to constitute a prepetition breach.  So the landlord would still have a prepetition claim based on that breach.

Finally, the debtor argued that the claim was not timely.  Although the landlord filed first a proof of claim, and then an amended proof of claim, after the bar date for general claims, the court determined that either (1) the claim was timely as a lease rejection claim (which had a later bar date) or (2) if the general bar date was applicable, there was excusable neglect since the landlord was not given proper notice of the bankruptcy filing.

This opinion addresses the issues in the context of a motion for summary judgment.  Depending upon how the facts develop, ultimately each of these issues might go either way.  However, as a practical matter, they suggest that (1) if you want to exercise an option to extend or terminate a lease, you would be well advised to clearly communicate the election in accordance with lease requirements, and (2) as noted in a prior blog (Leases: Is Rejection the Same as Termination and Who is the Tenant Anyway?) rejection of a lease does not necessarily result in termination.

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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