Daily Development for Thursday, January 20, 2005
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; ACCEPTANCE OR REJECTION: Developing consensus that leases rejected in bankruptcy are deemed breached, but not terminated.

McLaughlin v. Walnut Properties, 14 Cal.Rptr.3d 369 (Cal. App. 2004)

In 1992, Walnut leased land from McLaughlin for twenty years  for purposes of developing a movie theater.  Walnut experienced a number of difficulties, fell behind in the rent, and then, in 1994, when McLaughlin continued to press for payment of back rent, filed for bankruptcy.  Walnut’s principles, however, told the court and McLaughlin that Walnut indeed had hopes of carrying out the theater project, and the bankruptcy was dismissed about eighteen months after it had been filed.  At this point, Walnut had not actually commenced construction on the land, which apparently was undeveloped.  The original guarantor of the lease had died during the bankruptcy, but other principles of the company continued to negotiate with the landlord over payment of back rent and with the city over the design for the theater.

Notwithstanding the apparent interest of Walnut in proceeding, the back rent obligation continued to add up, and in March, 1998 it totaled $1 million, at which time McLaughlin brought suit against Walnut and the guarantor’s estate.  A few months after that, Walnut sent a letter to McLaughlin confirming that it no longer had any interest in the property.

The landlord treated the letter as an abandonment of the lease and in addition to the bank rent, landlord argued it was entitled to damages for future rent from March, 1998.  (Apparently the lease limited damages on abandonment to three year’s rent.)  The tenant, however, contended that the 1994 bankruptcy filing resulted in a termination of the lease, noting that as a matter of bankruptcy law a lease that is not approved within sixty days of a bankruptcy filing is deemed rejected.  As the lease had therefore been rejected as a matter of law, the tenant contended, the landlord’s claim for the three years of future rent necessarily commenced at the time at the time of such rejection, and was comprehended in the million dollar claim that the landlord alleged was all “back rent.”

The trial court found that the lease had been abandoned as of the March, 1998 letter, and therefore recognized a claim for back rent prior to that time and for three year’s of future rent after that time - a total of $2.6 million.  (Although California recognizes a duty to mitigate, the trial court decision was rendered three years after commencement of the suit, and the court apparently was satisfied that landlord had met its duty.)

On appeal, tenants pointed out that California law had earlier determined that the rejection of a lease in bankruptcy indeed did terminate a lease, a ruling that was supported by cases in other jurisdictions at that time. The court concluded, however, that subsequent authority around the country had established a new developing consensus that a bankruptcy rejection was deemed to be a breach of the lease, upon which the landlord could rely to declare the lease terminated, but was not in and of itself a termination of the lease. See In re Austin Development Co. 19 F.3d 1077 (5th Cir.1994) ; In re Locke 180 B.R. 245 (Bankr.C.D.Cal.1995) ; In re Tri-Glied, Ltd.179 B.R. 1014 (Bankr.E.D.N.Y.1995).  Other California courts had already joined in the trend.  Syufy Enterprises v. City of Oakland 104 Cal.App.4th 869, 128 Cal.Rptr.2d 808 (2002) (the DIRT DD of 4/13/03); Vallely Investments, L.P. v. BancAmerica Commercial Corp. 88 Cal.App.4th 816, 829-830, 106 Cal.Rptr.2d 689 (2001) (the DIRT

DD for 6/4/01).

The court concluded that the reasoning of the newer, Austin rule, was more consistent with the language of the bankruptcy statutes, which do not provide literally that rejection terminates a lease, and that the Austin rule is consistent with good policy.  It admitted that the Bankruptcy Code does provide that a lessee must surrender possession upon the effective date of a lease rejection.  But it noted that this does not prevent a landlord from waiving the rejection and continuing to treat the lease as still in effect.  Further, it noted that the interests of non-bankrupt third parties, such as leasehold mortgagees and leasehold tenants in common might be improperly injured if the lease were treated as terminated by the fact of its rejection by a bankrupt tenant.  The court commented that

“ . . . [T]erminating a lease simply because the debtor-lessee has rejected it would allow unscrupulous lessees to evade their contractual obligations by the simple expediency of filing for bankruptcy, then dismissing their petition after the lease had been rejected.”

As the tenants had never manifest an intent to terminate the lease prior to their March, 1998 letter, and indeed appeared to be acting as if the lease were still in effect, negotiating with the landlord and with the City to continue with the planned theater project, the court concluded that liability under the lease continued until that date, even though, technically, the bankruptcy law had terminated the tenant’s right of possession.  It upheld the award of damages for future rent dating from the March, 1998 letter.

Comment 1:   The tenant made a big deal about the fact that it didn’t ever “take possession” but how do we compute that here?  When a tenant leases vacant land as a building site, when does possession commence anyway?  And when does it end?

Comment 2: On the other hand, conceptually, a lease is a transfer of possession in exchange for rent.  The editor can understand that in many cases, such as in the recently reported DD involving a retroactive rejection, one would want to see a formal surrender before one concluded that the lease had really ended upon rejection.  But in other cases, such as here, with vacant land, it may be difficult to conclude that the tenant’s possession really has ended.  Note that the bankruptcy law doesn’t say that possession ends upon rejection.  It simply says that there should be a surrender.  But should the statute tip the scales in favor of finding a surrender when the tenant has rejected?  Obviously not much tipping went on in this case, but there did seem to be special circumstances, of which the court took note.

Comment 3: Further, note that the statute doesn't require the surrender of all possessory rights. It simply says that the Debtor shall surrender possession.  According to Bob Zinman here at St. John’s, the courts have read this to mean that an existing subtenant or leasehold mortgagee, not themselves in bankruptcy, have a “piece” of the possessory interest of the Debtor, which is not surrendered.  They therefore are being permitted to step into the shoes of the Debtor to continue the lease when the Debtor rejects it..

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