Daily Development for Thursday, January 13, 2004
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

BANKRUPTCY; LEASES; ASSUMPTION OR REJECTION; RETROACTIVE REJECTION:    Court may retroactively approve rejection of lease back to time of filing, even if tenant is not in possession, and therefore owes no rent, and landlord is stayed from reletting property during that period.

At Home Corp. v. Pacific Shores Development, Inc. (In re At Home Corp.) , 2004 Westlaw 2984300 , No 03-157869 (9th Cir. 12/28/04)

Tenant, another DotCom flameout, executed a lease for space that was to be extensively renovated.  The rental payment it appears from the report, was $1 million per month.  Tenant deposited $20 million in escrow to pay for the renovations, and they were nearly complete when Tenant realized that it wasn’t going anywhere financially and filed for bankruptcy.  At the time, there was$1 million remaining in the construction escrow account.  Apparently the escrow agreement permitted the landlord to convert this money into a rent payment, so Tenant did not make any effort to notify the landlord that it was surrendering the premises until after it had filed for bankruptcy.  It never took occupancy of the premises.

 The court states that the landlord nevertheless did attempt to convert the $1 million into a rent payment the same day as the filing, but does not tell us the timing of that event versus the filing.  The issue becomes moot here, because the court held that the tenant didn’t owe any rent for the period following the filing.  Apparently the tenant had not been in default prior to that (or else there was no issue concerning back rent or other security deposits.)

The filing was on September 28.  The tenant promptly filed a petition to reject the lease retroactive to the date of filing.  A hearing was held on this petition on October 9.   The trial court found that the tenant could reject the lease nunc pro tunc, retroactive to September 28.  The apparent effect of this was that no rent was owed for the month of October (which may have been the first month for which rent was payable) and the landlord was out $1 million - which it already had in cash.  Not surprisingly, the landlord felt this was worth fighting over, and this litigation was joined.

The opinion is quite plainly written and constitutes a good basic primer for lawyers litigating these issues in the Ninth Circuit, and possibly elsewhere.  It begins with a discussion of what the court calls the 1984 “shopping center amendments” to Section 365 (although it does not appear that the premises in this case was a shopping center).  In particular, the court alluded to 365(d)(3), which states that a tenant is obligated to perform all obligations under a lease, including particularly the obligation to pay rent at the contract rate, until the lease is rejected.  Prior to these amendments, a bankrupt tenant may have let the landlord languish for a substantial period (with extended time for determining whether to affirm or reject the lease), and then, when it finally chose to reject, the landlord might be left with nothing to show for the months or even years that it could not get at its premises except for the “costs of preservation of the estate,” which might have be!

 en far
 lower than the contract rent or what the landlord actually expended.

The court here acknowledged that the revised language of 365(d)(3) was intended to protect the landlord from the risks resulting from the landlord’s being stayed from regaining possession while a petition to affirm or reject was pending.  Nevertheless, it maintained  that bankruptcy courts have discretion, in the appropriate equitable circumstances, to make the rejection of the lease retroactive, thus avoiding the tenant’s responsibility for the contract rent between such effective date and the date the court ruled.  Here, although that period was only 10 days or so, the rent (apparently non apportionable) would have been $1 million.  It cited the well known Thinking Machines decision from the First Circuit, which has been an influential decision regarding the 365 provisions, as authority for this equitable exception.  (It also noted that a minority of jurisdictions actually make the lease rejection effective immediately upon the petition to reject.)

In fact, the landlord in this case acknowledged that the court had discretion to make the rejection retroactive, but it disputed that the circumstances of this case were appropriate for such an action.  Landlord maintained that the tenant should not be able to get retroactive approval of a rejection in cases in which the landlord was unable to regain possession of the premises.  It pointed out that such a rule was consistent with the stated and acknowledged purpose of the 365 amendments to protect the landlord from a “dead period” during which it could neither relet nor collect rent from the tenant.

The Ninth Circuit concluded that the landlord overstated the case.  Although the degree to which the landlord’s economic expectations were frustrated was relevant, the court noted that where tenant in bankruptcy did not occupy the premises following the petition for rejection, the landlord was certainly in a position to seek out a substitute tenant, even though the landlord was stayed from actually renting to that tenant.  Further, it stated that where, as here, it was plain that the tenant in fact cooperated in arranging for a prompt hearing on the rejection petition, and it was plain that the tenant was not interested in “milking” the situation, the equities favored the tenant’s position.

Comment 1:  Of course, if there are negative equities, then it is obvious that the court would not be inclined to give the tenant what seems to be characterized here as exceptional relief in the form of a retroactive declaration of rejection.  But is an absence of negative equities enough?  Isn’t the fundamental purpose of the statute to protect, in most cases, the landlord from the loss of rent when it cannot relet the premises?  And isn’t that exactly what happened here?    Aside from producing an additional million dollars to distribute to the debtor’s other creditors, what equitable purpose was served by granting the tenant the relief it sought?

Cynics can say that making the estate fatter, thus facilitating a more satisfactory resolution for other creditors, is all the reason a bankruptcy court needs for doing whatever it wants, regardless of what the law says.  But keep in mind that there is not one word in the Bankruptcy statute authorizing retroactive rejection.  Because of that, one would assume that the relief ought to be provided only in extraordinary equitable circumstances, such as where the landlord itself has an inappropriate  scheme to wrest away from the other creditors assets that might otherwise be distributed to them.

Here, however, the landlord had no such scheme.  Although, of course, it wanted the rent, it should be noted that it didn’t already have the premises to let out specifically because the tenant had decided to file for bankruptcy without tendering the premises back to the landlord.  It seems absurd to argue that the landlord really has a meaningful chance to look for another tenant when faced with the uncertainties of a tenant’s bankruptcy strategies (and the court’s reaction to them).  Further - who says the landlord has such a duty?  A significant number of courts do not require a landlord to mitigate as a matter of common law.  Should the federal court be rewriting this rule?

Comment 2: Bankruptcy mavens Bob Zinman and Dick Lieb, neighbors of the editor here in his visit at St. John’s Law School, both have the same reaction to this issue.  They simply don’t find a an “equitable exception” for retroactive recognition of rejection at all.  The statute says the tenant pays the contract rent until rejection.  Rejection cannot be backdated in their view.  There’s nothing in the statute that says this.  As to the fact that Thinking Machine says otherwise, Zinman responds “that’s just one Circuit” (of course now two).  Note that the landlord gave in on this issue without a fight.  It conceded that there could be retroactive recognition of the rejection, but disagreed about the standards.

Comment 3: This retroactive period was a matter of a ten days, but the periods in question could be months or even years.  This is not unusual in complex cases, even without the debtor’s scheming to extend the period needlessly.  Once the precedent is set, this loophole may well be expanded far beyond the short period here, and landlords may now want to develop strategies to reverse this judicial trend before it becomes an epidemic.  The Ninth Circuit has been wrong before in bankruptcy cases.

Comment 4: In any event, as the editor suggests, the case makes a good read, and will reward study in planning your next hearing on these issues.

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