Contributed by Charlie Chen
Breach or termination? In most cases involving the rejection of an unexpired lease where the debtor is the lessee, whether a rejection constitutes merely a “breach,” as stated in section 365(g) of the Bankruptcy Code, or a “termination” is largely academic – the debtor vacates the premises, and the lessor files a prepetition claim for rejection damages. The debtor and its landlord may argue about the magnitude of the claim or the effective date of rejection, but “termination” of the lease rarely is in dispute. The distinction between breach and termination may be important, though, when the debtor has sublet part of the leased premises, and the court must determine the effect of rejection on the subtenant. It is in this context that Judge Walrath of the United States Bankruptcy Court for the District of Delaware recently held in In re Overseas Shipholding Group, Inc. that rejection and vacating the premises constitutes a breach, but not termination, of an unexpired lease. Although such decision could have enabled the subtenant to assert a rejection claim against the debtor, the court went on to find that the subtenant waived its right to assert a rejection damages claim pursuant to specific language in the sublease.
Overseas Shipholding entered into a lease for two floors of an office building in New York and later sublet part of this space. The sublease was set to expire one day before the expiration of the prime lease, but the sublease provided that the sublease would also terminate earlier if Overseas Shipholding’s prime lease terminated, in which case Overseas Shipholding would have no liability to the subtenant for damages resulting from such early termination.
After Overseas Shipholding filed for bankruptcy protection, it entered into a court-approved stipulation with the lessor and the subtenant pursuant to which the debtor (Overseas Shipholding) rejected the prime lease and sublease, and the debtor and its subtenant agreed to vacate the leased premises. The stipulation, however, did not explicitly state that the prime lease was “terminated.” Accordingly, after the rejection date, the subtenant filed a claim against the debtor for the return of its security deposit, as well as damages from the rejection of the sublease. The debtor objected to the rejection damages claim and sought to limit the allowed claim to the amount of the security deposit.
The debtor argued that the early termination provision in the sublease relieved the debtor of liability for rejection damages. It also argued that the subtenant waived any right to seek damages from the debtor pursuant to a separate provision in the sublease, in which the subtenant agreed that the debtor/tenant would not “be personally liable for the performance of Tenant’s obligations under this Sublease,” and the subtenant would “look solely to Tenant’s interests in the Lease to enforce Tenant’s obligations hereunder and shall not seek any damages against Tenant or any of the Tenant’s Related Parties.”
Relying upon the plain language of section 365(g) of the Bankruptcy Code and controlling case law in the Third Circuit. Judge Walrath rejected the debtor’s argument that vacating the premises by the rejection date operated as a termination of the prime lease. Consequently, the court held that rejection of the lease was not an actual termination but simply a prepetition breach of the lease. Moreover, the court noted that the stipulation entered into by the debtor and claimant expressly used the term “rejection,” which the court believed evidenced the parties’ intent that the lease would be rejected and not terminated.
Judge Walrath also disagreed with the debtor’s argument that rejection should be treated as a termination under the authority of Chatlos Sys., Inc. v. Kaplan, which held that “[r]ejection of a non-residential lease results in termination of the lease.” In Chatlos, the debtor rejected a lease that was subject to a sublease; however, the subtenant failed to surrender possession of the leased premises upon the debtor’s rejection. The Chatlos court noted the anomalous result that a debtor must surrender the premises immediately upon lease rejection under section 365(d)(4) of the Bankruptcy Code while the subtenant may exercise its rights under section 365(h)(1) to remain in possession “for the balance of the term of such lease” to the extent permitted “under applicable nonbankruptcy law.” Under these circumstances, the court in Chatlos determined that the debtor had rejected the lease and “done everything possible to surrender the premises” to the landlord, thereby terminating the lease. Judge Walrath determined that Chatlos was not applicable in the present case because (i) the claimant vacated the premises and did not elect to remain in possession, and (ii) Chatlos did not address the rights of a subtenant to seek damages as a general unsecured claim under section 365(h)(1).
Next, Judge Walrath analyzed the debtor’s alternative argument that the subtenant waived any rejection damages claim in the sublease. The court agreed that the sublease clearly provided that the claimant “shall not seek any damages against” the debtor for the debtor’s failure to perform its obligations under the sublease. Therefore, the court disallowed the rejection damages claim. Additionally, Judge Walrath performed an analysis of section 365(h) of the Bankruptcy Code based upon the claimant’s election to vacate the premises and seek an unsecured damages claim against the debtor. The court noted that section 365(h) does not create any additional rights for the claimant, and the amount of damages that may be asserted in the bankruptcy case is no greater than the amount of damages the claimant may assert outside of bankruptcy, with reference to the sublease and applicable state law. Consequently, Judge Walrath determined that the claimant’s damages were limited pursuant to the sublease, and, thus, the rejection damages claim was disallowed.
This case serves as yet another reminder of the importance of clear and specific language in agreements. The debtor/tenant could have avoided the whole dispute over the subtenant’s claim if, for example, the subtenant and the landlord had separately agreed that the landlord would provide the subtenant a new lease on the same terms as the prime lease if the prime lease was terminated or breached for any reason or even if the sublease had specified that it would terminate once the debtor vacated the premises and no longer had any ongoing obligations under the prime lease. Moreover, even if the prepetition sublease was ambiguous, the debtor, the landlord, and the subtenant negotiated a postpetition stipulation in which the debtor and the subtenant agreed that they no longer had any right to occupy the premises. It seems as if it would have been entirely consistent with the stipulation to include a statement that the prime lease was terminated. At a minimum, if the debtor had raised the issue when it was negotiating the postpetition stipulation, it would have known whether the stipulation could lead to a later dispute.