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Section 365 of the Bankruptcy Code addresses the assumption (and perhaps assignment) and rejection of unexpired leases and executory contracts. Though � 365 is generally considered the most convoluted section of the Bankruptcy Code, due in part to amendments prompted by special interests, this article focuses on the specific provisions of � 365(h). These provisions are implicated when the debtor in bankruptcy seeks to reject an unexpired lease in which the debtor is the lessor (as opposed to the lessee) of real property. Commonly, a debtor will be the lessee of real property and will assume or reject the lease if the contract terms are more or less advantageous than prevailing market rates. If the debtor rejects the lease, there are three important consequences. First, the debtor must vacate the premises in order to avoid the continued accrual of administrative rent by the bankruptcy estate. Second, the debtor’s rejection will be deemed to have occurred just prior to the filing of the bankruptcy case, the lessor will be left with a general unsecured claim for the damages arising from the debtor’s rejection and such claim will be paid on a pro rata basis with other general unsecured creditors. Third, any claim for rejection damages by the lessor will be limited by the “cap” on lease-rejection damages set forth in � 502(b)(6). When the debtor is the lessor of real property, however, the consequences of rejecting the lease are significantly different in two respects. First, � 365(h) gives to the nondebtor lessee the right to remain in possession of the premises for the balance of the lease term and any extensions thereof, even though the debtor will no longer be required to fulfill its other obligations under the lease. Second, while the lessee’s claim for rejection damages will be a prepetition general unsecured claim, the � 502(b)(6) cap will not apply because, by its express terms, it is limited to situations where the debtor is the lessee and not the lessor. Addressing a nondebtor lessee’s possessory right A nondebtor lessee’s residual possessory right under � 365(h) can be a nettlesome issue for the bankruptcy estate. If a sale of the real property is necessary, it would behoove a nondebtor lessee to assert its rights under � 365(h) even if only to extract more advantageous treatment of its claims in the case. As the 7th U.S. Circuit Court of Appeals recently pointed out, a debtor must provide adequate protection of a nondebtor lessee’s interest in the real property when selling “free and clear” of residual possessory rights under � 365(h). See In re Precision Industries Inc., 327 F.3d 537 (7th Cir. 2003). In Precision Industries, the debtor sold real property to a buyer under � 363(f). However, the real property was the subject of a lease to a certain lessee. Nine months after the sale, the buyer changed the locks and excluded the lessee. The principal question before the court was whether � 363(f) authorized a sale “free and clear” of a lessee’s rights under � 365(h). The 7th Circuit ruled that � 363(f) does authorize such a sale. The 7th Circuit went on to state, however, that the nondebtor lessee’s residual possessory right constitutes an “interest” in the real property for purposes of � 363(f) and that the lessee is entitled to “adequate protection” of such interest pursuant to � 363(e). Unfortunately, the nondebtor lessee in that case did not object to the proposed sale and, as a result, the issue of adequate protection was not addressed squarely. Nonetheless, the 7th Circuit suggested that adequate protection under � 363(e) could be in the form of a cash payment from the proceeds, which would necessarily involve issues over the relative value of the residual possessory interest as against the overall 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 nondebtor lessee in Precision Industries seems a bit harsh. In denying the lessee any relief under � 363(e), the court certainly seemed persuaded by the fact that the lessee did not object to the sale until nine months afterward. One might question this conclusion given the fact that the debtor never sought to reject the lease and the lessee could easily have thought the sale was subject to, as opposed to free and clear of, its lease. Regardless, the practice tip appears to be: Do not let a sale of real property in which a client has an interest get approved without completely understanding how the sale will affect the client’s rights. Unlike the situation in Precision Industries, if a nondebtor lessee demands adequate protection of its residual possessory interest in the real property, the debtor will have to pay off the lessee for its residual possessory right essentially as a secured or administrative claim. This favored treatment could have a material negative impact on the outcome of the case, particularly if it relates to the payment of unsecured claims. Good practitioners should thus look for creative ways to avoid implicating � 365(h)’s provisions: They should consider a three-pronged approach. First, counsel for the debtor should determine whether there is any basis for terminating the agreement by its own terms. An agreement could contain provisions for terminating the contract upon written notice, or the debtor could have the right to terminate the lease for a breach by the nondebtor lessee. Of course, this approach will succeed or fail based on the agreement’s provisions, and there is no suggestion that a pretextual breach would carry the day. Nonetheless, the point is to know the documents, as they may contain the simplest solution. Second, counsel should ask this question: Is the lease a true lease or some other executory contract dressed up as a lease? The residual possessory rights set forth in � 365(h) apply only to true leases and not other executory contracts. In Butner v. United States, 99 S. Ct. 914 (1979), the U.S. Supreme Court held that the nature of property interests should be based upon the state laws under which they arose, absent a clear and manifest federal interest. Under the law of most states, a valid real property lease must set forth, at a minimum, a definite description of the premises being leased, the rent to be paid and the grant of exclusive possession of the premises. While creative drafting may obscure the matter, courts will look beyond the terminology of the agreement to its economic substance. Finally, if the agreement qualifies as a true lease under state law, the issue is not necessarily settled. In In re PCH Assocs. Inc., 804 F.2d 193 (2d Cir. 1986), and In re Morreggia & Sons Inc., 852 F.2d 1179 (9th Cir. 1988), the 2d and 9th circuits concluded that the leases at issue were financing and joint venture agreements, and not the type of “lease” covered by the protections of � 365(d). They reasoned that “[s]imply meeting the state law definition of a lease will not necessarily mandate the ‘mindless application’ of section 365. Rather, the ‘economic realities’ of the particular agreement must properly fall within the scope of the type of agreement anticipated by Congress in enacting section 365.” 852 F.2d at 1183. Is there a true landlord/ tenant relationship? Based upon PCH and Morreggia, a nondebtor lessee must show that, in addition to having a true lease under applicable state law, its lease fits within the intended purview of � 365. Courts will consider a wide range of factors, such as the intended scope of the statutory provision at issue, whether the parties intended a true landlord/tenant relationship, whether there are any executory obligations, the relative value given for the lease, the balancing of risks between the parties and other indicia of ownership. Such considerations are not exhaustive by any means. Indeed, the reasoning of PCH and Morreggia can be applied to other subsections of � 365, such as the residual possessory rights set forth in � 365(h). Thus, when faced with a nondebtor lessee that is asserting a right to remain in possession of the real property under � 365(h), a debtor can argue that the lease at issue is not the type of lease to which � 365(h) should apply. It would be impossible to catalog all the types of “leases” that would qualify as leases under � 365(h). Consideration of certain contracts may provide a sense of the statute’s intended scope. For instance, standard residential leases would most probably fall within the purview of � 365(h), given the presumption of uniqueness of such property. Certain commercial leases where location is important would probably also qualify. On the other hand, PCH and Morreggia strongly suggest that leases lacking a traditional landlord/tenant relationship, such as disguised secured financing transactions and joint ventures, are outside the statute’s intended scope. Other contracts that grant possession of the real property as an incident to an agreement to provide other services or to acquire personal property, such as harvesting and mining agreements, would also not qualify because the economic substance of the transaction is not one of landlord/tenant. Such interests could be satisfied with money damages. The precise scope of � 365(h) will be established by future cases. With interest rates on the rise, there is the potential for more bankruptcy filings by debtors who are lessors of real property. A spate of such cases would do much to develop what would essentially be a separate federal common law on the issue of what is a true lease for purposes of � 365, and arguably other provisions of the Bankruptcy Code. Craig Rankin is a partner at Los Angeles-based bankruptcy boutique Levene, Neale, Bender, Rankin & Brill. Christopher Alliotts is of counsel in the Menlo Park, Calif., office of Los Angeles-based SulmeyerKupetz.

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