Legal Briefs

Retro Rejection

Actions speak louder than words when landlords come before the bankruptcy court.

When tenants file for Chapter 11 bankruptcy both landlords' and tenants' rights and responsibilities come under the purview of the U.S. Bankruptcy Code. Landlords cannot evict tenants in bankruptcy absent relief from the automatic stay, and tenants must continue to pay post-petition rent. Decisions concerning lease acceptance and rejection fall under a bankruptcy court's jurisdiction, and landlords would be wise to consider their actions when involved in such cases.

The recent ruling of the 9th U.S. Circuit Court of Appeals in Pacific Shores Development LLC v. At Home Corp. (In re At Home) has created anxiety — or opportunity, depending on perspective — in the commercial real estate industry.

The 9th Circuit decision affirmed the bankruptcy court's decision to approve a tenant's retroactive lease rejection. Landlords should note that the bankruptcy court considered the conduct of both parties in determining whether retroactive rejection was appropriate. A demonstrated effort by landlords to cooperate with tenants in bankruptcy should go a long way in protecting them against the extra sting of retroactive lease rejection.

The Case

In early 2000, broadband network service provider At Home Corp., leased two office buildings from Pacific Shores Development Corp. and placed $20 million in an escrow account for remodeling the buildings. At Home's business ambitions were not realized, and on Sept. 28, 2001, the company filed for Chapter11 bankruptcy. At that time, the buildings' renovations were nearly complete, but At Home had never occupied the buildings, although it also never formally surrendered them.

On the day At Home filed bankruptcy, it also filed an emergency motion to reject its lease with Pacific Shores, retroactive to the date it filed the motion. The landlord objected to retroactive rejection. Without retroactive rejection, At Home would owe more than $1million in post-petition rent, which accrued during the 11-day period between the motion's filing and hearing.

In granting At Home's motion to reject the lease retroactively, the bankruptcy court considered the following: At Home moved to reject the lease immediately upon filing its bankruptcy petition and set the matter for hearing promptly; the company was “not in possession of the premises;” and Pacific Shores opposed the retroactive rejection without suggesting “that this process should be speeded up so that [Pacific Shores] could get…its indefeasible right to re-let the premises.” Apparently the bankruptcy court thought the landlord's sole interest was “in running up the administrative rent.”

The district court affirmed the bankruptcy court's decision. On appeal, the landlord argued that the bankruptcy court lacked the authority to order retroactive rejection to a date before the landlord regained possession of the premises and that the bankruptcy court erred in its determination of the factors it considered in granting At Home's emergency motion.

The Appeal Decision

The appellate court began its analysis by discussing the Shopping Center Amendments added to the Bankruptcy Code in 1984 to protect commercial landlords from long-term vacancies and the failure of debtor tenants to pay post-petition rent. The court also examined differing views regarding the effective date of a lease rejection and adopted the position of In re Thinking Machines Corp. The Thinking Machines case states the following: “Rejection under [Bankruptcy Code] Section 365(a) does not take effect until judicial approval is secured, but the approving court has the equitable power, in suitable cases, to order rejection to operate retroactively.”

Since retroactive rejection facilitates cooperation between debtor tenants and landlords to get a debtor's motion heard quickly, “Courts generally focus on whether the parties have facilitated or hindered the prompt return of the leased premises to the landlord when deciding whether to approve the rejection of a lease retroactive to an earlier date.”

The court held retroactive rejection was appropriate in this case, even though the tenant (not the landlord), retained legal possession of the premises post-bankruptcy. The landlord's possession of the leased premises was not a requirement for retroactive granting of the motion to reject the lease. Although a landlord will regain possession soon after rejection and receive administrative priority rent in the interim, “nothing in the text or history of the statute, nor in our case law, suggests that bankruptcy courts are powerless to deviate from the usual rule in appropriate circumstances.” The bankruptcy court may mold its order “to reflect the circumstances and the action of both parties to the lease.”

After determining that the bankruptcy court had the authority to order retroactive rejection of the lease, the appeals court examined the bankruptcy court's determination of the “exceptional circumstances.”

A key circumstance was the landlord's conduct and motives in the matter. The debtor moved quickly to reject the lease, and Pacific Shores never made any suggestion to speed up the rejection process. The bankruptcy court stated that the landlord “was more concerned with obtaining administrative rent than with re-letting the premises.” The court also considered the “fairly interesting amount of rent per month” in reaching its decision. Although the contract rate — rather than any rate based on benefit conferred to the debtor — controls the calculation of administrative rent under Bankruptcy Code Sections 365(d)(3) and 503(b)(1), the Court of Appeals found that the bankruptcy court still had the discretion to consider the amount of rent accruing in reaching its retroactive lease rejection decision.

In summary, the Court of Appeals concluded that the bankruptcy court had the equitable authority to order retroactive rejection of the lease, and the bankruptcy court did not abuse its discretion in its application of that authority in this case.

Landlords should not be intimidated by the At Home retroactive rejection holding. If a solution short of bankruptcy cannot be reached, landlords should send written proposals to debtors/tenants or the trustee to stipulate shortening the time for the hearing on any lease rejection motion, or even stipulating rejection as part of first-day motions. Under the “business judgment test,” courts generally grant these motions unless it is clear that the debtor is wasting an undermarket lease that it should be assuming and assigning.

Gregg Ficks

Gregg Ficks, JD, is a partner at Coblentz, Patch, Duffy & Bass LLP in San Francisco. Contact him at (415) 772-5779 or gficks@cpdb.com.

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