Chapter Four Lease Rejection

• Jurisdiction: United States

Chapter Four Lease Rejection

I. Introduction

A debtor has a statutory right to "reject" a lease of nonresidential real property, and by so doing, to limit the financial burden of future rental payments.

A debtor's obligation to perform its lease obligations only continues until the debtor assumes or rejects a lease.²⁵⁴ Thus, lease rejection is a pivotal moment and the focus of much attention in retail cases. Assumption requires the debtor to timely perform all obligations, but rejection terminates the duty to perform the lease obligations in a timely manner. A debtor has a statutory right to "reject" a lease of nonresidential real property. Upon rejection, the landlord has a claim for future rent and perhaps the ability to evict the tenant, although the courts are somewhat muddled on this as well. The rejection is a breach and gives rise to a claim for the breach. However, the claim for breach is limited or capped, as discussed below. The rejection right, coupled with the statutory cap on the damages that may be "allowed" to a landlord, makes bankruptcy an extremely effective reorganization device from the perspective of a retail or commercial tenant. Most of the issues that arise concerning a landlord's claim deal with the rejection of a lease.

A debtor's right to reject a lease is said to be "vital to the basic purposes of a chapter 11 reorganization, because it can release the debtor's estate from burdensome obligations that can impede a successful reorganization."²⁵⁵ "By permitting debtors to shed disadvantageous contracts but keep beneficial ones, § 365 advances one of the core purposes of the Code: to give worthy debtors a fresh start."²⁵⁶

The meaning of "rejection" continues to be debated. At its most basic level, the rejection of a lease constitutes a "breach" of the lease and thus gives rise to a claim for payment in favor of the landlord. This "breach" is treated as if the breach had occurred immediately prior to the filing of the bankruptcy, thus it renders the claim by the landlord for breach a pre-petition, unsecured claim. The timing of when the breach is deemed to occur, and the cap on damages, make the claim subject to being "treated" in a bankruptcy plan and thus reduced to a pro rata amount equal to what other unsecured creditors will be receiving in the case.

An open issue is whether rejection is a breach or a termination of the lease. Although most scholars agree that rejection is not a termination for most types of executory contracts, many courts have held that the rejection of a commercial real estate lease should be viewed as a termination. Under state law, a breach of a lease does not cause the real property interest of the tenant to be extinguished; at the same time, however, a tenant remains obligated to continue to pay rent for the life of the lease. A "termination" ends the leasehold estate and gives the landlord a claim for contractual damages only, not rent. Differences in the two theories may arise under rules pertaining to mitigation of damages. The termination issue also affects the courts' view of the rights of third parties that are derivative of the lessee's rights, such as subtenants and leasehold mortgagees.²⁵⁷

II. Legal Grounds for Rejection; Business Judgment Rule

The general rule in the corporate arena is that courts should "not interfere with" decisions of corporate directors upon matters entrusted to their business judgment except upon a finding of bad faith or gross abuse of their business direction.²⁵⁸ "Transposed to the bankruptcy context, the rule as applied to a bankrupt's decision to reject an executory contract because of perceived business advantage requires that the decision be accepted by courts unless it is shown that the bankrupt's decision was one taken in bad faith or gross abuse of the bankrupt's retained business discretion."²⁵⁹ Moreover, "[a] court should defer to a debtor's decision that rejection of a contract would be advantageous unless the decision is so unreasonable that it could not be based on sound business judgment, but only on bad faith or whim."²⁶⁰ The classic statement of this principle is found in In re Curlew Valley Assocs.,²⁶¹ wherein Judge Ralph Mabey stated, "The courtroom is not a boardroom. The judge is not a business consultant."

Generally, a debtor's motion to reject a lease will be granted on a minimal showing and will prove difficult to contest. Landlords' efforts to interject conditions upon the rejection have not been met with success.²⁶²

III. Consequences of Rejection on Third Parties: Rejection as Termination

A. One View: Rejection Is Effective as Termination in Chapter 11 and Subleases Are Terminated

The consequences of a debtor rejecting a lease raise complex issues, which vary depending on whether the debtor is tenant or subtenant (and hence, also a "lessor"). The issues concern at least the following: (1) whether rejection is a termination of the leasehold estate or a mere "breach"; (2) whether the effect of rejection is to cause an implied rejection of any subtenancy; and (3) whether rejection by the debtor as lessor, if a termination, causes third-party mortgagees to lose their rights in the estate.

Two Code sections are relevant. First, § 365(d)(4) requires that when a debtor as tenant rejects a lease, it must immediately surrender the premises to the landlord. Section 365(h), however, provides that when the debtor as lessor rejects a lease, the subtenant has the right to elect to retain possession to the extent permitted under applicable nonbankruptcy law. Mortgagees presumably receive no legal protection under § 365(h).

The first issue is, what are the rights of a subtenant when a debtor rejects a lease? Some courts view a lease rejection as a complete termination of the lease, and hence as a termination of any subservient estate connected to the lease, including a sublease and a leasehold mortgage. Some courts base this result on the statutory obligation of surrender, which is found in § 365(d)(4) and states that when the lease is deemed rejected, the trustee is obligated to "immediately surrender such nonresidential real property to the lessor."²⁶³ The logic is that the duty to surrender suggests that the breach is viewed as a material breach, thus excusing performance by the lessor and perhaps terminating the leasehold estate.

Another basis for this view is that the policy of § 365(d)(4) is that landlords be able to obtain possession of their property following lease rejection and "it would be contrary to this policy to allow mortgagees or sublessees whose rights are derived solely from a debtor's interest as direct lessee to continue to tie up the property with litigation in bankruptcy court or state court."²⁶⁴ Further, under this view, it was stated that federal bankruptcy law pre-empted state law: "As to the effect of state law on this issue, the court held that section 365(d)(4) preempts or supersedes any state law right that the sublessee could assert following the underlying lease being rejected."²⁶⁵

One of the first cases to address the issue of "dual rejection" (where debtor is both lessee/lessor and sublessor) is In re Dial-A-Tire Inc.²⁶⁶ In this case, the court agreed that where a debtor as tenant rejects a lease and the debtor has a sublessee, the sublease is also deemed rejected. "Under New York law, a sublease is constitutive of the paramount lease out of which it has been carved. The existence of the sublease depends on the continuing viability of the paramount lease.... Accordingly, rejection of the Lease in this case must result in the Sublease being deemed rejected as well."²⁶⁷

Significantly, however, the court said the rights of a sublessee are governed by a different Code section, namely § 365(h)(1). This section provides that where the debtor as lessor rejects a lease, the nondebtor subtenant may retain its possessory rights "to the extent permitted 'under applicable nonbankruptcy law.'"²⁶⁸ Confronted with this form of "dual rejection," the court held that the rejection of the prime lease ended the leasehold estate of the debtor, but not necessarily that of the subtenant, and left the issue of the subtenant's rights to be dealt with under state law:

The Code provides specifically that upon rejection of a lease by a debtor, qua lessee, nonresidential real property must be immediately surrendered to the lessor. 11 U.S.C. § 365(d)(4). In contrast, 11 U.S.C. § 365(h)(1) provides that upon rejection of a lease of nonresidential real property by a debtor, qua lessor, "the lessee may remain in possession from the balance of the lease term to the extent permitted "under applicable nonbankruptcy law." 11 U.S.C. § 365(h)(1). The application of these subsections in this case produces the anomalous result of the debtor being obligated to surrender the premises, but [the sublessee] not necessarily having to. The matter is resolved by resort to forum law. Thus, the dual rejection which occurred here will leave the landlord and [the sublessee] to vie for possession of the premises according to New York law. In re Elmhurst Transmission Corp., 60 B.R. 9 (Bankr. E.D.N.Y. 1986).²⁶⁹

The notion that the matter is left to the state courts may have various implications. One meaning is that the subtenant must look to whatever rights it has acquired through its contractual and direct relationship with the prime landlord, such as an attornment or nondisturbance agreement. That is, a subtenant should create its own independent rights through direct contractual privity with the landlord, which survive the termination of the primary lease. Some landlords may not be willing to enter into such agreements with subtenants, and in that case, it seems likely that rejection by the debtor as lessor will, in fact, extinguish the rights of the subtenant, unless a court finds that § 365(h) fully protects the subtenant.

It is unclear whether § 365(h) creates an independent right to possession for the subtenant in the absence of...