§ 28.05 Rejection and Its Effect on Landlords and Tenants
| Jurisdiction | United States |
| Publication year | 2022 |
§ 28.05 Rejection and Its Effect on Landlords and Tenants
[1]—Character of Rejected Contracts or Leases
Claims arising from the rejection of an executory contract or an unexpired lease are treated as prepetition claims by Section 365(g) of the Bankruptcy Code.1
Rejection of an executory contract or unexpired lease does not invalidate, repudiate, repeal or avoid a contract or lease; rather, the effect of rejection is that the contract can no longer be assumed and the nondebtor party cannot seek payment of an administrative expense from the debtor's estate if the debtor fails to make required rent payments or otherwise breaches.2
Similarly, rejection is not rescission.3 Moreover, the Bankruptcy Code lacks clarity with regard to the effect of rejection and a variety of terms are used to describe the effect of rejection. If a debtor/tenant under a nonresidential lease does not assume its interest by the statutory deadline to do so, the lease is deemed rejected and the trustee is required to immediately surrender the premises;4 if a tenant rejects a lease, the lease is treated as breached as of the date immediately before the filing of the petition;5 and the landlord's lease termination damages are capped,6 as will be discussed below.7
The ambiguity of the statutory framework has led to a case law split regarding the effect of rejection. Among other things, some courts have held that the lease is deemed terminated or rescinded upon rejection and others have held that the lease is merely deemed to have been breached.8
The issue becomes critical for a subtenant whose sublandlord has rejected an underlying primary lease, as the termination of the underlying primary lease generally will collapse the sublease. Additionally, the issue is critical for leasehold lenders, as the termination of a commercial lease securing repayment destroys the lender's collateral. In light of the uncertainty in the law, the subtenant should seek to obtain a non-disturbance, attornment or recognition agreement from the landlord of the underlying primary lease (which generally will provide that, upon termination of the primary lease, the subtenant will be recognized by the landlord of the primary lease as a direct tenant of such landlord and that the subtenant will pay the landlord of the primary lease rent at the higher of: (1) the sublease rent, and (2) the underlying base lease rent). The leasehold lender should obtain the agreement of the landlord of the primary lease to enter into a new lease with the lender upon termination of the old lease or its rejection in bankruptcy.
Somewhat as an aside, lenders to commercial landlords should consider the impact of rejection by the landlord's tenants, who may file for bankruptcy relief.9 For example, losing an anchor tenant is almost certain to impair the value of a real estate asset that may constitute a mortgagees' collateral, as well as impair the mortgagor's cash flow and, therefore, its ability to service its debt.
[a]—Mortgage Lender Protection
In order to protect themselves, a mortgagee with an assignment of rents should protect itself by filing a proof of claim when a borrower's tenant files for bankruptcy relief, since the claim is likely to be a part of the mortgage lender's collateral, especially if the mortgagor has assigned rents to the mortgagee.
If a lease is rejected by the debtor/tenant, the landlord has a claim for damages based on breach of the lease.10 If the tenant has subleased its premises or pledged the lease as security for a loan, the effect of rejection on the subtenant or lender is less clear.
[b]—Surrender of Premises
A number of courts have found the language of Bankruptcy Code Section 365(d) (4) to require a debtor/tenant and any subtenants who claim an interest in a leasehold to immediately surrender the leasehold upon rejection of a lease, without the necessity of an eviction proceedings under state law.11 Other courts have disagreed.12
If after a lease is rejected the debtor/tenant remains in possession, it continues to be liable for rent under Bankruptcy Code Section 503(b)(1).13 The reasonable value of such use and occupancy of the premises by a holdover tenant has been found by many courts to be the rent reserved under the lease.14 Courts have reasoned that it would be inequitable to permit the debtor/tenant to have a rent obligation less burdensome during its holdover tenancy than when it was properly occupying the nonresidential real estate during the Section 365(d)(4) 120-day period.15
[2]—Effect of Rejection on Subtenants and Leasehold Mortgages
Rejection of the prime lease prior to or simultaneously with the rejection of the sublease by the lessee/sublessor/debtor results in the rejection of the sublease and deprives the sublessee of any right to occupy the leasehold following such rejection notwithstanding the protections afforded a tenant when its landlord rejects that are available under Section 365(h) of the Bankruptcy Code, including the right to stay in possession.16 If, however, the debtor or trustee were to assume the primary lease and simultaneously or thereafter reject the sublease, the subtenant would have the benefit of Section 365(h) of the Bankruptcy Code and its right to possession would be protected.17
A further discussion of Section 365(h) of the Bankruptcy Code is appropriate at this point. This Bankruptcy Code provision was included in the statute for the express purpose of preserving a tenant's possessory interests when a debtor/landlord is a party to a rejected lease.18
Section 365(h) permits the nondebtor/tenant to remain in possession of the leasehold and offset against the rent reserved under the lease damages caused by the rejection. Alternatively, the tenant may treat the lease as "terminated" and vacate the premises and assert a claim for the damages caused by the rejection.19 Although a number of courts have concluded that the provisions of Section 365(h) are the exclusive remedies of a debtor/lessor,20 other courts have held that Section 365(h) does not limit a debtor/lessor's right to sell property free and clear of a lease under Section 363(f).21 If the tenant chooses to remain in possession, it may offset any damages caused by the landlord's subsequent nonperformance of lease covenants against the reserved rent.22
For a subtenant or lender, there is considerable controversy as to whether the lease, if rejected by the debtor/tenant, remains "alive" or is effectively terminated.23 If the lease is terminated, any sublease predicated on that lease will collapse (absent any contrary agreement between the landlord and the subtenant). If a lease that has been pledged as security is terminated, the leasehold lender's security is lost.
This is a problem in theory that can be easily solved in practice. As to the theoretical issue, the case law is divided. In terms of practice, the problem can be solved by using a recognition agreements (in the case of a secured leasehold lender) and non-disturbance agreement (in the case of a subtenant). Pursuant to the terms of these types of agreements, the landlord under the master lease agrees to recognize the lender's or subtenant's rights if the primary lease is terminated because of the primary lessee's default.
If a prospective subtenant cannot obtain a non-disturbance agreement from the prime lease landlord (which is likely if the master lessee failed to negotiate for the right in the master lease) and has doubts about the continued solvency of its landlord (the prime lease lessee), the prospective subtenant should attempt to obtain an assignment of the underlying lease rather than a sublease. An assignment obviates the risk that a bankrupt sublessor will reject the master lease on which the prospective subtenant's tenancy is based.
If a landlord wishes to recover control of leased premises after a tenant's rejection of the tenant's interest in the lease in bankruptcy without having to litigate the entitlement to possession, the landlord will be well served by including a provision in its form of lease stating that the right to possession terminates if the lease is rejected by a debtor/tenant in any bankruptcy or other insolvency proceeding.24
If a lease is rejected and the bankruptcy case is subsequently dismissed, a plain reading of Section 349(b) of the Bankruptcy Code would appear to dictate that the lease is revived. [NTD - See if you can find a case].
[a]—Legal Standards Governing Lease Rejection
Most courts have held that an executory contract or unexpired lease may be rejected where the debtor's business judgment indicates that rejection will benefit the bankruptcy estate.25 Some courts examine the impact of rejection on the debtor only.26 Other courts determine business judgment by reviewing the effect of rejection on the recovery that may be available to the general unsecured creditors.27
Proper reasons for rejection include the following: (1) the contract is uneconomical to complete according to its terms; (2) the contract is financially burdensome to the estate; (3) rejection will make the debtor more attractive to prospective purchaser or investor; (4) rejection will result in a large claim against the estate; and (5) in the case of a stock option contract, the debtor can market shares and receive a higher or better price than by virtue of the option agreement.28
[b]—Refusal to Authorize Rejection
Although the decision to assume or reject is governed by the "business judgment" rule, there are times when the courts have refused to authorize rejection. Some courts have refused to authorize rejection and, in fact, have dismissed the bankruptcy petition when the debtor files the petition for the sole purpose of rejecting an executory contract.29 Still other courts have refused to consider the motives for filing a petition where the sole issue before the court is assumption or rejection.30
[c] —Effective Date of Rejection
A debtor or trustee is no longer obligated to...
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