Daily Development for Monday, April 13, 2003
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
dirt@umkc.edu

LANDLORD/TENANT; ASSIGNMENTS AND SUBLEASES;
RIGHTS OF SUBTENANT: Where master tenant files bankruptcy and
rejects master lease, subtenant's lease is terminated absent special
language in master lease or other agreement with master landlord
guaranteeing non-disturbance.

Syufy Enters., LP v City of Oakland, 128 CR2d 808 (Cal. App. 2002)

This was a major battle in which the subtenant hired a leading California
real estate lawyer who fired all the cannons.  Landlord was represented
by a former contributor to the ABA Quarterly Report and to DIRT.
Although the subtenant lost, we are rewarded with a thorough analysis of
many of the relevant arguments and authorities on this issue.

Subtenant, a movie theater operator,  held possession under a sublease in
which it had expressly assumed the master tenant/sublandlord's
obligations under the master lease. The master tenant filed bankruptcy
and the period for assuming or rejecting the master lease expired without
the master tenant taking any action, leading to the consequence that the
master lease was deemed rejected ain bankruptcy.  The master landlord
landlord then evicted Subtenant.

Subtenant sued the landlord for, among other things, breach of contract
based on its claim that it was a third party beneficiary of the master lease.
The trial court found that Subtenant lost its right to possession of the
property when the master tenant rejected the lease in its bankruptcy
proceedings, and granted the landlord a judgment of nonsuit. The Court
of Appeal affirmed, agreeing that rejection of the master lease terminated
the subtenant's right of possession.

The court first considered whether the issue was resolved by federal
bankruptcy law.  It  noted that federal courts have reached different
conclusions on this issue.  It stated that some courts have concluded that
rejection in bankruptcy  results in a complete termination of the lease.
This has been held also to terminate subleases.  The California court,
however, concluded that more recent courts have viewed the rejection as,
in effect, a breach of the lease, suggesting  that such construction  does
not adjudicate rights of third parties who may retain the right to assert
their subservient interests. The rights of such parties, then, would be
disposed of according to state law.

The court ascertained that the current trend in Ninth Circuit bankruptcy
cases was to treat a debtor's rejection of a lease as a breach, rather than a
termination, and that therefore the continuing viability of the sublease
was a question of California law.

The court, goaded apparently by thoroughly briefed arguments from
Subtenant's counsel,  exhaustively evaluated California law and finally
concluded that forfeiture of the master estate terminates the derivative
interest of a sublessee..

The court rejected Subtenant's argument that, because it enjoyed direct
contractual privity with the landlord (under the assumption), its rights
were not merely derivative. The court pointed out that the subtenant's
asserted right to possession was based entirely on the master lease and its
derivative sublease; there was no separate contract for the subtenant to
enforce.  It distinguished Vallely Investments, L.P. v. BancAmcerica
Commercial Corporation, 106 Cal.Rptr.2d 689  (Cal. App. 2001) (the
DIRT DD for 6/4/01), which had held that termination of a sublease in
bankruptcy does not relieve a prior assuming party of liability, since
liability in that case is based upon the assumption, not the sublease itself.
By contrast, the Sublessee here was trying to bootstrap the assumption
into a claim under the sublease.

The court, rather relied upon a portion of the holding in Ilkhchooyi v.
Best, 45 Cal. Rptr. 2d 766 (Cal. App. 1995) (the DIRT DD for 4/18/66),
which found that rejection of a master lease in bankruptcy terminates
subleases.

Editor's Comment:  The Ilkhchooyi case is really about the validity of a
provision in a new lease entered into by the subtenant after the original
master lease was terminated, and the discussion of the impact of the prior
master tenant's bankruptcy is not critical to the result.  Further, the
authority relied upon by Ilkhchooyi is the very federal bankruptcy law
that the Court of Appeals in the instant case had earlier rejected.  The
cases Ilkhchooyi relied upon had held that rejection automatically
terminates subleases, while the California Court of Appeals in the instant
case chose to view such rejection as a default, but not an automatic
termination of all derivative rights.  To the extent that Ilkhchooyi was
based upon the now discredited federal cases, it is difficult to reach the
conclusion that it also states a conclusion of California state common
law.  All of this is somewhat moot, of course, because the court in the
instant case is making the common law even if it didn't exist before.

Reporter's Comment: [I have substantially altered the report that Roger
Bernhardt originally included in this case in a California Bar publication.
But Roger's notes to that case are worth repeating [although I've
shortened them.  I'll give a further response to Roger's comments in a
second Editor's Comment at the end.  Here are Rober's comments:}

The case is an object lesson in showing that what is often considered as
inconsequential boilerplate can, in the end, really make a difference. The
lack of critical bouilerplate language in a master lease here really hurt an
innocent subtenant.  The rejection of the lease and termination by the
landlord were driven by defaults by the master tenant occurring prior to
the sublease and assumption.  Thus, these events entitled the landlord to
evict the subtenant even though the sublease had never been in default
and the subtenant had not even been notified of the prime tenant's
bankruptcy.

Although termination was hard on the subtenant in this case, in other
situations it could be equally hard on the landlord- e.g., when the
landlord may have been counting on the subrent to cover the rent it was
to receive for the balance of the term. Both landlord and subtenant may
want the same kind of security that motivates landlord and tenant (and
master tenant and subtenant) to enter into their own binding long-term
arrangements in the first place.

That security may be obtained, but it does not arise automatically. A
binding long-term lease between landlord and tenant, combined with a
binding long-term sublease between tenant and subtenant, do not
together amount to a binding long-term arrangement between landlord
and subtenant that will survive the disappearance of the intermediate
tenant. That arrangement has to be accomplished separately, in one of
two ways.

First, appropriate provisions can be included in the master lease when it
is initially executed that will make a later-executed sublease effectively
binding on landlord and subtenant. Or, second, comparable provisions
can be included in the sublease or in a separate document accompanying
the sublease when it is later executed. There are virtues in both
approaches, and the best arrangement would be to use both.

A major virtue of the first arrangement is that it was used and upheld in
Chumash Hill Props. Inc. v Peram 1226, 46 CR2d 366 (Cal. App. 1995)
. This outcome is in striking contrast to Syufy. The sublease in Chumash
Hill survived the prime tenant's bankruptcy and deemed lease rejection
because of good language in the original master lease. That lease
provided that, in the event of an incurable default by the prime tenant
(e.g., filing bankruptcy), then the "sublessee's possession and use shall
not be disturbed by lessor or by mortgagee  as long as . . . sublessee
performs his sublease's provisions . . . [and] attorns to lessor and
mortgagee." The court of appeal held that this provision-a kind of
nondisturbance and attornment (NDA) clause-was not defeated when the
master lease (which included it) was deemed rejected in bankruptcy, was
enforceable by the subtenant as a third party beneficiary, and did not
violate public policy. That's about as good as it gets.

While it is possible the Chumash Hill landlord may not have been very
happy to put such a clause in the lease, it is equally likely that that was
exactly what it originally wanted-the security of knowing that it would
have a back-up tenant even if its main tenant later failed.

That means that if you represent a subtenant negotiating a sublease, you
should check the master lease for the kind of protection it offers your
client, and the kind of requirements your client has to meet to get that
protection. You not only want to get the landlord's assent to your
sublease (if that is required), but you also want some kind of estoppel
letter from the landlord, acknowledging that the NDA provisions are still
in force and that you qualify under them.

If you don't find that kind of provision in the master lease, it is not too
late to create one. Indeed, a new arrangement between landlord and
subtenant may be more effective than the old one between landlord and
tenant, and could be created even though there were appropriate
provisions in the master lease. Under an agreement directly between
landlord and subtenant specifying contingent future arrangements
between them in case of a prime tenant default, the subtenant acquires
the status of an express beneficiary rather than an implied third party
beneficiary of the old master lease (who may not have even been in
existence at the time it was signed). Privity of contract is always helpful.
As a two-party agreement, it would not require the prime tenant's assent,
and it surely would survive his bankruptcy, if that ever happened. It
would be wise for the subtenant to propose this new agreement even
though the original lease already provided for it, especially if there are
other details to be worked out-e.g., the time gap between the different
remaining terms of the lease and the sublease, other property that is
included in the lease but not the sublease, and curing the tenant's existing
defaults.

Of course, these provisions are only the beginning. After this basic
arrangement between landlord, tenant, and subtenant has been worked
out, the parties next have to deal with the rights, duties, and priorities of
the fee mortgagee, the leasehold mortgagee, the tenant's assignees, and
the landlord's purchasers. Who is subordinating what interest to which
lien in return for what additional NDA provisions? But if that seems too
complicated to work out in advance, just imagine what the litigation
would be like if those arrangements haven't been made-think about poor
Syufy Enterprises.

Editor's Comment:  The editor appends a further comment here only to
note that he would not regard a clause in the master lease agreeing to
attorn to any non-default subtenant as nothing more than "boiler plate."
Whether to attorn to a subtenant following the master tenant's
bankruptcy is an important separate decision on the part of the master
landlord, which the master landlord may not want to make until all the
consequences of the master tenant's bankruptcy on the overall economic
picture of the landlord are clear.  Perhaps there were lessons learned as to
the original lease that the landlord now would like to change, based upon
bitter experience.  Perhaps the economic picture that drove the original
lease is quite different, and, given a blank slate, the landlord would like
the opportunity to go in a different direction entirely.

In short, lawyers representing master tenants and subtenants should not
assume that even an assuming subtenant will easily win an advance
commitment from the master landlord to attorn following the master
tenant's bankruptcy.

Readers are encouraged to respond to or criticize this posting.

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