Section 365(h) – Rejecting a Lease When the Debtor Is the Landlord

on January 18, 2013 ·

Posted in Assumption and Rejection,Breaking the Code,Executory Contracts & Unexpired Leases

It’s been awhile since we’ve taken our “Breaking the Code” super-random-topic-generator for a spin, and in keeping with our new year’s resolution to learn every single provision of the Bankruptcy Code, it seemed the right time to dust it off for another installment of “Breaking the Code.”  This time, the generator spat out section 365(h), a section of the code that has garnered some notoriety in recent years when courts interpreting its interaction with another section of the Bankruptcy Code created a split in authority that has yet to be resolved.

Section 365(h) Limits the Effect of Rejection and Provides Special Protections to Non-Debtor Tenants

Every bankruptcy practitioner is generally familiar with section 365 of the Bankruptcy Code, which permits a trustee to reject burdensome executory contracts and unexpired leases of real property under which a debtor is a party.  The rejection of contracts and leases is treated as a prepetition breach, not a termination, and the effect of rejection generally is to deprive the non-debtor party the right to seek specific performance and to grant the non-debtor party a general unsecured rejection damages claim.  Section 365(h) limits the effect of rejection when the debtor landlord seeks to reject an unexpired lease of real property and grants the non-debtor tenant special protections. 

Upon rejection, the tenant has two options: (1) treat the lease as terminated, vacate the property, and assert a general unsecured rejection damages claim against the debtor’s estate, or (2) if the lease term has already started, retain its rights in or appurtenant to the real property for the remainder of the lease term, including the right to remain in possession of the property, and continue to pay rent.  If the tenant elects to retain its rights under the lease, it can, under section 365(h)(1)(B), offset against the rent due under the lease post-rejection damages resulting from the debtor’s failure to perform its contractual obligations under the lease (like paying utilities and taxes or maintaining the property) but it will have no affirmative rights against the estate for any rejection damages claim.  Section 365(h)(1)(D) further extends these special protections to any “successor, assign or mortgagee” permitted under the terms of the lease.

Do Special Protections for a Non-Debtor Tenant Continue to Apply if a Debtor Landlord Seeks to Sell the Leased Property Free and Clear?

Congress intended section 365(h) to “strike a balance” between the rights of the debtor landlord and the non-debtor tenant by allowing the lessee to retain the right to possess the property for the remainder of the term it bargained for, while permitting rejection to free the debtor of other burdensome obligations that it may have assumed under the lease.  See Precision Indus., Inc. v. Qualitech Steel, SBQ, LLC; Jetz Laundry Sys., Inc. v. Wingates, LLC, (citing Qualitech); see also In re Lee Road Partners, Ltd., (“In enacting § 365(h), Congress sought to ‘codify the delicate balance between the rights of a debtor-lessor and the rights of its tenants’… the statute was designed to preserve a lessee’s possessory interests in its leasehold while allowing a debtor-lessor to escape the burden of providing continuing services to a tenant.”).

What makes section 365(h) interesting is the section’s interaction with another provision of the Bankruptcy Code, section 363(f), and whether the protections afforded to the lessee under section 365(h) survive a sale free and clear pursuant to section 363.  Courts faced with this question have reached divergent conclusions.

Some courts have held section 365(h) provides the debtor landlord its sole remedy with respect to the lease and, therefore, a debtor cannot extinguish a tenant’s leasehold interest in a sale free and clear pursuant to section 363(f).  In re Zota Petroleums, LLC.; In re Haskell, L.P.; In re Taylor.  These courts rely on the legislative history to section 365(h) that evinces Congress’s desire to protect a tenant’s interests in its leasehold estate when a landlord files for bankruptcy and reason that permitting a debtor to sell a lease free and clear of the tenant’s interests under section 363(f) would completely undermine this desire and, therefore, cannot be the result Congress intended.  See, e.g., Zota Petroleums,482 B.R. at 163 (“The rights of the tenant may not be extinguished by a § 363 sale; to hold to the contrary would give open license to debtors to dispossess tenants by utilizing the § 363 sale mechanism.”); Haskell, 321 B.R. at 9 (holding that a debtor should not be permitted to dispossess a tenant through a sale free and clear because it would be “doing indirectly what it could not do directly” under section 365(h)); Taylor, 198 B.R. at 166 (“To allow a sale free and clear of a leasehold interest pursuant to § 363 even if the lessee received the value of its interest from the proceeds would effectively provide a debtor-lessor with means of dispossessing the lessee, a result which would appear to be in contravention of Congressional intent.”).  These courts rely on the general principle of statutory construction that the more specific provision should trump the general, and reason that the specific provisions protecting tenants in section 365(h) should trump the general provisions of section 363(f) regarding a debtor’s ability to sell its property free and clear. 

Other decisions hold that the protections of section 365(h) do not apply at all when a debtor landlord seeks to sell its property free and clear under section 363 and, therefore, a debtor can extinguish a tenant’s leasehold interest.  See, e.g., Qualitech, 327 F.3d at 547-48; see also Cheslock-Bakker & Assocs., Inc. v. Kremer (In re Downtown Athletic Club of New York City, Inc.), (“However, Section 365(h) applies when a debtor-lessor remains in possession of its property and rejects a lease, not when the debtor-lessor sells property subject to an interest (such as a lease) free and clear of that interest pursuant to section 363.  Thus, when the debtor-lessor sells property subject to a lease free and clear of that lease pursuant to Section 363(f), the Court will not apply Section 365(h).”); In re R.J. Dooley Realty, Inc. (declaring section 365(h) “irrelevant” to the court’s determination of whether or not a debtor’s building could be sold free and clear of leasehold interests). 

These courts rely on the general principles that a statute should be afforded its plain meaning and that two statutes should be construed to avoid a conflict between them.  Qualitech, 327 F.3d at 547; South Motor Co. of Dade County v. Carter-Pritchett-Hodges, Inc. (In re MMH Automotive Group, LLC).  They argue that when Congress did intend to subordinate or condition section 363(f), it expressly did so.  For example, section 363(l) is explicitly subordinate to section 365.  See Qualitech, 327 F.3d at 547; see also MMH Automotive Group, 385 B.R. at 366 (“Had Congress intended the protections of section 365(h) to apply without limitation even when the property subject to the lease is sold, Congress could have made that clear.  This omission…is telling.”).  Here, Congress provided no limitations in the plain language of sections 365 or 363 and there is no legislative history for either section 365 or 363 demonstrating congressional intent to exclude leasehold interests from the reach of section 363(f).  Qualitech, 327 F.3d at 547; MMH Automotive Group, 385 B.R. at 365.  In fact, these courts hold that, as drafted, sections 365(h) and 363(f) explicitly address two different scenarios.  When a debtor landlord rejects a lease, section 365(h) applies; when a debtor landlord sells property subject to a lease, section 363(f) applies.  R.J. Dooley Realty, 2010 WL 2076959, at *6.  Lastly, in applying section 363(f) alone to a situation where the debtor landlord seeks to sell real property subject to a lease, these courts interpret the phrase “any interest” expansively and as encompassing all forms of interests in real property, including a lessee’s possessory interest.  Qualitech, 327 F.3d at 547-48; Downtown Athletic Club of New York City, 2000 WL 744126, at *4. 

The second line of decisions has drawn strong criticism and reaction from the real estate and leasehold investment and financing communities, both of which actively participated in Congress’s original enactment of section 365(h) and its subsequent amendments.  See generally Robert M. Zinman, Precision in Statutory Drafting: The Qualitech Quagmire and the Sad History of § 365(h) of the Bankruptcy Code, 38 John Marshall L. Rev. 97, 98-119 (2004) (summarizing the legislative history and development of section 365(h)).  In fact, seven years after the Qualitech decision was handed down, on July 30, 2010, a bill was introduced in the House of Representatives to overrule the Qualitech decision, but the bill died in subcommittee.       

There is support for both lines of judicial authority and it does not seem likely that there will be a definitive resolution of the split of authority by the courts or Congress anytime soon.  In the meantime, as more financial restructuring transactions are accomplished through section 363 sales, it is likely that section 365(h) will continue to garner some notoriety as courts struggle to reconcile it with section 363.  What will be equally interesting to follow, however, is whether the decisions analyzing the interaction between sections 365(h) and 363(f) will inform courts’ analyses of similar interactions between section 363(f) and other Code sections, for example section 365(n), which provides protections to licensees of intellectual property rights that are analogous to those protections provided to lessees of real property under section 365(h).

11 USC Sec. 365
Sec. 365. Executory contracts and unexpired leases
    (h)(1)(A) If the trustee rejects an unexpired lease of real property under which the debtor is the lessor and -
    (i) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection; or
    (ii) if the term of such lease has commenced, the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable nonbankruptcy law.

    (B) If the lessee retains its rights under subparagraph (A)(ii), the lessee may offset against the rent reserved under such lease for the balance of the term after the date of the rejection of such lease and for the term of any renewal or extension of such lease, the value of any damage caused by the nonperformance after the date of such rejection, of any obligation of the debtor under such lease, but the lessee shall not have any other right against the estate or the debtor on account of any damage occurring after such date caused by such nonperformance.
    (C) The rejection of a lease of real property in a shopping center with respect to which the lessee elects to retain its rights under subparagraph (A)(ii) does not affect the enforceability under applicable nonbankruptcy law of any provision in the lease pertaining to radius, location, use, exclusivity, or tenant mix or balance.
    (D) In this paragraph, "lessee" includes any successor, assign, or mortgagee permitted under the terms of such lease.
    (2)(A) If the trustee rejects a timeshare interest under a timeshare plan under which the debtor is the timeshare interest seller and -
    (i) if the rejection amounts to such a breach as would entitle the timeshare interest purchaser to treat the timeshare plan as terminated under its terms, applicable nonbankruptcy law, or any agreement made by timeshare interest purchaser, the timeshare interest purchaser under the timeshare plan may treat the timeshare plan as terminated by such rejection; or
    (ii) if the term of such timeshare interest has commenced, then the timeshare interest purchaser may retain its rights in such timeshare interest for the balance of such term and for any term of renewal or extension of such timeshare interest to the extent that such rights are enforceable under applicable nonbankruptcy law.

   (B) If the timeshare interest purchaser retains its rights under subparagraph (A), such timeshare interest purchaser may offset against the moneys due for such timeshare interest for the balance of the term after the date of the rejection of such timeshare interest, and the term of any renewal or extension of such timeshare interest, the value of any damage caused by the nonperformance after the date of such rejection, of any obligation of the debtor under such timeshare plan, but the timeshare interest purchaser shall not have any right against the estate or the debtor on account of any damage occurring after such date caused by such nonperformance.
Precision Indus., Inc. v. Qualitech Steel, SBQ, LLC. 327 F.3d 537, 546 (7th Cir. 2003).
Jetz Laundry Sys., Inc. v. Wingates, LLC, No. 2:04-CV-243, 2005 WL 1388392, at *3-4 (S.D. Ohio June 10, 2005).
In re Lee Road Partners, Ltd 155 B.R. 55, 60-61 (Bankr. E.D.N.Y. 1993).
In re Zota Petroleums, LLC. 482 B.R. 154, 163 (Bankr. E.D. Va. 2012).
In re Haskell, L.P. 321 B.R. 1, 9 (Bankr. D. Ma. 2005).
In re Taylor 198 B.R. 142, 167 (Bankr. D.S.C. 1996).
Cheslock-Bakker & Assocs., Inc. v. Kremer (In re Downtown Athletic Club of New York City, Inc.) No. M-47 (JSM), 2000 WL 744126, at *4 (S.D.N.Y. June 9, 2000).
In re R.J. Dooley Realty, Inc. No. 09-36777, 2010 WL 2076959, at *6-7 (Bankr. S.D.N.Y. May 21, 2010).
South Motor Co. of Dade County v. Carter-Pritchett-Hodges, Inc. (In re MMH Automotive Group, LLC) 385 B.R. 347, 364-66 (Bankr. S.D. Fla. 2008).

Previous post:

Next post: