Daily Development for Friday, November 10, 2006
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; REJECTION: Is a tenant’s bankruptcy rejection a “termination” or a “default,” and why does it matter? 

In re CP Holdings, Inc., 349 B.R. 189 (8th Cir. BAP 2006)

Lender CALPERS held a mortgage on CP’s (debtor/landlord’s) leased property along with an assignment of rents.  The assignment contained an important covenant that precluded the borrower from terminating the lease without the express consent of the lender.

CP leased premises to Kmart, which filed for bankruptcy and rejected the leases.  Following the rejection, the landlord relet the premises in mitigation, but still had a substantial claim for unpaid rent post rejection rent not covered by the mitigation.   CALPERS filed lease rejection a claim in the Kmart bankruptcy, relying upon language in the lease assignment that stated that it was appointed as the “true and lawful attorney of assignor” to collect all the rents and other amounts assigned.  The court ultimately allowed the claim in the amount of $3.5 million.

CP, the landlord/debtor, then also filed for bankruptcy.  The Chapter 7 trustee claimed that the lease rejection claim was property of the Debtor.  The argument was that (1) a lease rejection terminates a lease, (b) the resulting rights are only contract rights and not a “rent” claim, and ( c) CALPERS did not perfect its security interest on general intangibles. 

The BAP here rejected the Debtor’s claim, holding that a lease rejection functions only as a breach of the lease, and not a termination.  Conceptually, this normally means that the rent obligation continues, and is not converted into a “contract claim,” which is not an interest in real property. 

The court then held that the fact that Kmart had rejected the lease, and the landlord had relet, also did not alone indicate that the lease had been terminated.  The court apparently accepted the notion that a landlord may re-let a premises in mitigation, collect rent, and then apply the rent to the charges due from the original tenant, with a claim against that original tenant for the balance.   

Reporter’s Comment 1:  The notion that a rejection is not a termination is supported by highly respected scholars, but has not received uniform recognition in bankruptcy courts.  It should be noted, however, that the concept that rejection is a termination in commercial cases has been described in at least one case as the “majority rule.”  In re Park, 275 B.R. 253 (Bankr. E.D. Va. 2002).  (In fact, the Park court elected not to follow the “majority” approach.  The Park court indicated that the law in residential leases, where the tenant must surrender possession upon rejection, is a termination, and that many courts had followed the same approach in nonresidential leases where the tenant was required to surrender possession.  (Including the 4th Circuit in an unpublished opinion.)

Reporter’s Comment 2: Several observations seem appropriate. First, mortgage lenders who have an assignment of rents must be mindful that they should seek to file a claim when their borrower’s tenants file for bankruptcy.  The bankruptcy claim is essentially part of the mortgage lender’s collateral.  Well drafted security documents will give the lender the right to file such a claim.

Second, since the “rent” claim (a real property interest) may be converted by termination in to a contract claim in some courts, and hence a general intangible, mortgage lenders must be careful to perfect there interest by recording a UCC statement as to any general intangibles that might result from lease termination. 

Reporter’s Comment 3: The CP Holdings case mostly is significant in that it will give added protection to lenders that have taken an assignment of a borrower’s long term lease (or to leasehold mortgagees) against the risk that a ground lease tenant may reject a lease in its bankrutpcy filing and thereby terminate the estate for both itself and the lender.

Editor’s Comment: The editor questions whether the “rejection is termination” rule can really be called the “majority.”  At the Circuit Court of Appeals level, a 1989 9th Circuit case has followed this approach, as have cases in the 3rd Circuit, and, as stated, an unpublished 4th Circuit opinion.  But holding parallel with the reasoning of the instant case are Circuit Court of Appeals panels in the 5th Cir. and a number of recent bankruptcy court decisions, including quite a group in California, notwithstanding the  Ninth Circuit.  Several of the California cases have been  DIRT DD’s.  See DD’s for1 /20/05, 4/13/03 and 6/4/01. 

Editor’s Comment 2: Note, however, that not all courts will treat the landlord’s claim for loss of future rents to be a claim for rents, rather than damages.  Further, in many jurisdictions, where the landlord reclaims the property and substantially alters it as part of mitigation efforts, such as expanding or contracting space, demolishing or constructing buildings, or even significantly extending the term of a mitigation lease, the court may conclude that the landlord’s actions have terminated the lease and the landlord’s claim for rents going forward. 

Further, some jurisdictions, including Pennsylvania, Iowa and Florida, permit claims for accelerated rent (with rebates to the tenant if the landlord relets).  In such cases, can the accelerated rent be considered “rent,” or is it “liquidated damages?”

This report is based upon an item in a Sidley Austin update by David Kuney and Bill Sudow of the Chicago office. 

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