A Sublessee’s Rights in the Face of A Debtor-Sublessor’s Rejection of an Unexpired Lease Under Chapter 11
By: Adam Lau
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
In In re Overseas Shipholding Group, Inc.,[i] a bankruptcy court held that rejection of a lease by a debtor constituted a pre-petition breach of the lease and was not a termination of the lease.[ii] The debtor, Overseas Shipholding Group, Inc., entered into a lease agreement with TST/Commerz East Building (“TST”) that was set to expire on December 31, 2020.[iii] Two years into the lease, debtor subleased a part of the space to Maritime Overseas Corporation (“Maritime”).[iv] After filing voluntary petitions under chapter 11, the debtor and Maritime entered into a stipulation with the assignee of TST whereby the debtor and Maritime agreed to reject the lease and the sublease.[v] Maritime then vacated the premises and proceeded to file a claim against debtor for $30,788.32 for return of its security deposit under the sublease, but amended its claim, adding $367,858 for damages from rejection of the sublease, including moving expenses, increased rent, electricity, and legal fees relating to Maritime’s relocation.[vi] The debtor objected to the amended claim, and asked the court to disallow the claim for rejection damages and to limit the recovery to the amount of the security deposit.[vii] The debtor argued that the rejection of the lease constituted a termination of the lease, which would, under Clause 2 in the sublease, preclude Maritime from recovering rejection damages.[viii] Clause 2 provided that, “this Sublease shall terminate (in whole or in part, as applicable) on the date of such termination as if such date had been specified in this Sublease as the Expiration Date and Tenant shall have no liability to Subtenant with respect to such termination.”[ix] The debtor relied on Chatlos Systems, Inc. v. Kaplan[x], where the court held that a debtor’s rejection of a non-residential lease resulted in termination of the lease.[xi] In response, Maritime argued the Bankruptcy Code establishes that the rejection of the overlease was not a termination of the lease but merely a pre-petition breach.[xii] The court was not persuaded by the debtor’s argument, finding that the Chatlos case was not applicable because that case involved a lessee of the debtor who chose to remain in possession of the property, whereas Maritime did not elect to remain on the premises.[xiii] However, while the bankruptcy court agreed with Maritime’s argument that the rejection of the lease constituted a breach and not termination, Maritime was still precluded from claiming rejection damages because Clause 22(j) in the sublease[xiv] provided that the “subtenant shall look solely to Tenant's interests in the Lease to enforce Tenant's obligations hereunder and shall not seek any damages against Tenant or any of the Tenant's Related Parties.”[xv]
The Bankruptcy Code explicitly uses the terms “rejection,” “breach” and “termination” differently under Section 365(g)[xvi] and states that, in general, rejection of an executory contract or unexpired lease constitutes a breach, not a termination.[xvii] Courts have relied on this language and have universally rejected the argument that a rejection of a lease constitutes a termination rather than a breach when the sublessee does not elect to remain on the premises.[xviii] For example, the court in Doral Commerce Park, Ltd. v. Teleglobe Communications Corp. (In re Teleglobe Communications Corp.)[xix], the court noted that courts have agreed that rejection and surrender of a nonresidential real property lease is “a breach of the lease and not a termination thereof.”[xx] The Fifth Circuit held that rejection “should be viewed only as a ‘power to breach.’”[xxi] The Third Circuit, in Enterprise Energy Corp. v. United States (In re Columbia Gas Systems)[xxii], described rejection as “equivalent to a nonbankruptcy breach”[xxiii] that “leaves the nonbankrupt with a claim against the estate just as would a breach in the nonbankruptcy context.”[xxiv]
However, there is an exception to the general rule that is briefly discussed in Overseas.[xxv] The debtor tried, but failed, to argue that the case in Overseas was factually similar to Chatlos,[xxvi] where a court found that the rejection of the lease constitute termination.[xxvii] According to The Chatlos court, when a debtor rejects a lease that was subject to a sublease, the sublease must be deemed rejected under section 365(d), and the debtor must surrender possession to the landlord.[xxviii] There, the court noted that because the sublessee remained on the premises and because the debtor had rejected the lease and had done everything it could to surrender to premises to the landlord, the lease was terminated.[xxix] The court in In re 6177 Realty Associates, Inc.[xxx] noted that the “surrender language in section 365(d)(4) … renders rejection of a non-residential real property lease different from other executory contracts in which rejection may not equal termination.”[xxxi] The court in In re Southwest Aircraft Services, Inc.[xxxii] explained that the surrender language found in section 365(d)(4) of the Code makes it “clear Congress intended that rejecting a lease terminates the lease.”[xxxiii]
Overseas reinforces the general rule that a rejection of an executory contract or unexpired lease does not constitute termination.[xxxiv] While there are instances where a rejection does constitute termination, as is the case when the sublessee wishes to remain in possession of the premises, this was not the case in Overseas, as the sublessee did not elect to stay on the premises. Overseas helps explain the remedies available to a sublessee facing rejection of an unexpired lease under Chapter 11 when a sublessee does not elect to stay. Any claims arising from a rejection of a lease is considered a pre-petition claim that is not entitled to priority as an expense of administration of the estate.[xxxv] The amount of damages a sublessee can claim cannot be more than it could claim outside of bankruptcy and is subject to the underlying agreements and the applicable state statutes.[xxxvi] This application can be seen in Overseas, where the court found that Maritime’s remedy was limited by a provision in the underlying sublease that precluded the sublessee from claiming damages against the debtor.[xxxvii] Therefore, sublessees who are faced with a rejection of an unexpired lease, who do not wish to remain on the premises and who wish to claim damages, should review any underlying agreement as well as any applicable state laws to determine remedies available to them.
[i] In re Overseas Shipholding Group, Inc., 2015 WL 3475727, at *1 (Bankr. D. Del. June 1, 2015).
[ii] See id. at *3.
[iii] See id. at *1.
[iv] See id.
[v] See id.
[vi] See id.
[vii] See id.
[viii] See id. at *2.
[x] Chatlos Systems, Inc. v. Kaplan, 147 B.R. 96 (Bankr. D. Del. 1992).
[xi] See id. at 98.
[xii] See 11 U.S.C. § 365(g) (2012).
[xiii] See In re Overseas Shipholding Group, Inc., 2015 WL 3475727, at *3 (Bankr. D. Del. June 1, 2015).
[xiv] Id. at *4.
[xv] Id. at *3.
[xvi] See Eastover Bank for Savings v. Sowashee Venture (In re Austin Development Co.), 19 F.3d 1077, 1082 (5th Cir. 1994); see, e.g., In re Giles Associates, Ltd., 92 B.R. 695, 698 (Bankr. W.D. Tex. 1988).
[xvii] 11 U.S.C. § 365(g).
[xviii] See California Public Employees’ Retirement System v. Stanton (In re CP Holdings, Inc.), 349 B.R. 189, 192 (8th Cir. 2006) (holding “rejection under 11 U.S.C. § 365 does not terminate a lease”); GSL of Illinois, LLC v. McCaffety Electric Company (In re Demay Int’l LLC), 471 B.R. 510, 532 (Bankr. S.D. Tex. 2012) (noting the “Debtor’s decision not to assume a lease or executory contract, does not equate to ‘termination’); In re Palace Quality Services Industries, 283 B.R. 868, 886 (Bankr. E.D. Mich. 2002); CASC Corp. v. Milner (In re Locke), 180 B.R. 245, 260 (Bankr. C.D. Cal 1995); John Hilsman Investments, LLC v. Quality Properties, LLC, 500 B.R. 105, 115 (Bankr. N.D. Ala. 2013); Couture v. Burlington Housing Authority (In re Couture), 225 B.R. 58, 64 (Bankr. D. Vt. 1998).
[xix] Doral Commerce Park, Ltd. v. Teleglobe Communications Corp. (In re Teleglobe Communications Corp.), 304 B.R. 79 (D. Del. 2004).
[xx] Id. at 83.
[xxi] Eastover Bank for Savings v. Sowashee Venture (In re Austin Development Co.), 19 F.3d 1077, 1082 (5th Cir. 1994).
[xxii] Enterprise Energy Corp. v. United States (In re Columbia Gas Sys.), 50 F.3d 233 (3d Cir.
[xxiii] Id. at 239 n.8.
[xxv] In re Overseas Shipholding Group, Inc., 2015 WL 3475727, at *2 (Bankr. D. Del. June 1, 2015).
[xxvii] Chatlos Systems, Inc. v. Kaplan, 147 B.R. 96, 98 (Bankr. D. Del. 1992).
[xxviii] Id. at 99.
[xxix] See id. at 100.
[xxx] In re 6177 Realty Assocs., Inc., 142 B.R. 1017 (Bankr. S.D. Fla. 1992).
[xxxi] Id. at 1019.
[xxxii] In re Southwest Aircraft Services, Inc., 53 B.R. 805 (Bankr. C.D. Cal. 1985).
[xxxiii] Id. at 810.
[xxxiv] 11 U.S.C. § 365(g).
[xxxv] See Enterprise Energy Corp. v. United States (In re Columbia Gas Sys.), 50 F.3d 233, 239 (3d Cir. 1995).
[xxxvi] See In re Overseas Shipholding Group, Inc., 2015 WL 3475727, at *4 (Bankr. D. Del. June 1, 2015) (citing Enterprise Energy Corp. v. United States (In re Columbia Gas Sys.), 50 F.3d 233, 239 n.8 (3d Cir. 1995)).
[xxxvii] See In re Overseas Shipholding Group, Inc., 2015 WL 3475727, at *4 (Bankr. D. Del. June 1, 2015).