Bankruptcy trustees and chapter 11 debtors in possession who are lessors under real property leases have the right under section 365 of the Bankruptcy Code to reject a tenant’s lease. Accordingly, a tenant of a debtor in bankruptcy needs to be mindful that its’ rights under a lease could be affected substantially by the bankruptcy. Fortunately, chapter 11 debtor/landlords generally choose to assume their leases with their tenants, leaving unaffected the rights of the parties. This is the case because debtor/landlords generally find their leases economically advantageous.
If a bankruptcy trustee or chapter 11 debtor in possession elects to reject an unexpired lease, the tenant has the option under section 365(h) of the Bankruptcy Code of: (1) treating the lease as terminated; or (2) remaining in possession of the premises for the remaining term and any extensions or renewals. The important takeaway from section 365(h) from the tenant’s prospective is that the trustee or debtor in possession cannot unilaterally terminate a tenant’s right to possess the leased premises by rejection of the lease. Rejection of the lease does, however, relieve the trustee or debtor in possession of its ancillary obligations under the lease, such as furnishing utilities or other services. Accordingly, section 365(h) of the Bankruptcy Code provides a mechanism for a trustee or debtor in possession to shed burdensome financial obligations under an undesirable lease, while maintaining a tenant’s right to remain in possession of the leased premises, if it so elects.
After a rejection and tenant election to treat the lease as terminated, the tenant will have a non-administrative claim in the bankruptcy case against the debtor’s estate for any resulting damages. Alternatively, if the tenant elects to remain in possession, then the tenant will remain responsible for all rental payments provided for in the lease; however, the tenant may offset from the rents any damages that result from the debtor/landlord’s nonperformance of its ancillary obligations under the lease. If the rejected lease is of real property in a shopping center, the rejection will not affect the enforceability of any provision in the lease pertaining to radius, location, use, exclusivity, tenant mix, or balance.
Notwithstanding the protections contained in section 365(h) of the Bankruptcy Code that allow a tenant to remain in possession of the leased premises upon rejection of the lease, some courts have held that a debtor/landlord may sell property under 363(f) of the Bankruptcy Code free and clear of a tenant’s leasehold interest. Such an interpretation of the Bankruptcy Code effectively sidesteps the protections provided tenants under section 363(h). Courts are not in harmony regarding whether a sale free and clear under section 363(f) of the Bankruptcy Code can be used to trump the protections afforded tenants under section 363(h). However, commentators have criticized decisions that allow sales free and clear of a tenant’s interest under section 363(f), and the better reasoned decisions afford tenants the protection provided under section 363(h) of the Bankruptcy Code. It is important to note that in some of the cases in which the court allowed a sale free and clear of the tenant’s interests, the tenant failed to timely raise an objection to the sale in the bankruptcy court.
Tenants should diligently monitor their debtor/landlord bankruptcy cases, paying particular attention to motions to assume or reject leases and motions to sell assets free and clear liens and interest. Chapter 11 plans and disclosure statements should also be scrutinized for provisions that may affect the tenant, including provisions dealing with the assumption or rejection of executory contracts, which would include tenant leases, and sales free and clear of liens and interests.
Bankruptcy cases often move quickly. Accordingly, corporate counsel may have little time to react to filings that may affect the company’s lease. Close and timely monitoring of the bankruptcy case is key.
Republished with permission. This article first appeared in Inside Counsel on July 14, 2015.