Pre-Bankruptcy Lease Termination for Default: Will That Allow the Landlord to Escape Bankruptcy?

In re Chase Monarch Int’l. Inc., 581 B.R. 715 (Bankr. D Puerto Rico 2017) –

A landlord sought immediate surrender of commercial leased premises on the basis that the lease was terminated prior to bankruptcy so that the debtor had no interest in the premises and they did not become part of the bankruptcy estate. The debtor objected on several grounds.

Under section 541(b)(2) of the Bankruptcy Code the bankruptcy estate does not include “any interest of the debtor as a lessee under a lease of nonresidential real property that has terminated at the expiration of the stated term of such lease before the commencement of the [bankruptcy case]” (emphasis added).

One paragraph of the lease provided that if rent was late, “[o]n the 11th day Landlord shall have the right to terminate the lease and take over the property without further notices.” A second paragraph provided that if the tenant breached any obligations or conditions of the lease “the landlord may terminate this contract immediately after Seven (7) calendar-days written notice to cure to Tenant.”

On October 23 the landlord sent a notice to the debtor that it had not yet received the October rent and requesting payment. On October 31 (8 calendar days later), the landlord’s attorney sent a letter to the debtor terminating the lease due to tenant’s noncompliance with the terms of the lease. On November 14, the debtor filed bankruptcy.

As noted above, the landlord argued that this meant the lease terminated for purposes of section 541 so that (1) the debtor did not have any remaining interest as a lessee, and thus (2) the landlord was entitled to immediate surrender of the premises.

The court first disposed of the argument that “expiration of the stated term of such lease” is limited to the end of the regular term of the lease. Citing several cases with approval, the court held that this clause was broad enough to include early termination under the terms of the lease. In other words, the court had to look to state law to determine whether the lease had been properly terminated, as opposed to merely looking at the regularly scheduled end date.

Turning to the applicable statutes: “[o]bligations arising from contracts have legal force between the contracting parties, and must be fulfilled in accordance with their stipulations.” Further, contracts are “perfected” by mere consent. The freedom to contract is not unlimited: an agreement must not be in contravention of “law, morals or public order.” However, once there is a valid contract, parties must fulfill their obligations.

The debtor first argued that the landlord was not entitled to unilaterally terminate the contract and was motivated by an improper intent to take over profitable opportunities. But the court found that the landlord had a clear right to terminate under the terms of the lease, and the landlord’s supposed intent was not relevant.

The debtor also argued that the lease should be reviewed using the doctrine of “rebus sic stantibus” (things thus standing) which under state law was implicit in all contracts and allows a contract to be altered because of a change in circumstances. (This is in contrast to “pacta sunct servanda” – promises must be kept). In response the court noted that this doctrine is applied as “an exceptional remedy to extraordinary circumstances,” and a series of conditions must be met – including that the circumstances must be unforeseeable.

The debtor supported its argument by pointing to Hurricane Maria as the type of monumental event that would justify use of this doctrine. While acknowledging that the hurricane was “a remarkable meteorological phenomena, severe in its scope,” the court state case law only that natural phenomena such as hurricanes could be reasonably anticipated. Thus, the condition was not met, and the debtor was not entitled to relief.

Accordingly, the court found that the lease was binding, it was legally terminated prior to bankruptcy so that it was not part of the debtor’s bankruptcy estate, and thus the debtor was required to surrender the property.

As a matter of a pre-bankruptcy planning strategy, a landlord must weigh the potential benefits of having the lease terms in place against the potential for immediately extricating the leased property if bankruptcy is filed by terminating the lease. Although generally there is an assumption that early termination under lease default provisions will be sufficient to keep a lease property out of bankruptcy, this case is a reminder that this may not necessarily be the case.

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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