Tuesday, May 04, 2021
What Rights and Possible Exposure to Consequences Arise for Tenants When a Real Property Lease is Rejected by a Bankrupt Landlord?
By Bill Siegel
Section 365(h) of the Bankruptcy Code provides special protection for non-debtors who have rights as tenants if a trustee or Chapter 11 debtor landlord rejects an unexpired lease. The lessee/tenant has the option of retaining possession of the leased premises. That said, it is not entirely clear what the tenant's obligations are under the rejected lease or any related agreements.
Tenant’s Section 365(h) Election
The Sixth Circuit Court of Appeals addressed this issue in regard to the guarantor of an agreement that was related to a rejected real property lease1 . The Sixth Circuit found that when a tenant elects to retain possession of a rejected real property lease under Section 365(h), the guaranty of a separate agreement may, depending on the facts, be equally enforceable by virtue of the tenant's Section 365(h) election.
Section 365(a) of the Bankruptcy Code provides that an unexpired lease/executory contract may be assumed or rejected by the debtor subject to bankruptcy court approval. Moreover, and just as important, rejection does not constitute termination of the lease but instead constitutes a breach.
Section 365(h)(1) provides that, if the trustee or debtor rejects an unexpired real property lease under which the debtor is the lessor, the non-debtor lessee has the option of either treating the lease as terminated or retaining its rights under the lease for the balance of the lease term. So, even if the debtor lessee has the right to treat the breach as terminated, the non-debtor “… 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.” 11 U.S.C. § 365(h)(1)(A)(ii).
The Situation in EPLET
The facts before the Sixth Circuit were a bit circuitous but suffice it to say, the debtor manufacturer was a landlord under a real property lease and pursuant to a separate agreement, referred to as a utility services agreement, the tenant had agreed to provide steam to the debtor which owned an adjacent factory. The holding company of the tenant had executed a guaranty and indemnity in connection with any environmental claims arising from the utility services agreement. During the bankruptcy, the debtor manufacturer/landlord rejected the real property lease The tenant elected to retain possession of the property. Later, the debtor confirmed its plan, which created a creditor’s trust and which ultimately sued the Guarantor for environmental claims.
One of the issues addressed by the Sixth Circuit was whether, the tenant’s/guarantor’s obligations under the utility services agreement had been preserved by virtue of having chosen to retain possession of the leased premises after the debtor manufacturer had rejected the lease.
The Sixth Circuit first noted that because the tenant chose to retain possession after rejection, the tenant waived the breach and thus had a more limited right of recovery against its landlord for breaches. The Court then focused on whether the lease and the utility services agreement were severable. If the agreements were not severable, by virtue of retaining the benefits of the rejected lease, the tenant must then assume the obligations under the contract. In other words, a tenant cannot accept all the benefits of a contract without accepting all of its burdens including integrated contracts. It cannot pick and choose. It’s all or nothing.
Here, the Sixth Circuit found the real property lease and the utility services agreement were not severable based on the inter-relationship of the lease and the utility services agreement having a common subject matter. As a result, it reversed the district court which had found that the utility services and the guarantor had terminated after the debtor manufacturer/landlord had rejected them in bankruptcy.
Thus, when deciding whether or not to retain possession of a real property lease that has been rejected by a landlord debtor, the tenant should consider whether there are other agreements involved and whether they are severable, as the consequences for failing to do so could be problematic.
- EPLET, LLC v. DTE Pontiac N., LLC, 984 F.3d 493 (6th Cir. 2021).
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