A debtor rejected a master lease. The landlord and a subtenant filed claims for rejection damages, and the debtor objected. The bankruptcy court found in favor of the debtor and the claimants appealed to the district court.
The debtor leased a floor in an office building from the landlord pursuant to a master lease. Eventually the debtor vacated the space and subleased it to a subtenant. The rent payable to the debtor under the sublease was less than the rent owed by the debtor under the master lease.
The sublease provided that if the master lease “shall terminate for any reason” the sublease would also terminate unless the landlord agreed otherwise. In addition, the sublease provided that the debtor could terminate the master lease without the subtenant’s consent if the landlord agreed to assume and accept the sublease as a direct lease.
The three parties also entered into a consent to the sublease and a subordination, nondisturbance, and attornment agreement (SNDA). Under the S NDA if the master lease was terminated other than as a result of casualty or condemnation or the subtenant’s default, the sublease would continue as a direct lease between the landlord and subtenant, except that the subtenant agreed to pay the greater of the rent due under the sublease and the rent due under the master lease.
The day that the debtor filed bankruptcy it filed a motion to reject the master lease, sublease and SNDA, which was approved by the bankruptcy court. The landlord filed a proof of claim seeking unpaid rent resulting from rejection of the master lease, and the subtenant filed a proof of claim seeking ~$1.6 million in damages based on the additional rent it was required to pay.
The bankruptcy court disallowed both claims. It held that the landlord did not suffer any damages because it continued to receive the full rent from the subtenant, and the subtenant did not have a damages claim because it received what it bargained for: “the benefit of undisturbed occupancy, rather than [having to] face potential eviction.”
On appeal the district court began by noting that section 365(a) of the Bankruptcy Code authorizes a debtor-in-possession to assume or reject an unexpired lease, subject to court approval. Subsection(g) provides that “the rejection of an executory contract or unexpired lease of the debtor constitutes a breach of such contract or lease… [which is deemed to occur] immediately before the date of the filing of the petition.”
Rejection gives rise to a remedy for breach of contract, with the claim treated as a pre-petition claim. The Bankruptcy Code gives the non-debtor party a claim, but generally state law determines the parties’ rights with respect to the contract and breach.
When a creditor files a proof of claim, the claim is deemed allowed unless there is an objection. One basis for objection and disallowance of the claim is that “such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law for reason other than because such claim is contingent or unmatured.”
The appellants argued that because rejection constitutes a breach and “it is axiomatic that a breach entitles the non-breaching party to a remedy,” they were entitled to damages. They conceded that damages were not recoverable if the contract anticipated the particular breach and provided a specific remedy, but contended there was nothing in the lease documents that contemplated a unilateral breach by the debtor or disclaimed damages if such a breach occurred.
The bankruptcy court disagreed. It noted that section 2 of the SNDA provided that where the master lease is terminated but the subtenant stays, the subtenant must pay the full amount of the rent. Further, the sublease provided that if the master lease terminated, the sublease would also terminate unless the landlord agreed otherwise “and in no event shall [the debtor] be liable therefor.”
Thus the documents contemplated that if the master lease terminated and the subtenant stayed, it would be liable to pay the full rent as provided in the master lease, and if the master lease terminated the sublease would also terminate (unless landlord agreed otherwise) with no liability to the debtor. However, as explained by the Second Circuit:
While rejection [under section 365(g)(1)] is treated as a breach, it does not completely terminate the contract. Thus, rejection merely frees the estate from the obligation to perform; it does not make the contract disappear.
Accordingly, the district court concluded that the master lease was not terminated solely by the debtor’s rejection, and thus it was not clear that the SNDA and sublease language relied on by the bankruptcy court was applicable. The bankruptcy court erred either because it treated rejection as termination or because it failed to make a finding of fact that the master lease was terminated.
Given the uncertainty about the basis for the bankruptcy court’s opinion, the district court vacated the bankruptcy court decision and remanded for further proceedings.
It can be easy to jump to the conclusion that a rejected lease has been terminated. However, as illustrated by this case, termination does not automatically result. It may be the ultimate result. However, it is usually necessary to fill in intermediate steps to reach that result (e.g. rejection equals breach, breach equals default, default terminates lease under lease terms and/or applicable law).
Vicki R Harding, Esq.