Leases: Prepetition Termination May Be A Get Out of Bankruptcy Free Card – Or Not

In re Indiana Hotel Equities, LLC, 586 B.R. 870 (E.D. Mich. 2018) –

The debtor leased nonresidential real property under a lease that was terminated before the bankruptcy petition was filed. The lessor filed a motion seeking a bankruptcy court order confirming that the automatic stay did not apply to its efforts to obtain possession of property.

The debtor operated a hotel located on property near an airport that it leased from the Indianapolis Airport Authority. The lease as amended had a term of 72 years commencing in 1962 and ending in 2034. After the debtor defaulted the lessor exercised its right to cancel the lease “in its entirety.”

This led to litigation between the parties in state court. Ultimately the state court determined that (1) the debtor defaulted, (2) the lessor had the right to terminate the lease because of the defaults, (3) the lessor validly terminated the lease, (4) because of the termination the debtor had no right of possession, and (5) the lessor’s acceptance of monthly rent after the effective termination date was not a waiver of either the right to terminate or the actual termination of the lease.

The state court also ordered the debtor to vacate and turn over possession of the hotel by a specified date. Shortly before that date the debtor filed bankruptcy and remained in possession. The debtor also filed a notice of appeal of the state court order. The state court had not yet ruled on the debtor’s request for a stay pending appeal when the bankruptcy court addressed the lessor’s motion.

Technically the lessor did not request relief from the automatic stay, but rather asked for an order confirming that the automatic stay did not apply. Based on collateral estoppel, the bankruptcy court started with the premise that the lease was in fact validly terminated prior to bankruptcy. So, the issue turned on interpretation of sections 362(b)(10) and 541(b)(2) of the Bankruptcy Code.

Section 362(b)(10) provides (emphasis added):

The filing of a petition … does not operate as a stay … of any act by a lessor to the debtor under a lease of nonresidential real property that has terminated by the expiration of the stated term of the lease before the commencement of or during the case under [the Bankruptcy Code] to obtain possession of such property[.]

Section 541(b)(2) provides (emphasis added):

Property of the 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 case under this title[.]

The critical question was whether termination by or at the expiration of the “stated term” of the lease meant only the calendar date specified as the end of the lease term (as argued by the debtor) or whether it could also refer to the earlier termination date that occurs when a lease is terminated pursuant to terms of the lease and applicable nonbankruptcy law (as argued by the lessor).

The opinion recognizes that courts are split on the issue of whether an early lease termination constitutes expiration of the stated lease term for purposes of sections 362 and 541. Here the court concluded that it agreed with the debtor: expiration of the stated term was in 2034, which obviously had not yet occurred. The court found support for its decision in the definition of “Term” in the lease. There was nothing that suggested the right to cancel the lease would affect the Term. Rather, the cancellation section provided grounds for terminating early prior to expiration of the Term.

Accordingly, since the stated term of the lease had not expired, the debtor’s interests under the lease were part of the bankruptcy estate and the automatic stay was applicable to the lessor’s efforts to regain possession of the leased property. The court noted that that this did not preclude the lessor from filing a new motion seeking relief from the automatic stay. However, it signaled that this would present difficult questions because, among other things, the pending appeal could result in reversal so that the lease was no longer terminated.

A landlord often must make a strategic decision about whether to terminate a lease in default prior to bankruptcy in the hopes that the property will not be tied up in bankruptcy – as opposed to leaving the lease in place so that the landlord may be able to enforce the terms of the lease and have a claim for continuing rent. However, depending on the jurisdiction, it may be difficult to keep the property out of bankruptcy even if the lease has been terminated prepetition.

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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