Lease Rejection: What Happens When the Landlord and Tenant Are Both in Bankruptcy?

In re Railyard Co., LLC, 562 B.R. 481 (Bankr. D. N.M. 2016)

Both the landlord and an affiliated tenant filed bankruptcy. The landlord’s trustee filed a motion to reject the lease in the landlord’s case and filed a motion for relief from the automatic stay in the tenant’s case to permit litigation of the rejection motion. The bankruptcy judge issued a single opinion for both cases.

The landlord was formed to develop an abandoned rail station into a large, multi-unit building. The project was located on property subject to a long-term ground lease. The landlord’s income came from subleasing the space.

The managing members of the landlord also formed the tenant to own and operate an entertainment business, including a restaurant, bar and bowling lanes. Although the members had no experience with this type of business, they associated with others who did. The lease for this space was the subject of the opinion.

The landlord refinanced existing debt with a loan that included funds designated for tenant improvements, including $300,000 for buildout of the debtor tenant’s space. Unfortunately another significant tenant filed bankruptcy and moved out, creating major cash flow problems for the landlord. A few months later the lender declared a default and refused to release any further funds for tenant improvements.

Not surprisingly, the landlord subsequently filed bankruptcy. The court eventually determined that cause existed to appoint a chapter 11 trustee. The trustee filed a motion to reject the lease and the court scheduled a trial on the motion. In the meantime the tenant continued delay tactics in the hopes that it could complete the improvements and open – thus generating monthly rent that would benefit the landlord’s bankruptcy estate and make it harder to reject the lease. When the court refused to continue the trial, the tenant filed bankruptcy “about 15 minutes after the start of the lease rejection trial.”

The court reviewed a number of details relating to the lease. Among other things, the third amendment provided that the lease would commence

90 days after the full funding of equipment and working capital as outlined in the opening cost worksheet… contemplated in the loan between [the lender and the landlord], and upon the full reimbursement to [the tenant] for any construction costs provided by [the tenant] for a certificate of occupancy, and/or any other costs associated with delays in funding the opening cost worksheet in the loan agreement between [the lender and the landlord].

By the time this amendment was signed the landlord and the lender were at odds and the clear intent was to make sure the tenant did not have to pay rent until the disagreement was resolved to its satisfaction.

The court also concluded that the lease was not negotiated at arm’s length and a number of terms were not commercially reasonable, such as:

  • There was no deadline for the lease to commence and the tenant to start paying rent since the conditions to commencement were unlikely to occur.
  • There was no cap on what the landlord was required to pay for tenant improvements and no deadline for completing the improvements.
  • There was no deadline for the tenant to begin operating its business, which was a violation of the underlying ground lease.
  • The lease did not require any personal guarantees or security deposit even though the tenant was not a national credit tenant and had never operated a similar business.
  • The lease was for 20 years, with six 10 year renewal options, so that the tenant could control the space on highly unusual terms for 80 years even though it was only a start-up business.
  • Rent only increased by 10% every 5 years, thus locking in the rate for 80 years.
  • There were also a number of ambiguities.

In addition to the very unfavorable terms (from the landlord’s perspective), the trustee did not want to do business with the tenant and its members. They had been difficult to work with and fought and/or sued a number of other parties.

The tenant’s business also adversely affected other space in the building. Other tenants were bothered by the noise of a bowling alley and there were no restrictions on the time the bowling alley could operate (for example, only after normal retail hours). Finally, the lease included space on the first floor that the tenant was not using that was attractive to other potential tenants.

On the other side of the ledger: The main portion of the leased space would be difficult to relet since it was large, located on the second floor, and the entrance was near the back of the building. The tenant also offered to partially waive its right to abate rent, and continued putting money and effort into completing the improvements.

Against this background the court first concluded that immediate resolution was important to both bankruptcy estates. So it granted relief from the automatic stay in the tenant’s case for “cause” to permit the parties to litigate the rejection motion in the landlord’s case.

With respect to rejection, the court considered both the business judgment rule (which it characterized as not particularly strict and subject to giving deference to the trustee’s judgment), and an alternate articulation that the court “will approve a proposed assumption or rejection unless it is manifestly unreasonable or derives from bad faith, whim, or caprice.” Considering the facts, the court concluded it had no choice but to approve rejection.

However, in the court’s view it would be in the best interests of both debtors to have a new lease for the primary space on more reasonable terms. Consequently the court believed the trustee and the tenant should make commercially reasonable efforts to negotiate an agreement, and planned to issue an order directing mediation.

While rejection of this lease might seem like a no-brainer, as this case illustrates a trustee or debtor-in-possession cannot count on a court rubberstamping its decision. The outcome becomes even fuzzier when both the landlord and tenant are in bankruptcy, requiring consideration of the circumstances from two adverse perspectives.

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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