Rejection versus termination: a sublessee's rights in a lease rejected in a bankruptcy proceeding under 11 U.S.C. 365(d) (4).

• Author: Sankaran, Vivek

When a party files for bankruptcy under chapter 11 of the United States Code,(1) the court typically appoints a trustee to handle all of the party's financial obligations.(2) The trustee's responsibilities include investigating the financial condition of the debtor, the operation of the business, the desirability of continuing the business, and any other matter relevant to the disposition of the bankrupt estate.(3)

If a bankrupt party holds a commercial lease,(4) the trustee possesses two options for dealing with the lease.(5) One option is to reject the lease, which ends the bankrupt party's obligation to adhere to the provisions of the lease.(6) The trustee may decide to reject the lease because the rent of the property is above the market price or because the particular leased premises are not needed.(7) The second option is to assume the lease, which requires the bankrupt estate to take on the obligations set forth in the lease.(8) The assumption of a lease permits the bankrupt party to receive benefits from the lease, such as the continued use of the property and rent derived from subletting the property, at the cost of meeting its obligations.(9) According to 11 U.S.C. [sections] 365(d)(4) (the "surrender provision"), if the trustee for the bankrupt party fails to either reject or assume the lease within sixty days of filing for bankruptcy, the lease is deemed rejected automatically, and the trustee must immediately surrender the property to the lessor.(10)

Chapter 11 also defines the rights of a lessee when its lessor files for bankruptcy and the trustee rejects the lease. Section 365(h)(1)(A)(ii) (the "applicable nonbankruptcy law provision") states that, in such situations, the lessee possesses the right to remain on the property for the duration of the lease to the extent permitted "by applicable nonbankruptcy law."(11) In situations involving the subletting of property, the applicable nonbankruptcy law provision suggests that, when a bankrupt lessee or sublessor rejects the original lease, the sublessee of the original lease should also have the right to remain on the premises as permitted by "applicable nonbankruptcy law."(12)

When a party that subsequently files for bankruptcy subleases property to a third party, it is both a lessor and a lessee. It is a lessor because it is subleasing the property to another party; but it is a lessee because it is leasing the property from another. Because of the multiple roles of the bankrupt sublessor, both the surrender provision and the applicable nonbankruptcy law provision seem to apply when the sublessor rejects the lease or when the lease is deemed rejected.(13) While the applicable nonbankruptcy law provision provides the sublessee with the right to assert nonbankruptcy law to preserve its rights under the rejected lease, the surrender provision appears to mandate the sublessor to surrender immediately the property to the original lessor upon rejection.(14) The explicit language in section 365 appears to provide both the sublessee and the lessor the right to occupy the property after the bankrupt sublessor rejects the lease.

The key question to resolve is whether, in a subletting situation, the rejection of a lease due to the trustee's failure to act under the surrender provision that results in the immediate surrender of the property to the lessor terminates the lease and extinguishes all rights of third-party sublessees under the lease. If rejection under this provision terminates the lease, a sublessee has no recourse under the applicable nonbankruptcy law provision, since the lease no longer exists.(15) If, however, rejection does not terminate the lease, but rather stands as a breach of the lease, the sublessee may be able to look to the applicable nonbankruptcy law provision to assert its right to remain in the property.(16)

The future of parties subleasing commercial property depends on the resolution of this crucial issue. The surrender provision is invoked when a bankrupt sublessor fails to assume or reject a lease within sixty days after filing for bankruptcy.(17) If, as a matter of federal law, sublessees' rights are terminated pursuant to the surrender provision, their rights are forfeited without the opportunity for a court to address their interests. Consequently, this policy of automatic forfeiture would increase the transaction costs(18) of entering into subleases because it would force sublessees to perform extensive credit checks to assess the probability of potential sublessors' filing for bankruptcy.

A number of bankruptcy courts have addressed the apparent conflict between the surrender provision and the applicable nonbankruptcy law provision. Some courts have determined that, in enacting the surrender provision, Congress intended for property to revert immediately to the lessor upon rejection by the bankrupt sublessor, even in a subletting situation.(19) Other courts, relying on the applicable nonbankruptcy law provision, have held that the property rights of a sublessee are matters of nonbankruptcy law.(20) These courts have found that once the bankrupt sublessor's actions result in the rejection of a leased premise, sublessees can assert applicable nonbankruptcy law in state courts.(21) By applying the applicable nonbankruptcy law provision instead of the surrender provision, these jurisdictions hold that the rejection of a lease does not necessarily extinguish the rights of third-party sublessees to the lease.(22)

This Note argues that a lease deemed rejected under the surrender provision ends the bankrupt sublessor's interest in the lease but does not terminate the rights of a sublessee. State property law, rather than federal law, should determine the sublessee's rights when the primary lease is deemed rejected. Part I argues that Congress intended that rejection and termination have different meanings. Congress did not evince an intent, contrary to the suggestion of some courts, for a rejected lease to be terminated. Congress further demonstrated its intent to preserve the rights of sublessees by incorporating the phrase "immediately surrender" into the surrender provision. Part II asserts that, since the surrender provision does not terminate third-party sublessee interests to the lease, the applicable nonbankruptcy law provision should govern the rights of a sublessee. Once a lease is "immediately surrendered," the sublessee should have the opportunity to assert its rights in state court since the proceedings no longer involve bankruptcy law. This Note concludes, in Part III, that the surrender provision provides parties with an incentive to enter into subleases because, under that provision, the distinction drawn between rejecting and terminating a lease reduces the transaction costs of entering into such an agreement. This distinction furthers Congress's desire to encourage the efficient use of property through section 365 of the Bankruptcy Code.

1. CONGRESS'S USE OF REJECTION AND TERMINATION IN SECTION 365

   Congress intended that rejection and termination have different meanings in section 365 of the Bankruptcy Code(23) so that a lease rejected under the surrender provision would not be terminated. Courts reading the surrender provision to find that a sublessee's rights are extinguished upon the bankrupt sublessor's rejection of the lease interpret the phrase "immediately surrender" to convey Congress's intention that a rejected lease be terminated.(24) Although the statutory provision does not mention termination,(25) these courts reason that Congress used rejection and termination interchangeably throughout the statute.(26) Assuming that Congress did not intend different meanings between rejection and termination throughout section 365, these courts developed their own interpretation of what it means to "immediately surrender" a lease.(27)

   This section asserts, to the contrary, that Congress intended to preserve the differences between rejection and termination in section 365. Section I.A argues that Congress clearly differentiated between rejection and termination throughout section 365. Section I.B asserts that Congress incorporated the terms into the statute with an understanding of the consequences accompanying rejecting and surrendering a lease under the common law. Courts, therefore, should adhere to the definitions of rejection and surrender used in the statute and understood under the common law, and should not equate the surrendering of a lease with the termination of all third-party sublessee interests to the lease.

   1. Different Meanings of Rejection and Termination

      The provisions of section 365 may be redundant and complex, but Congress's varied usage of rejection and termination does not reflect confusion. A careful examination of section 365 indicates that Congress intended the differences between rejecting a lease and terminating a lease and drafted the statute with this knowledge, using the terms in a consistent manner. The distinct use of these terms by Congress creates the presumption that it intended them to have different meanings.(28)

      Congress evinced its understanding of the limited consequences of rejecting a contract in section 365. Throughout the section, rejection refers to the bankrupt sublessor's decision not to assume a burdensome lease.(29) Congress characterized the rejection of a lease as a breach of the lease,(30) granting the solvent party to the lease a damages claim when the conditions of the lease are not fulfilled.(31) If the lease no longer existed after the rejection (i.e., the lease was terminated), then the solvent party would have no recourse since its rights under the lease presuppose the existence of the lease.(32) Thus, a reading of the statute equating rejection with termination is inconsistent with Congress's grant of a damage claim to the sublessee.(33)

      Congress also demonstrated its understanding of termination by specifically authorizing the termination of...