Upland/Euclid, Ltd. v. Grace Restaurant Co. (In Re Upland/Euclid, Ltd.)

56 B.R. 250, 13 Collier Bankr. Cas. 2d 898, 1985 Bankr. LEXIS 5162, 13 Bankr. Ct. Dec. (CRR) 1159

• Court: United States Bankruptcy Appellate Panel for the Ninth Circuit
• Decided: October 11, 1985
• Docket: Bankruptcy No. LA 84-13891-BR, BAP No. CC-85-1005-AbMV
• Status: Published

Opinions

ABRAHAMS, Bankruptcy Judge.

The debtor/lessor appeals from an order denying its motion to reject an unexpired lease of real property and to set a reasonable rent for the remainder of the lease term. We affirm.

FACTS

In 1976, appellant Upland/Euclid, Ltd. leased real property to appellee Grace Restaurant Company for twenty-five years, with options to extend the term for an additional fifteen years. The annual rent reserved in the lease is the greater of $51,-256.92 or five percent of the restaurant’s gross income.

Upland, as debtor-in-possession, moved to reject the unexpired lease under 11 U.S.C. § 365(a) and to set a reasonable future rent for the premises. Upland contended, and we will assume, that a current “reasonable rent” would be more than the rent under the lease. The bankruptcy judge denied the motion to modify the rent. He then suggested that Upland withdraw the motion to reject the lease. Upland followed this suggestion, because any attempt to reject the lease would be futile if the rent could not be raised. We treat this as denying Upland’s motion to reject the lease.¹

DISCUSSION

When a debtor/lessor rejects a lease of real property, the lessee has a choice under 11 U.S.C. § 365(h)(1):

[T]he lessee under such lease may treat the lease as terminated by such rejection, or, in the alternative, may remain in possession for the balance of the term of such lease and any renewal or extension of such term that is enforceable by such lessee under applicable nonbankruptcy law.²

Here, because the lessee indicated that it would elect to remain in possession, 11 U.S.C. § 365(h)(2) applies:

If such lessee remains in possession, such lessee may offset against the rent reserved under such lease for the balance of the term after the date of the rejection of such lease and any such renewal or extension, any damages occurring after such date caused by the nonperformance of any obligation of the debtor after such date, but such lessee does not have any rights against the estate on account of any damages arising after such date from such rejection, other than such offset.

The issue here is whether section 365(h)(2) allows the bankruptcy court to change the rent set by the rejected lease if the debtor/lessor rejects an unexpired lease of real property and the lessee elects to remain in possession.

I.

Appellant contends that the reason for permitting debtors to assume or reject leases and executory contracts is to increase the estate funds available for payment of creditors. If the rent paid by a lessee of real property were to increase, the distribution to creditors would also increase. Therefore, appellant reasons that the bankruptcy judge must set the rent at the higher market rate.

We disagree. To us, section 365(h)(2) permits only a limited rejection by lessors. The debtor/lessor may reject a lease, provide no more services, and stop the flow of funds benefitting the lessee but cannot deprive the lessee of its possessory property interest in the leased premises. As a balance to allowing continued possession by the lessee, section 365(h)(2) limits the lessee’s remedy for loss of services to an offset against the rent under the rejected lease.

The statute’s phrase “offset against the rent reserved” implies that the rent under the lease continues. It makes no sense to apply the offset against the reserved rent if that rent is not charged. If the offset could be against a modified rent, the section would have stated that the offset is against “the rent that would otherwise be due,” “the reasonable rental value of the property,” or simply “the rent,” not “the rent reserved under such lease.”

Appellant’s position finds no support in the legislative history of the subsection. The House and Senate committee reports restate and slightly amplify the provisions of the section without saying that the rent can be modified by a debtor/lessor. H.R. Rep. No. 595, 95th Cong., 1st Sess. 349 (1977); S.Rep. No. 989, 95th Cong., 2d Sess. 60 (1978), U.S.Code Cong. & Admin.News 1978, 5787.

II.

Our conclusion is in accord with In re Stable Mews Associates, 35 B.R. 603 (Bankr.S.D.N.Y.1983). There, the lessor’s bankruptcy trustee rejected leases of real property and sought to compel the lessees to pay a market rate more than five times the rent under the lease. The court analyzed section 365(h) against the history of the related provision of the former Bankruptcy Act protecting the tenant's “estate.” ³ The court observed that Congress was aware of the confusion as to possession and liability for rent generated by previous cases and addressed the matter in section 365(h). Therefore, the plain meaning of the statute controlled. Although the lessor could reject the lease and stop providing services, the lessees could not be compelled to pay more than the rent reserved in the lease less any offset allowed by section 365(h)(2).

III.

Our holding is consistent with other portions of the Bankruptcy Code. Subsection 365(h) parallels subsection 365(i). Upon rejection of real estate sales contracts by a debtor/seller, section 365(i)(l) allows the purchaser in possession either (1) to treat such contract as terminated, surrender possession, and receive a general claim against the estate, or (2) to remain in possession. The Code goes on to provide:

[I]f such purchaser remains in possession ... such purchaser shall continue to make all payments due under such contract, but may, offset against such payments any damages occurring after the date of the rejection of such contract caused by the nonperformance of any obligation of the debtor after such date, but such purchaser does not have any rights against the estate on account of any damages arising after the date of such rejection, other than such offset. ...

11 U.S.C. § 365(i)(2). By requiring the purchaser to continue making the payments under the original contract — a contract rejected by the debtor — Congress clearly intended that the debtor/seller could not increase the purchase price.

The similarities between subsections 365(h) and (i) are obvious. In each instance, one with real property rights is given an option to continue an “estate” and to offset the damages arising from the loss of benefits promised by the debtor. The offset cannot exceed the amount due under the lease or purchase contract. The only difference between the subsections is that purchasers are expressly required to make all payments due under the contract, while ■the similar requirement as to lessees is implicit from the reference to the “rent reserved.” Both subsections show a legislative intention that certain expectations of parties to real property transactions are to be protected although this protection does not benefit the bankruptcy estate.⁴ Any general goal of maximizing the bankruptcy estate is limited in recognition of these real property interests. Collier summarized this limitation as follows:

The desire to effect a feasible plan of reorganization cannot override the vested rights of third persons who are not creditors of the debtor. Insofar as the lessee’s leasehold is concerned he is as much a stranger to the reorganization as one who purchased, received and paid for goods of the debtor prior to reorganization.

6 Collier on Bankruptcy II 3.24, at 602-03 (14th ed.1977).

IV.

Appellant relies upon In re Schnabel, 612 F.2d 315 (7th Cir.1980), a case construing section 70(b) of the former Bankruptcy Act. In Schnabel the tenant remained in possession after the bankruptcy but did not pay the rent. The lessor’s trustee rejected the lease and the tenant later vacated the premises. When the trustee sued for the rent, the tenant responded that rejection cancelled all contractual relations between the parties, including the duty to pay rent. The court disagreed, holding that “the trustee may charge and recover a reasonable rental for the demised premises until the end of the term,” citing 4A Collier on Bankruptcy ¶ 70.44, at 541 n. 6 (14th ed. 1967) (quoting In re Freeman, 49 F.Supp. 163, 165 (S.D.Ga.1943)) (emphasis added).

We find Schnabel unpersuasive here for three reasons. First, the Bankruptcy Act had no provision comparable to the present 11 U.S.C. § 365(h)(2). Second, it is doubtful that our question as to the effect of the rent reserved was before the court. Third, any reliance on Collier and Freeman was misplaced.

Schnabel held that “if the tenant [remaining in possession] is injured by the modification of his rights he is deemed a creditor and has a remedy against the bankrupt.” 612 F.2d at 317 n. 2. But, under section 365(h)(2), a tenant remaining after rejection has no rights against the estate as a creditor except the offset.

The tenant’s primary contention in Schnabel was that no rent whatsoever was owed because the lessor failed to accept the lease. The tenant, the trustee, and the court assumed that if anything was owed, it was the fair rental value.⁵ Because the tenant introduced no evidence as to the fair value, the bankruptcy judge ruled that the fair rent was equal to the lease rent. Thus, the tenant would have paid the same amount whether the court awarded the reserved rent or the fair rental value.

In re Freeman, 49 F.Supp. 163 (S.D.Ga. 1943), cited by Schnabel as a basis for the view of Collier, was a case under Chapter XII of the Bankruptcy Act. The leased property was a house subject to a mortgage. The bankruptcy estate would realize nothing if the house were sold at a mortgage foreclosure sale. In contrast, a private buyer was willing to pay enough to provide the estate with some equity but only if he could have immediate possession. The trustee rejected the lease and evicted the tenant. On review, the district court held that rejection of the lease created a tenancy at sufferance, the trustee could collect a reasonable rent from the tenant because the rental contract no longer bound the parties, and the tenant’s remedy for loss of the leasehold estate was a claim against the bankruptcy estate for money damages.

Freeman’s characterization of the tenancy under a rejected lease as one at sufferance was later disapproved by its circuit as contrary to the clear language of the statute in Matter of Garfinkle, 577 F.2d 901, 904 n. 4 (5th Cir.1978); cf. Creedon & Zinman, Landlord’s Bankruptcy: Laissez les Lessees, 24 Bus.Law. 1391, 1431-32 (1971). The decision is criticized by a different part of the Collier treatise, the same work on which the Schnabel court relied:

The [Freeman ] court ... overlooked the fact that there is nothing in the Act giving the trustee or debtor in possession the right to disaffirm an executed performance, and that the lessee has a vested estate that is distinct from the exec-utory covenant contained in the lease.... The Freeman case, therefore, does not represent the proper view of the effect of rejection of an unexpired lease by the debtor-landlord.

6 Collier on Bankruptcy ¶ 3.24, at 602-03 (14th ed. 1977). Also, as discussed above, the Freeman remedy, a claim for damages against the estate, is now unavailable to a lessee in possession because of section 365(h)(2).

V.

Appellant would charge the market rent to prevent a lessee from obtaining what the appellant characterizes as an unfair windfall. The “windfall” results from paying the rent upon which the parties had earlier agreed. Presumably, the parties took the risk of market fluctuations into account when they set the rent.

Were we to adopt appellant’s view, the windfall might go to the lessor. The parties may not have apportioned the lessee’s costs evenly throughout the term of the lease. For example, a tenant may make a large initial payment and then pay a relatively small rent for the remainder of the term. Another tenant may lease bare ground from a debtor and then construct the buildings on that ground. These tenants would be severely harmed by setting the remaining rent at the market rate unless the court amortized the initial payment or the cost of the building over the life of the lease. Appellant’s rationale, however, suggests that past payments be ignored if to consider them would reduce the benefit to the estate from increased rent.

At oral argument, appellant suggested that adjustments could be made in the individual case. In effect, the courts would have to adjust “fair rental value” by concepts of “fairness to the tenant.” Instead of this extra procedure that is not mentioned in the statute, we think it best to recognize the obvious: the simplest and fairest approach is, as Congress obviously intended, to protect the lessee by not allowing an increase in the rent.

CONCLUSION

We hold that section 365(h) recognizes that the nondebtor lessee has an estate in the real property. The section interferes with that estate only by allowing the debt- or to eliminate services to the tenant and not by allowing an increase in rent.

The bankruptcy judge’s order is AFFIRMED.

1 . Whether a lease should be rejected is a matter for the debtor’s business judgment, In re Chi-Feng Huang, 23 B.R. 798 (Bankr.9th Cir.1982). Here, if the rent could not be changed, there would be no business reason to reject the lease. Rather than wasting the time of the court and the parties by pressing a motion that would obviously be denied, Upland appealed the denial of its motion to modify the rent. If Upland were successful on this appeal, it could have renewed the motion to reject the lease. 11 U.S.C. § 365(d)(2) (lease may be rejected "at any time before the confirmation of a plan”). To be a proper matter for us to resolve, an appeal must be definite and concrete, touching the legal relations of parties having adverse legal interests. It must be a real and substantial controversy admitting of specific relief through a decree of a conclusive character, as distinguished from an opinion advising what the law would be upon a hypothetical state of facts.

Aetna Life Insurance Co. v. Haworth, 300 U.S. 227, 240-41, 57 S.Ct. 461, 464, 81 L.Ed. 617 (1937) (citations omitted). Here, Upland desires to increase the rent and argues that the Bankruptcy Code enables it to do so. Grace desires that the rent remain unchanged and argues that the Bankruptcy Code justifies its position. Both positions have been argued vigorously on appeal. We do not doubt that a live controversy exists here and that the matter can be conclusively resolved. The dissent, however, would require the bankruptcy judge to decide the rejection issue — as to which there is presently no controversy — simply to preserve the rent issue for appeal. Under the dissent’s approach, we expect the following would happen: Upland will renew its motion to reject the lease, the bankruptcy judge will deny the motion, Upland will appeal, and the matter will be back before us, exactly as it is now except for some additional delay and expense.

2 . Upland filed this case under chapter 11 on June 28, 1984. The Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub.L. No. 98-353, made several alterations to section 365(h) which do not affect our decision. The nondebtor lessee’s rights both before and after the amendments are identical.

3 . Section 70(b) of the former Bankruptcy Act provided in part: "The trustee shall assume or reject an executory contract, including an unexpired lease of real property.... Unless a lease of real property expressly provides, a rejection of the lease or of any covenant therein by the trustee of the lessor does not deprive the lessee of his estate."

4 . Subsections 365(h) and (i) were amended in 1984 to apply this same legislative intention to timeshare transactions also.

5 . Schnabel may have assumed without discussion that the tenant had also terminated the lease. The tenant not only failed to pay the rent due under the lease but also vacated the premises before the end of the term. If both tenant and trustee considered the lease to be abrogated, then the tenant would have been a tenant at will and the trustee could have sought the fair rental value. The bankruptcy judge held the tenant liable for rent only during the actual occupancy, not the entire term. This is consistent with mutual termination of the lease and inconsistent with the tenant’s affirmation of his leasehold estate.