Daily Development for Monday, January 21, 2002

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

BANKRUPTCY; LEASES; ADMINISTRATIVE CLAIMS:

Sublessee injured by bankrupt sublessor's failure to secure non disturbance protection from master landlord for sublessee had no administrative priority damage claim against sublessor's bankruptcy estate. Sec. 365(d)(3) applies only to administrative claims of lessors against bankruptcy lessees.

Einstein/Noah Bagel Corp v. Smith (In re BCE WEST, L.P.) 264 BR 578 (9th Cir. BAP 2001)

The basic holding in this case is consistent with the editor's understanding of the meaning of the applicable Bankruptcy Code section, but kudos nonetheless to the sublessee's attorneys for a "nice try,"

attempting to exploit an ambiguity in the statute to recover a claim that, outside of the special equities of the bankruptcy process, was a perfectly appropriate one.

Sublessee held space under a May, 1998 sublease containing a provision that sublandlord would "exercise best efforts" to obtain from the master landlord a nondisturbance clause protecting sublessee in the even that sublandlord defaulted on the master lease. In October, 1998, sublandlord went bankrupt, never having obtained the desired nondisturbance protection.

Sublessee continued to operate and pay rent under the sublease for more than a year, but ultimately perceived (allegedly) that there was a danger in disruption of its activities if there were a default the master lease -

being operated by the sublessor as trustee in possession, leading to an eviction of the sublessee. Sublessee then relocated its facilities elsewhere. Sublessee apparently never failed to pay the rent under the sublease, even after it moved out. A few months later, sublessor move to reject the sublease, and sublessee did not object.

Sublessee filed a claim in sublessor's bankruptcy for $1.5 million in damages for sublessor's failure to diligently pursue the obtaining of a nondisturbance clause, leading to extensive relocation costs by sublessee. (Shortly thereafter, sublessee also filed for bankruptcy - it was closely related to sublessor, although nothing in the opinion makes anything of this.)

Sublessor's estate argued that the damages claim amounted to a an unsecured prepetition claim, since the sublease had been rejected. Sublessee, however, contended that Section 365(d)(3) provided that there was an administrative priority for claims against the sublessor for breaches of the lease agreement.

As the court noted, most people view the 365(d)(3) priority for postpetition lease claims as designed to protect lessors with bankrupt lessees from the consequences of a delay in the determination of whether or not to reject the lease. Under the automatic stay, the lessee can remain in possession of the premises following the filing of a bankruptcy petition. Should claims arising during the period following the filing of the petition but before the lessee's determination to reject the lease, it would be unfair to the landlord to treat these claims the same as other claims arising against the debtor postpetition, since the landlord was compelled by the automatic stay to provide the premises to the bankrupt lessee during this period. Consequently, the statute provides a requirement that the trustee perform all lease obligations, and this requirement is backed up by providing administrative priority for obligations not performed.

The sublessee's lawyers here made the clever claim that the language of the statute itself doesn't really say that the performance obligation applies only to bankrupt tenants acting as tenants, and argued that the "plain language" of the provision is that the obligations of the statute cover all leases, including subleases. Here's the language:

"The trustee shall timely perform all the obligations of the debtor, except those specified in section 365(b)(2), arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title. The court may extend, for cause, the time for performance of any such obligation that arises within 60 days after the date of the order for relief, but the time for performance shall not be extended beyond such 60-day period. This subsection shall not be deemed to affect the trustee's obligations under the provisions of subsection (b) or (f) of this section. Acceptance of any such performance does not constitute waiver or relinquishment of the lessor's rights under such lease or under this title."

The trustee mustered some legislative history indicating that the purpose of this language was to protect landlords, not subtenants, but the sublessee responded that such legislative history is irrelevant if the "plain language" of the statute was contra. It said that the sublandlord's failure to exercise best efforts to obtain a nondisturbance clause occurred during the operative period and it was entitled to administrative priority for the sublessee's failure to perform. Pretty clever, heh?

The court found a seed of meaning, however, in the last line, referring to "the lessor's rights." The court noted that if the term "lease" appearing elsewhere in the statute were intended to mean leases in which debtors were landlords, as well as those in which debtors were tenants, the language would have said "lessor or lessee" or at least "a lessor's rights " instead of "the lessor's rights." At least, this language provided the necessary ambiguity to resort to legislative history. Case closed, at least that part.

The sublessee had one more arrow. It claimed that it was still entitled to an administrative priority to the extent that it had conferred a benefit on the estate postpetition and pre-rejection, which it did with its rent. But the court noted that the rent was distinct from the claim for damages for failure to obtain the nondisturbance clause. In exchange for the rent, the sublessee got the right to possession. Hence, it was entitled to no claim that it had inappropriately benefitted the estate while not receiving a proportionate return. One could predict that the court would come out this way, but the editor nonetheless gives half a kudo for clever for this argument as well.

Comment 1: As noted above, the court's analysis of 365 (d)(3) is consistent with the editor's understanding of that section and, the editor believes, everyone else's.

Comment 2: The second point made by the sublessee, however, deserves a little more attention, to the editor's mind, than the court gave it. As a general principle, the court appears to be saying that when a lessee pays rent, but doesn't get possession, it may be conferring a benefit on the landlord's estate for which it deserves compensation, but if the lessee pays rent and is denied other contractual promises contained in the lease, the same reasoning does not apply. It may be that in the instant case the promise to work to deliver a nondisturbance clause was so insubstantial as to be inconsequential. But certainly other promises contained in a document set up as a lease could be more vital to the interests of the lessee than possession itself.

Remember that the situation we're hypothetically in is where the lessor has filed a bankruptcy petition but hasn't attempted to avoid the lease.

The lessee is still making lease payments in good faith. If it gets possession, but doesn't get the real value for which it advances the rent payments, has it no recourse? Or is there another approach that solves the lessee's problem?

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last six years, these Reports have been collated, updated, indexed and bound into an Annual Survey of Developments in Real Estate Law, volumes 1‑6, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Maria Tabor at the ABA. (312) 988 5590 or mtabor@staff.abanet.org

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