Lease Assumption (and Rejection): It Ain’t So Until the Court Says So

In re Upper Crust, LLC, 502 B.R. 1 (Bankr. D. Mass. 2013) –

In a bankruptcy case that was converted from chapter 11 to chapter 7, a landlord sought immediate payment or administrative priority for postpetition rents and rejection damages.  The trustee objected and sought court approval for retroactive rejection of a lease.

The debtor operated a chain of pizza restaurants.  At the time it filed a Chapter 11 bankruptcy in October 2012, it held 11 leases for restaurant locations.  A Chapter 11 trustee was appointed in early November.  At the end of November the trustee filed a motion seeking authority to assume, assign and sell the leases at a public auction.  The auction held on December 19 resulted in purchase agreements for all of the leases except one.

On December 21 the trustee filed a notice of intent to abandon the estate’s interest in equipment and other personal property remaining at the unsold location.  The landlord’s counsel sent an email to the trustee acknowledging receipt of the notice and asking about the status of lease rejection given that there were no bids for the lease.  The trustee replied in an email that the landlord should “consider the lease terminated as of December 31.”  According to the trustee, the keys were also returned to the landlord by no later than December 31.

Almost 5 months later, in May 2013, the landlord filed a motion seeking immediate payment or administrative expense priority for the December and January rents, and administrative expense priority for both February and March rents and its rejection damages.

While conceding that the landlord was entitled to payment of December rent, the trustee disputed any right to immediate payment or administrative priority status for rents due after December.  The trustee also asked the court to either approve rejection of the lease retroactive to December 31, 2012, or deem the lease rejected as a matter of law on February 1, 2013.

As a general matter:

  • Section 365(d)(3) of the Bankruptcy Code requires a trustee to “timely perform all the obligations of the debtor” under a non-residential real estate lease (with certain limited exceptions) until the lease is assumed or rejected.
  • If a non-residential real estate lease is assumed and then later rejected, Section 503(b)(7) gives the landlord a claim with administrative expense priority for sums due for a period of 2 years following the later of rejection and turnover of the premises.
  • Under Section 365(d)(4) a non-residential real estate lease “shall be deemed rejected, and the trustee shall immediately surrender” the property if the trustee does not assume or reject the lease within 120 days (or the earlier confirmation of a plan) after the bankruptcy is filed (subject to certain extensions).

The landlord contended that the lease was actually assumed as part of the court order approving the auction procedures.  Under that scenario, the landlord would have an administrative expense claim for post-assumption rent together with the rent due under the lease for two years after rejection.  The trustee objected, contending that (1) the lease was never assumed, and (2) it was rejected at the latest on February 1 (120 days after the petition date).

In response to the landlord’s argument, the court emphasized that under the Bankruptcy Code a lease can be assumed only with court approval.  In this case the sale procedures order gave the trustee the authority to attempt to sell the leases, and there was no order actually approving assumption until the order approving the results of the sale.  Since the sale order did not include this particular lease, it was not assumed.

As for rejection, unless the lease is deemed rejected under Section 365(d)(4), rejection also requires court approval.  Although the lease was deemed rejected on February 1, 2013, the trustee asked the court to go further and approve rejection effective as of December 31 (i.e., when the trustee surrendered the property after notifying the landlord of the decision to reject the lease).

The court began its analysis by citing existing precedent to the effect that rejection is effective only after judicial approval.  It noted that the cited case also suggested that approval might be retroactive “to the motion filing date.”  However, the court found no basis in the cited decision for approving rejection effective on a date prior to the date that a formal motion requesting approval is filed.

The court also surveyed a number of cases from various jurisdictions that approved rejection of leases retroactively.  Only rarely was approval retroactive to a date prior to the filing of the motion, and those cases “are either in the distinct minority or contain easily distinguishable fact patterns from the circumstances present in this case.”  Consequently, the court declined to approve rejection retroactive to December 31.

As a result of these rulings, the trustee was ordered to immediately pay the December and January rents (subject to a clawback if there was a future administrative insolvency), and the landlord’s request for payment or administrative expense priority for February and March and its rejection damages was denied.

Although leases and executory contracts are often dealt with as part of a Section 363 sale process, be aware that assumption or rejection requires separate treatment under Section 365.  Any interested parties should carefully review the procedures to determine how Section 365 issues will be resolved and approved by the court.  Similarly, it is at best unwise to rely on informal action to establish rejection of a lease.

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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