Bankruptcy in the Context of the Sublease:
The 48th Street Steakhouse Zinger and Other Woes
By Geoffrey Hargreaves-Heald
Geoffrey Hargreaves-Heald is of counsel with Nutter, McClennen & Fish LLP in Boston, Massachusetts.
Aptly described as "the land of broken promises," bankruptcy has a way of thoroughly devastating the reasonable expectation of leasing parties—and their attorneys. Even in the relatively well-charted regions of that land relating to leases, the Bankruptcy Code itself can be vague, its entanglement with nonbankruptcy law Gordian, and its interpretation and application by bankruptcy courts (which tend to be worlds unto themselves) various and unpredictable. Add to this the further complication of a sublease or two, and things become truly interesting.
The purpose of this article is to illuminate some of the practical risks and pitfalls facing parties in the context of a sublease that arise when one of those parties (referred to hereinafter as a "debtor") has filed for bankruptcy. These risks and pitfalls will be identified from the point of view of each of the participants: prime landlord, sublandlord, and subtenant.
Some Rules of the Game
A few basic rules need to be borne in mind during this discussion of subleases and bankruptcy.
The Sublease Estate
Black letter law in all jurisdictions provides that a subtenant's estate depends entirely for its existence and continuation upon the estate created by the prime lease. If the prime lease terminates for any reason, the sublease will immediately fail. See, e.g., 231 Centre Street Assocs. v. Post Bros. Service Stations, Inc., 675 N.Y.S.2d 92, 94 (N.Y. App. Div. 1998).
Section 365(a) of the Bankruptcy Code provides that a debtor can assume or reject an unexpired lease to which it is a party. 11 U.S.C. § 365(a) (2000). Failure by the debtor to assume or reject within 60 days after the filing of its petition (absent the bankruptcy court's permission to extend) results in an automatic rejection, and the debtor must surrender the property to the landlord immediately. Id. § 365(d)(4).
The assumption of an unexpired lease by the debtor (subject to the conditions for assumption set forth in Section 365(b)) entitles the debtor to continue the benefits and burdens of the lease. Assumption is also a prerequisite to the debtor's right to realize upon the value of the lease by selling and assigning its interest to another party.
Bankruptcy courts are somewhat divided on whether or not a rejection of an unexpired lease by the debtor terminates the lease, but the better position appears to be that a rejection is simply the exercise by the debtor of its right to rid itself of the burden of its obligations under the lease. Under Section 365(g), the rejection is deemed a breach of the lease immediately before the filing of the petition, entitling the other party to the lease to a claim for damages as a general unsecured creditor. Whether the breach will effect, or provide grounds for, a termination of the lease is a matter of interpretation of nonbankruptcy law and the terms of the lease.
The View from the Top: The Prime Landlord's Concerns
The Effects of a Subtenant Bankruptcy on Prime Landlord—The 48th Street Steakhouse Zinger
Sublandlords have to be highly motivated to submit themselves willingly to the slings and arrows of subleasing. In the usual case, that motivation will be saving money, either because the sublandlord is desperate for cash or because it cannot bear to pay rent to the prime landlord for unneeded space. If the sublandlord is depending on the subtenant to pay a portion of the prime lease rent, the subtenant's bankruptcy will quickly precipitate monetary defaults under the prime lease (and perhaps nonmonetary defaults, as well, if the sublandlord cannot get access to the subleased premises to cure them). The prime landlord will eventually lose patience (or want to beat the sublandlord's possible bankruptcy) and so terminate the prime lease to sweep the whole house of cards (including the subtenant's occupancy) off the table and start again.
In In re 48th Street Steakhouse, Inc., 61 B.R. 182 (Bankr. S.D.N.Y. 1986), the prime landlord had arrived at just this position. The debtor subtenant's defaults under the sublease resulted in immediate defaults under the prime lease (in this case, the subtenancy itself was merely part of a financing structure for the subtenant's acquisition of a restaurant business, the sublandlord being the seller of that business and having no true occupancy interest in the property), and the prime landlord eventually decided to rid itself of both sublandlord and subtenant by terminating the prime lease. The matter came before the bankruptcy court when the debtor subtenant claimed that the prime landlord's efforts to terminate the prime lease were a violation of the automatic stay in itsbankruptcy case.
Under Section 362(a)(3), the filing of a bankruptcy petition automatically stays any act to obtain possession of property from the estate of a debtor. 11 U.S.C. § 362(a)(3)(2000). The 48th Street court observed that the debtor subtenant had property interests in the subleased premises as a bare possessor for ten years, as an assignor (as part of the financing transaction), and as a subtenant. Because the termination of the prime lease would result in the immediate termination of these property interests, the court determined that the stay in the debtor subtenant's case would be violated. The court enunciated the general rule that when "a debtor and nondebtor are so bound by statute or contract that the liability of the nondebtor is imputed to the debtor by operation of law, then the Congressional intent to provide relief to debtors would be frustrated by permitting indirectly what is expressly prohibited by the Code." 61 B.R. at 188. Accordingly, the prime landlord's default and termination notices were deemed without effect.
The result of the 48th Street Steakhouse zinger is that prime landlords can be rendered helpless to regain possession of their property during the pendency of a subtenant's bankruptcy without action by the bankruptcy court. Clearly, the financial viability of a subtenant can be just as important to a prime landlord as that of a sublandlord, and a prime landlord needs to be cautious about accepting a subtenant as a quick solution to the problem posed by a financially unstable sublandlord.
The View from the Middle: The Sublandlord's Concerns
The Effects of a Prime Landlord Bankruptcy on a Sublandlord
According to many observers, the effect of a prime landlord bankruptcy on a tenant is one of the better charted areas of bankruptcy law. As noted above, the debtor prime landlord will have the right to assume or reject an unexpired lease under Section 365(a). In the usual instance, the lease will be assumed and the rents administered for the benefit of the estate. But in virtually all Chapter 7 (liquidation) cases, and from time to time in Chapter 11 (reorganization) cases, the debtor will elect to reject the lease to relieve itself of the lease obligations after rejection.
In the face of a rejection, a tenant is granted unusually generous protections by the Code. Section 365(h) provides, in essence, that the tenant will have an option either (1) to terminate the lease if permitted under the lease or applicable nonbankruptcy law, seek damages from the prime landlord for the breach caused by the rejection, and go on to greener pastures, or (2) to remain in the premises and continue to perform under the lease. Because the rejecting debtor prime landlord is relieved of its obligations under the prime lease after rejection, including delivering services, the tenant that elects to continue may find itself having to provide for its own heat, trash removal, janitorial services, and common area maintenance, among other things. Again, Section 365(h) comes to the tenant's rescue by permitting the tenant to offset its expenses for such services against rent. 11 U.S.C.§ 365(h)(1)(B) (2000).
The difficulty in the context of a sublease arises when the sublandlord determines that it "wants out" of the prime lease. Such a decision may be made for any of a number of possible reasons, including being saddled with a lease with above-market rent or the burden of services that rent cannot sufficiently offset. Can the sublandlord simply take the Section 365(h) election to terminate the prime lease, thus immediately terminating the sublease, collect whatever miserable amount of damages it can from the debtor prime landlord's estate, and walk away with impunity? The answer lies not in the Code, but in the sublease itself and the effect of applicable state law.
Sublandlords typically bargain for, and sometimes get, a sublease provision that absolves them of liability to the subtenant if the prime lease terminates for any reason, or at least for any reason not the fault of the sublandlord. Subtenants in some areas of the country have come to view such provisions as simply part of the risk of subleasing, and it seems likely that these provisions are effective to permit the sublandlord to make the Section 365(h) election without fear of subtenant reprisal. But what if the sublease lacks such a provision?
The typical sublease will include a so-called "quiet enjoyment" provision (or may have the benefit of such a provision imputed by statute), the purpose of which is to afford a tenant the fundamental right to be free of interference by its landlord so long as the tenant is performing under the lease. It has long been held in most jurisdictions that a termination of a prime lease by a sublandlord that results in the termination of a sublease will constitute a breach of the subtenant's covenant of quiet enjoyment and give the subtenant an action for damages against the sublandlord. See, e.g. , Casassa v. Smith, 91 N.E. 891 (Mass. 1910). Accordingly, absent a provision in the sublease absolving the sublandlord as noted above, it appears likely that a sublandlord's Section 365(h) right to terminate a prime lease following rejection by the debtor primelandlord will be illusory in mostjurisdictions.
The Effect of a Subtenant Bankruptcy on a Sublandlord
Beyond the inevitable financial loss that a subtenant bankruptcy will inflict upon any sublandlord (a loss that, as noted above, can be devastating to a financially insecure sublandlord), there are other unpleasant consequences of a subtenant bankruptcy worthy of note.
First, a sublandlord is unlikely to be able to gain access to subleased premises after a subtenant bankruptcy filing without leave of the bankruptcy court—something that can be time consuming and expensive. The practical consequence of the need to obtain leave is that the sublandlord may be unable to cure nonmonetary defaults in the subleased premises such as pressing maintenance obligations, compliance with legal requirements, maintenance of heat, and the like, leaving the sublandlord exposed to action by a hostile prime landlord under the prime lease. The fact that the 48th Street Steakhouse zinger may stay the prime landlord's hand for a time in such circumstances will be cold comfort to the beleaguered sublandlord.
Further, if the debtor subtenant elects to assume and then assign the sublease to a third party, the sublandlord can find itself bound to a stranger selected by a bankruptcy court that may knowingly disregard the use limitations contained in the sublease. This situation will, of course, be of even greater concern to a sublandlord operating a shopping center where the tenant mix is considered vitally important. The Code contains extraordinary protections for shopping center operators. See 11 U.S.C. § 365(b)(3) (stating, among other things, that an assignment of a shopping center lease will be "subject to all the provisions thereof, including (but not limited to) provisions such as a radius, location, use, or exclusivity provision . . . . "). Bankruptcy courts, however, have shown a willingness to pay little mind to such restrictions in an effort to realize the maximum value of the sublease for the benefit of a debtor subtenant's creditors. See Harris Ominsky et al., Assignments in Tenant Bankruptcies—What's Left of the Lease?, ABA Annual Meeting materials (2002).
The View from the Bottom: The Subtenant's Concerns
The Effect of a Prime Landlord Bankruptcy on a Subtenant
The primary concern of any subtenant regarding bankruptcy will be that, through some bankruptcy mischief and no fault of the subtenant, the prime lease cord will be cut and the subtenant dumped into the street, its business seriously disrupted, with no claim against anyone to soften the blow.
As illustrated above, so long as typical protective language exists in the sublease, a sublandlord in most jurisdictions will have the right, under Section 365(h), to terminate the prime lease, and thus the sublease, thereby realizing the subtenant's worst fears. As a remedy for the problem, some commentators have suggested that the subtenant seek the right in the sublease to control the sublandlord's Section 365(h) election (see, e.g., proposed language in COLLIER ON BANKRUPTCY PRAC. GUIDE § 68.07 (Alan N. Resnik & Henry J. Sommer eds. 2003). It will be a rare subtenant, however, with enough leverage to win such a provision.
The Effect of a Sublandlord Bankruptcy on a Subtenant—Rock, Paper, Scissors
At first glance, the effect of a sublandlord bankruptcy on a subtenant appears to be no different from that of a prime landlord bankruptcy on a tenant. Could a subtenant take advantage of the extraordinary protections that Section 365(h) provides (see discussion above) and decide whether to terminate or continue with the sublease as the subtenant sees fit? The answer of course is, "yes, but . . . ."
The problem, as one seasoned bankruptcy attorney describes it, is like the game of "rock, paper, scissors." The rock is the sublandlord's decision to reject the sublease under Section 365(b), and the paper is the subtenant's countervailing right under Section 365(h) to terminate or continue under the sublease. But the scissors (aptly named in view of the potential effect) can be the sublandlord's rejection of the prime lease, which, if it results in the termination of the prime lease, will cut off the estate of the subtenant under the sublease, regardless of the benefits of section 365(h).
For a subtenant, the "if" in the foregoing sentence obviously can be crucial. It brings us once again to a consideration of the effect of a rejection under Section 365(a), this time in the context of a prime lease rejected by a sublandlord. The matter is complicated by the apparent effect of Section 365(d)(4), which requires that possession of the prime leased premises be immediately delivered to the prime landlord if the debtor sublandlord fails to assume or reject the prime lease within 60 days after filing—something that is common in Chapter 7 cases and that has been deemed by some courts to be a termination that will cut off the subtenant's further rights. On the other hand, Section 365(g) calls a rejection a "breach" under an unexpired lease, and the clear intent of Section 365(h) is to permit tenants (and subtenants) to make the best of a situation they did not create and to carry on or terminate as they see fit, as permitted by applicable nonbankruptcy law. How can the Code provide both the prime landlord and the subtenant with a right to possession of the subleased premises at the same time?
The case of Block Props. Co., Inc. v. American Nat'l Ins. Co., 998 S.W.2d 168 (Mo. Ct. App. 1999), illustrates an interpretive path through the conflict. In that case, the prime lease was deemed rejected by the debtor sublandlord under Section 365(d)(4). This rejection led the prime landlord to demand that the subtenant deliver possession of the subleased premises because the rejection had terminated the prime lease and thus the sublease. The subtenant commenced an action in state court seeking a declaration that the sublease had survived the rejection and that the subtenant was entitled to remain in possession. The Missouri Court of Appeals agreed, finding that the sublandlord's rejection was only a breach of the prime lease under Section 365(g) that could lead to a termination, but it was not itself a termination. The prime landlord's possession under Section 365(d)(4) would be subject to the sublease if the sublease survived the prime lease breach. The court then went on to examine the prime lease and applicable state law, determining that the terms of the prime lease were unclear about whether a rejection constituted a breach entitling the prime landlord to terminate; termination was permitted under general principles of Missouri law if there was a substantial breach of the prime lease; and, because the subtenant had continued to pay the full amount of the rent due under the prime lease under the terms of the sublease, the prime landlord was receiving the benefit of its bargain and no termination of the prime lease would be permitted.
Clearly, the story might have ended less happily if the subtenant, as is so often the case, were paying considerably less rent under the sublease than was due under the prime lease. This consideration points to the importance of a subtenant's seeking nondisturbance agreements from the prime landlord to guard against the effects of the sublandlord's rejection of the prime lease. Unfortunately, such nondisturbance agreements can be difficult to obtain, especially if the subtenant's rent is lower than the rent payable under the prime lease or if the continuation of the subtenant in the subleased premises after rejection may make the prime leased premises less marketable. See generally Vivek Sankaran, Rejection Versus Termination: A Sublessee's Rights in a Lease Rejected in Bankruptcy Proceeding Under 11 U.S.C. § 365(d)(4), 99 MICH. L. REV. 853 (2001).
In the end, no party in a sublease context is free from concern about the effects of the bankruptcy of one of the other parties. The concerns range from simple inconvenience to diminished economic expectations to complete dispossession. Surprises may arise for the uninitiated. Clearly, certain issues can be addressed by careful crafting of prime leases (such as a provision in favor of the prime landlord that a rejection by the sublandlord will terminate the prime lease) and of subleases (such as a right in favor of the subtenant to make the Section 365(h) election for sublandlord in the event of a prime lease rejection by the prime landlord). A full understanding of the financial standing and prospects of the other parties will be helpful. But in the real world such protections will be available only as bargaining strength permits, and the parties often will be obliged to hope for the best.
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