A tenant that elected to retain its rights under a commercial lease after a debtor landlord rejected the lease sought clarification of its rights and moved for summary judgment. The bankruptcy court granted the motion in part; a purchaser of the leased property appealed; the district court affirmed; and the purchaser appealed again to the Third Circuit.
Under the Bankruptcy Code, if a landlord in bankruptcy rejects a lease, section 365(h)(1) gives the tenant special rights. If the rejection would entitle the tenant to treat the lease as terminated by virtue of its terms, applicable nonbankruptcy law, or an agreement, the tenant may elect to treat the lease as terminated.
Alternatively, the tenant may elect to retain rights under the lease that are “in or appurtenant to the real property” for the balance of the term, including any renewals or extensions, to the extent enforceable under nonbankruptcy law. This specifically includes rights such as “those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation.”
If a tenant elects to retain its rights it may offset damages caused by nonperformance of obligations owed to the debtor against rent due under the lease, but otherwise has no rights against the bankruptcy estate or the debtor for damages caused by nonperformance after the rejection.
In this case the tenant had a long-term lease giving it the right to operate two nightclubs and a beach club at a casino owned by the debtor. The lease was characterized as “an almost impenetrable web of formulas, defined terms and cross-references” that was described by the bankruptcy court as a “bloated morass.” So, the Third Circuit chose to summarize terms rather than quote the lease:
Capital contributions: The lease contemplated that both the landlord and the tenant would make capital contributions to build out the tenant’s venues. The total budget was $80 million with the landlord responsible for ~$48 million and the tenant obligated for ~$16 million, with the remaining $16 million to be contributed by the tenant or the landlord at the tenant’s option. The tenant’s contributions were allocated among its three venues and were relevant to determining rent and “recoupment” payments.
Rent obligations: The tenant paid monthly rent on each venue. The rent for a particular venue was the distributable cash flow from that venue multiplied by its percentage share of the tenant’s capital contribution.
Recoupment obligations: During the first four years of the lease the landlord was required to make “recoupment” payments to the tenant. The payments were calculated based on whether a particular venue reached a designated threshold in gross sales, and whether it had a positive return on capital investment. If the venue met the gross-sales threshold but did not have a positive return, the landlord was required to refund to the tenant the amount necessary to breakeven for the applicable period.
The question presented to the court was whether the tenant could reduce its rent based on the recoupment payments that would be owed by the initial landlord under the lease. The Third Circuit agreed with both of the lower courts that the tenant did have a right to reduce its rent.
First, the rights protected by section 365(h) include rights relating to the “amount and timing of payment of rent and other amounts payable by the lessee.” The court determined that there was no doubt that this included the right to receive the recoupment payments. The net effect of the rent and recoupment provisions of the lease was to ensure that the tenant would pay rent during the first four years of the lease only if a venue turned a profit. If the tenant was required to pay “rent” without giving effect to the related “recoupment payment” provisions it would not have the right to remain in possession under the same lease rental terms.
Further, even if section 365(h) had not been available, the tenant was entitled to reduce its rent under the doctrine of equitable recoupment. Recoupment allows a creditor to receive full value for its claim by netting obligations of the creditor and debtor without regard to the bankruptcy priority of the claim. Recoupment requires that the claims arise from the same transaction, but applies regardless of whether the obligations arose before or after the bankruptcy was filed. In this case the rent and recoupment payments arose in a single transaction and were part of an overall framework. It would be inequitable to require the tenant to pay rent without receiving the benefit of the recoupment provisions.
Note that this issue could have been further complicated by the fact that the casino was sold to a third party purchaser “free and clear of all liens, claims, encumbrances and other interests of any kind.” However, in prior litigation the purchaser failed in its attempt to extinguish the tenant’s rights under the lease. As a result, the sale order specifically preserved rights of the tenant with respect to its proceeding against the landlord to clarify its rights and any rights that it elected to retain pursuant to section 365(h).
Accordingly, the court affirmed the lower court decisions holding that the tenant could reduce its rent obligations by the recoupment amounts provided for in the lease.
Since tenant bankruptcies are far more common than landlord bankruptcies, a tenant’s special rights under section 365(h) in a landlord bankruptcy receive far less attention than issues such as the timing and requirements for an assumption of a lease in a tenant bankruptcy. Anyone representing a tenant in a landlord bankruptcy needs to be familiar with both section 365(h) and the interaction of the treatment of leases under section 365 and the sale of the leased property free and clear of interests under section 363.
Vicki R Harding, Esq.
Bankruptcy-RealEstate-Insights 