Rejected! Bankruptcy Court Denies Debtors’ Attempt to Reject Lease While Property Still Occupied by Sublessee

Print This Post Print This Post

Contributed by Dana Hall

In a decision not-so-friendly for chapter 11 debtor Friendly Ice Cream Corporation, Judge Gross of the Bankruptcy Court for the District of Delaware determined, in In re Amicus Wind Down Corp., that a debtor may not reject a lease of nonresidential real property where the subject property is still occupied by the debtor’s sublessee.

In Amicus, the debtors leased certain nonresidential real property from a landlord and, in turn, subleased that property to a third-party. Shortly after the commencement of the debtors’ chapter 11 cases, the bankruptcy court entered an order authorizing certain lease rejection procedures and providing that rejection could not be made effective prior to the later of “the date of service of the [r]ejection [n]otice [and] . . . the date the Debtors relinquish (or already have relinquished) control of the applicable premises by delivering keys and/or security codes to the affected landlord . . . .” The debtors subsequently served both the over-landlord and the subtenant with notices of rejection of the lease and the sublease, respectively. Several days after service of the rejection notice, the subtenant filed a voluntary petition under chapter 7 of the Bankruptcy Code. Although the subtenant ceased operating at the leased premises, it left certain equipment and furniture on the premises and did not turn over the keys to the over-landlord. The landlord subsequently objected to the debtors’ rejection of the master lease on the basis that the debtors had not surrendered possession of the leased property to the landlord and had, therefore, failed to comply with the rejection procedures order. The debtors asserted, on the other hand, that for rejection to be valid, the debtors were only required to surrender their interests in the premises.

The Amicus court rejected the debtors’ argument and determined that, under both the Bankruptcy Code and the language of the lease rejection order, the debtors were required to provide the landlord with possession of the premises. Section 365(h)(1)(A)(ii) of the Bankruptcy Code provides that, in the event that a debtor rejects a sublease, the subtenant may nonetheless “retain its rights under such lease.” Although rejection of a lease frees the debtor from its performance obligations, a debtor’s tenant (or, as in this case, subtenant) is permitted to continue to use and possess the property in accordance with the payment and payment timing terms set forth in the lease or sublease. The Amicus court held that because, under New York law, there is no privity of contract between an over-landlord and a sublessee, the over-landlord could face significant cost and legal challenges in attempting to evict the subtenant. The over-landlord’s difficulties would likely be significantly heightened in light of the subtenant’s chapter 7 case. Accordingly, the bankruptcy court held that the debtors were best situated to bear the burden of evicting the subtenant. The bankruptcy court also relied on the express language of the lease rejection procedures order and determined that because, absent eviction, the debtors could not unilaterally surrender the subtenant’s possessory rights in the property, the debtors could not comply with the strictures of the rejection procedures order requiring the debtors to deliver the keys to the premises. The Amicus court suggested in closing that the debtors could proceed with either seeking to lift the stay in the subtenant’s chapter 7 case to pursue eviction proceedings or, alternatively, move for an order authorizing the chapter 7 trustee to abandon the subtenant’s possessory interest in the property.

The bankruptcy court rejected the reasoning in In re Chi-Chi’s, Inc., a United States Bankruptcy for the District of Delaware decision which held, under the circumstances of that case, that the effective date for a lease rejection was the “day the Debtors surrendered the premises to the [l]andlords, and the [l]andlords were able to enter into agreements with the current tenants.” The Amicus court noted that the holding in Chi-Chi’s “disregards [s]ection 365(h)(1)(A)(ii) of the Bankruptcy Code,” which preserves the rights of a tenant to continue possession of property leased from the debtor, and further found that the Chi-Chi’s holding would be inapplicable in a situation where the over-landlord wishes to evict the subtenant rather than enter into a direct lease. Although, historically, it has been common practice for debtors to reject both the prime lease and the sublease, thereby leaving the burden on the over-landlord either to evict the subtenant or execute a new lease directly with the subtenant (see Chatlos Systems, Inc. v. Kaplan), the Amicus decision calls this practice into question and may make it more difficult for debtors to reject burdensome leases in situations where the subtenant is unwilling to vacate the premises or enter into a new lease with the over-landlord without concessions on rent or other terms.