Subtenants, beware of bankruptcy and commercial leases
Subtenants, beware of bankruptcy and commercial leases
30 MARCH 2016 7:15 AM

A recent federal bankruptcy court decision provides a warning to subtenants who could find themselves immediately evicted if their landlords suddenly file for bankruptcy.

Real property leases are common throughout the hospitality industry. A hotel might be a landlord, as in the case of leased space for a candy store in a hotel lobby. Hotels may also be tenants, as in the case of a ground lease of the real estate where the hotel is located.

Where there is a real property lease, there is the potential for a sublease and the related complications. In that respect, a recent decision by the United States Bankruptcy Court for the Southern District of New York should be seen as a warning call to subtenants of commercial real property.

The warning itself is relatively simple: In certain circumstances, a subtenant could find itself subject to immediate eviction following a bankruptcy filing by the subtenant's landlord. Clearly, such immediate eviction could be catastrophic for the subtenant's business. While subtenants may not be able to prevent their landlords from seeking protection from creditors in bankruptcy court, there are actions a subtenant can, and should, take to protect its leasehold interest.

What to know about assumption vs rejection
Bankruptcy law provides a debtor with two choices with respect to non-residential real property leases. (Residential property leases are subject to differing standards, and such leases will not be discussed here.) A debtor may "assume" a lease, meaning that the debtor affirms it will continue to perform under the terms of the lease. Assumption requires the debtor to pay all past-due amounts in full. Rejection, on the other hand, allows a debtor to walk away from its obligations under the lease. The remedy for the non-debtor party to a rejected lease is to file a claim in the debtor's bankruptcy case.

The effect of a lease rejection differs depending on if the debtor is the landlord or the tenant. If the debtor is the tenant, the debtor vacates the premises following rejection and the landlord files a claim for damages resulting from the debtor's failure to comply with the lease. The landlord's claim is treated as a general unsecured claim that is often paid at much less than the full face amount in the bankruptcy case. Moreover, rejection damage claims are subject to a statutory cap that, generally speaking, limits the claim amount to one year's worth of rent under the lease.

If, however, the debtor is the landlord, the Bankruptcy Code provides certain protections to the tenant of a rejected lease. Under Bankruptcy Code section 365(h), the tenant has two choices. The tenant may choose to vacate and file a claim for damages resulting from the debtor/landlord failing to fulfill its obligations under the term of the lease. Alternatively, the tenant may elect to remain in the premises for the remaining term of the lease and any term extensions available under the lease. While the debtor/landlord is relieved of obligations under the lease post-rejection, the tenant going forward is permitted to offset costs that otherwise would be borne by the landlord, such as maintenance of the premises.

The A&P problem
The bankruptcy case giving rise to the cautionary tale for subtenants was filed by various entities operating the A&P grocery store chain. By filing for bankruptcy, various A&P entities sought an orderly liquidation of their assets, including the rejection of several hundred commercial leases.

The lease at issue in the case was for property located in New York City. Debtor A&P Real Property was the tenant for the property where it operated a grocery store. A&P Real Property also had subleased a relatively small portion of the premises to Rainbow, USA. Rainbow operated a clothing store in the space.

The sublease between A&P Real Property and Rainbow provided that if Rainbow did not receive a "recognition agreement" from A&P Real Property's landlord within 60 days following commencement of the sublease, Rainbow would have a right to terminate the lease. The bankruptcy court stated that there was no evidence such an agreement was ever executed. The court determined that there was no contractual relationship (to put it another way no "privity") between Rainbow and the landlord. This proved significant to Rainbow's rights in the case.

A&P Real Property sought an order from the bankruptcy court rejecting both the lease (between A&P Real Property and the landlord) and the sublease (between A&P Real Property and Rainbow). The landlord agreed to both the rejection and to a stipulated termination of the lease. Rainbow asserted that it should be provided with the protections granted under Bankruptcy Code section 365(h), including the right to remain in the premises. A&P Real Property disagreed, arguing that all of Rainbow's rights under the lease were terminated when the "primary lease" between A&P Real Property and the landlord was terminated.

Unfortunately for Rainbow, the bankruptcy court agreed with A&P Real Property. The court referred to the specific language of section 365(h), dealing with tenant rights—section 365(d)(4)—which sets forth a debtor’s or tenant's obligation to surrender premises to the landlord. The court held that because section 365(d)(4) obligated A&P Property to surrender the premises to the landlord, the lease and any other party's right to the leased premises were terminated. This is in contrast to a situation with no sublease involved, where the debtor would be the only landlord and the surrender of premises under section 365(d)(4) would not apply.

The effect of the court's decision was that Rainbow's right to occupy the premises was terminated immediately upon entry of the court's order rejecting the lease.

While Rainbow had a right to file a claim in A&P Real Property's bankruptcy case, A&P had no rights against the landlord because there was no privity between the landlord and Rainbow. Because unsecured claims in bankruptcy cases are rarely paid in full, this means that Rainbow likely will not come close to recovering in full for the damages associated with losing its right to occupy its subleased premises.

The ultimate lesson for subtenants is clear. They should ensure that they establish contractual privity with the landlord of the primary lease (sometimes referred to as the "overlandlord"). Such privity may allow the subtenant to convince a bankruptcy court to effectively view the transaction as one lease, thus permitting the subtenant to assert the protections of Bankruptcy section 365(h). In addition, even if the subtenant is unable to assert section 365(h) rights, the subtenant would have a claim against the overlandlord. Assuming the subtenant prevails on the merits, such a claim would be payable in full, rather than partially payable as a claim in a bankruptcy case.

Jason Binford is a director in the Dallas-based law firm of Kane Russell Coleman & Logan PC where he practices in the firm’s Insolvency, Bankruptcy & Creditor Rights section. His experience includes representation of debtors and creditors in large to mid-size Chapter 11 and Chapter 7 cases. He has significant familiarity and expertise in issues unique to vendor creditors, as well as 363 sales, intellectual property, landlord/tenant and franchise issues.

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