ection 365 ofthe BankruptcyCode addresses the assumption(and perhaps assignment) andrejection of unexpired leases andexecutory contracts. Though § 365is generally considered the most convolutedsection of the Bankruptcy Code, due inpart to amendments prompted by specialinterests, this article focuses on the specificprovisions of § 365(h). These provisions areimplicated when the debtor in bankruptcyseeks to reject an unexpired lease in whichthe debtor is the lessor (as opposed to thelessee) of real property.Commonly, a debtor will be the lessee of real property and will assume or reject thelease if the contract terms are more or lessadvantageous than prevailing market rates. If the debtor rejects the lease, there are threeimportant consequences. First, the debtormust vacate the premises in order to avoidthe continued accrual of administrativerent by the bankruptcy estate. Second, thedebtor’s rejection will be deemed to haveoccurred just prior to the filing of thebankruptcy case, the lessor will be left with ageneral unsecured claim for the damagesarising from the debtor’s rejection and suchclaim will be paid on a pro rata basis withother general unsecured creditors. Third, anyclaim for rejection damages by the lessor willbe limited by the “cap” on lease-rejectiondamages set forth in § 502(b)(6).When the debtor is the lessor of realproperty, however, the consequences of rejecting the lease aresignificantly differentin two respects. First, § 365(h) gives to thenondebtor lessee the right to remain inpossession of the premises for the balance of the lease term and any extensions thereof,even though the debtor will no longer berequired to fulfill its other obligations underthe lease. Second, while the lessee’s claim forrejection damages will be a prepetitiongeneral unsecured claim, the § 502(b)(6) capwill not apply because, by its express terms, itis limited to situations where the debtor isthe lessee and not the lessor.
Addressing a nondebtorlessee’s possessory right
A nondebtor lessee’s residual possessoryright under § 365(h) can be a nettlesomeissue for the bankruptcy estate. If a sale of the real property is necessary, it wouldbehoove a nondebtor lessee to assert itsrights under § 365(h) even if only to extractmore advantageous treatment of its claims inthe case. As the 7th U.S. Circuit Court of Appeals recently pointed out, a debtor mustprovide adequate protection of a nondebtorlessee’s interest in the real property whenselling “free and clear” of residual possessoryrights under § 365(h). See
In re PrecisionIndustries Inc.
, 327 F.3d 537 (7th Cir. 2003).In
Precision Industries
, the debtor sold realproperty to a buyer under § 363(f). Howev-er, the real property was the subject of a leaseto a certain lessee. Nine months after thesale, the buyer changed the locks andexcluded the lessee. The principal questionbefore the court was whether § 363(f)authorized a sale “free and clear” of a lessee’srights under § 365(h). The 7th Circuit ruledthat § 363(f) does authorize such a sale.The 7th Circuit went on to state, howev-er, that the nondebtor lessee’s residualpossessory right constitutes an “interest” inthe real property for purposes of § 363(f) andthat the lessee is entitled to “adequateprotection” of such interest pursuant to§ 363(e). Unfortunately, the nondebtorlessee in that case did not object to theproposed sale and, as a result, the issue of adequate protection was not addressedsquarely. Nonetheless, the 7th Circuitsuggested that adequate protection under§ 363(e) could be in the form of a cash pay-ment from the proceeds, which would neces-sarily involve issues over the relative value of the residual possessory interest as against theoverall sales price of the real property.While the 7th Circuit held that § 363(f)authorizes a sale free and clear of rights under§ 365(h), the outcome for the nondebtorlessee in
Precision Industries
seems a bitharsh. In denying the lessee any relief under § 363(e), the court certainly seemedpersuaded by the fact that the lessee did not
WWW.NLJ.COM
THE WEEKLY NEWSPAPER FOR THE
LEGAL PROFESSION
MONDAY, DECEMBER 20, 2004
BANKRUPTCY LAW
By Craig Rankin and Christopher Alliotts
is a partner at Los Angeles-basedbankruptcy boutique Levene, Neale, Bender,Rankin &Brill. is of counsel in the Menlo Park, Calif., office of Los Angeles-based SulmeyerKupetz.
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