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BANKRUPTCY LAW
Debtors As Lessors
By Craig Rankin and Christopher Alliotts
S
ection 365 of the Bankruptcy
Code addresses the assumption
(and perhaps assignment) and
rejection of unexpired leases and
executory contracts. Though § 365
is generally considered the most convoluted
section of the Bankruptcy Code, due in
part to amendments prompted by special
interests, this article focuses on the specific
provisions of § 365(h). These provisions are
implicated when the debtor in bankruptcy
seeks to reject an unexpired lease in which
the debtor is the lessor (as opposed to the
lessee) of real property.
Commonly, a debtor will be the lessee of
real property and will assume or reject the
lease if the contract terms are more or less
advantageous than prevailing market rates. If
the debtor rejects the lease, there are three
important consequences. First, the debtor
must vacate the premises in order to avoid
the continued accrual of administrative
rent by the bankruptcy estate. Second, the
debtor’s rejection will be deemed to have
occurred just prior to the filing of the
bankruptcy case, the lessor will be left with a
general unsecured claim for the damages
arising from the debtor’s rejection and such
claim will be paid on a pro rata basis with
other general unsecured creditors. Third, any
claim for rejection damages by the lessor will
be limited by the “cap” on lease-rejection
Craig Rankin is a partner at Los Angeles-based
bankruptcy boutique Levene, Neale, Bender,
Rankin & Brill. Christopher Alliotts is of
counsel in the Menlo Park, Calif., office of Los
Angeles-based SulmeyerKupetz.
MONDAY, DECEMBER 20, 2004
damages set forth in § 502(b)(6).
When the debtor is the lessor of real
property, however, the consequences of
rejecting the lease are significantly different
in two respects. First, § 365(h) gives to the
nondebtor lessee the right to remain in
possession of the premises for the balance of
the lease term and any extensions thereof,
even though the debtor will no longer be
required to fulfill its other obligations under
the lease. Second, while the lessee’s claim for
rejection damages will be a prepetition
general unsecured claim, the § 502(b)(6) cap
will not apply because, by its express terms, it
is limited to situations where the debtor is
the lessee and not the lessor.
Addressing a nondebtor
lessee’s possessory right
A nondebtor lessee’s residual possessory
right under § 365(h) can be a nettlesome
issue for the bankruptcy estate. If a sale of
the real property is necessary, it would
behoove a nondebtor lessee to assert its
rights under § 365(h) even if only to extract
more advantageous treatment of its claims in
the case. As the 7th U.S. Circuit Court of
Appeals recently pointed out, a debtor must
provide adequate protection of a nondebtor
lessee’s interest in the real property when
selling “free and clear” of residual possessory
rights under § 365(h). See In re Precision
Industries Inc., 327 F.3d 537 (7th Cir. 2003).
In Precision Industries, the debtor sold real
property to a buyer under § 363(f). Howev-
er, the real property was the subject of a lease
to a certain lessee. Nine months after the
sale, the buyer changed the locks and
excluded the lessee. The principal question
before the court was whether § 363(f)
authorized a sale “free and clear” of a lessee’s
rights under § 365(h). The 7th Circuit ruled
that § 363(f) does authorize such a sale.
The 7th Circuit went on to state, howev-
er, that the nondebtor lessee’s residual
possessory right constitutes an “interest” in
the real property for purposes of § 363(f) and
that the lessee is entitled to “adequate
protection” of such interest pursuant to
§ 363(e). Unfortunately, the nondebtor
lessee in that case did not object to the
proposed sale and, as a result, the issue of
adequate protection was not addressed
squarely. Nonetheless, the 7th Circuit
suggested that adequate protection under
§ 363(e) could be in the form of a cash pay-
ment from the proceeds, which would neces-
sarily involve issues over the relative value of
the residual possessory interest as against the
overall sales price of the real property.
While the 7th Circuit held that § 363(f)
authorizes a sale free and clear of rights under
§ 365(h), the outcome for the nondebtor
lessee in Precision Industries seems a bit
harsh. In denying the lessee any relief
under § 363(e), the court certainly seemed
persuaded by the fact that the lessee did not
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object to the sale until nine months after-
ward. One might question this conclusion
given the fact that the debtor never sought
to reject the lease and the lessee could easily
have thought the sale was subject to, as
opposed to free and clear of, its lease.
Regardless, the practice tip appears to be: Do
not let a sale of real property in which a
client has an interest get approved without
completely understanding how the sale will
affect the client’s rights.
Unlike the situation in Precision Indus-
tries, if a nondebtor lessee demands adequate
protection of its residual possessory interest
in the real property, the debtor will have to
pay off the lessee for its residual possessory
right essentially as a secured or administra-
tive claim. This favored treatment could
have a material negative impact on the
outcome of the case, particularly if it relates
to the payment of unsecured claims. Good
practitioners should thus look for creative
ways to avoid implicating § 365(h)’s
provisions: They should consider a three-
pronged approach.
First, counsel for the debtor should
determine whether there is any basis for ter-
minating the agreement by its own terms.
An agreement could contain provisions for
terminating the contract upon written
notice, or the debtor could have the right to
terminate the lease for a breach by the
nondebtor lessee. Of course, this approach
will succeed or fail based on the agreement’s
provisions, and there is no suggestion that
a pretextual breach would carry the
day. Nonetheless, the point is to know
the documents, as they may contain the
simplest solution.
Second, counsel should ask this question:
Is the lease a true lease or some other execu-
tory contract dressed up as a lease? The resid-
ual possessory rights set forth in § 365(h)
apply only to true leases and not other
executory contracts. In Butner v. United
States, 99 S. Ct. 914 (1979), the U.S.
Supreme Court held that the nature of prop-
erty interests should be based upon the state
laws under which they arose, absent a clear
and manifest federal interest. Under the law
of most states, a valid real property lease
must set forth, at a minimum, a definite
description of the premises being leased, the
rent to be paid and the grant of exclusive
possession of the premises. While creative
drafting may obscure the matter, courts will
look beyond the terminology of the agree-
ment to its economic substance.
Finally, if the agreement qualifies as a true
lease under state law, the issue is not neces-
sarily settled. In In re PCH Assocs. Inc., 804
F.2d 193 (2d Cir. 1986), and In re Morreggia
& Sons Inc., 852 F.2d 1179 (9th Cir. 1988),
the 2d and 9th circuits concluded that the
leases at issue were financing and joint ven-
ture agreements, and not the type of “lease”
covered by the protections of § 365(d). They
reasoned that “[s]imply meeting the state law
Section 365(h) gives
nondebtor lessees
the right to remain
in possession of the
premises for the
balance of the
lease term.
definition of a lease will not necessarily
mandate the ‘mindless application’ of
section 365. Rather, the ‘economic realities’
of the particular agreement must properly
fall within the scope of the type of agreement
anticipated by Congress in enacting section
365.” 852 F.2d at 1183.
Is there a true landlord/
tenant relationship?
Based upon PCH and Morreggia, a
nondebtor lessee must show that, in addition
to having a true lease under applicable state
law, its lease fits within the intended purview
of § 365. Courts will consider a wide range of
factors, such as the intended scope of the
statutory provision at issue, whether the
parties intended a true landlord/tenant
relationship, whether there are any executory
obligations, the relative value given for the
MONDAY, DECEMBER 20, 2004
lease, the balancing of risks between the
parties and other indicia of ownership.
Such considerations are not exhaustive
by any means. Indeed, the reasoning of PCH
and Morreggia can be applied to other sub-
sections of § 365, such as the residual posses-
sory rights set forth in § 365(h). Thus, when
faced with a nondebtor lessee that is assert-
ing a right to remain in possession of the real
property under § 365(h), a debtor can argue
that the lease at issue is not the type of lease
to which § 365(h) should apply.
It would be impossible to catalog all the
types of “leases” that would qualify as leases
under § 365(h). Consideration of certain
contracts may provide a sense of the statute’s
intended scope. For instance, standard
residential leases would most probably fall
within the purview of § 365(h), given the
presumption of uniqueness of such property.
Certain commercial leases where location is
important would probably also qualify.
On the other hand, PCH and Morreggia
strongly suggest that leases lacking a
traditional landlord/tenant relationship,
such as disguised secured financing transac-
tions and joint ventures, are outside the
statute’s intended scope. Other contracts
that grant possession of the real property as
an incident to an agreement to provide other
services or to acquire personal property, such
as harvesting and mining agreements, would
also not qualify because the economic
substance of the transaction is not one of
landlord/tenant. Such interests could be
satisfied with money damages.
The precise scope of § 365(h) will be
established by future cases. With interest
rates on the rise, there is the potential for
more bankruptcy filings by debtors who are
lessors of real property. A spate of such cases
would do much to develop what would
essentially be a separate federal common law
on the issue of what is a true lease for
purposes of § 365, and arguably other
provisions of the Bankruptcy Code. NLJ
This article is reprinted with permission from the
December 20, 2004 edition of THE NATIONAL
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