Eastover Bank for Savings v. Sowashee Venture (In Re Austin Development Co.) , 19 F.3d 1077 ( 1994 )

United States Court of Appeals,
Fifth Circuit.
No. 93-7127.
In the Matter of AUSTIN DEVELOPMENT COMPANY, Debtor.
EASTOVER BANK FOR SAVINGS, Appellant,
v.
SOWASHEE VENTURE, et al., Appellees,
v.
AUSTIN DEVELOPMENT COMPANY and J.C. Bell, Trustee, Appellees.
May 3, 1994.
Appeal from the United States District Court for the Southern District of Mississippi.
Before HIGGINBOTHAM, DAVIS, and JONES, Circuit Judges.
EDITH H. JONES, Circuit Judge:
The debtor was a lessee under a ground lease and sublessor of a movie theater it built; it
assigned its interest in the ground lease and the theater's income st ream to a bank as security for
various loans. During its Chapter 11 proceeding, the debtor's inaction led to an automatic rejection
of its ground lease. 11 U.S.C. § 365(d)(4).1 The district court and bankruptcy court held that the
"deemed rejection" of the lease effected the termination of the bank's rights under the ground lease
and the bank's assignment of the theater sublease.2 We reverse and remand.
BACKGROUND
The facts in this case are straightforward. Austin Development Company (Austin) entered
1
11 U.S.C. § 365(d)(4) reads:
[I]f the trustee does not assume or reject an unexpired lease of nonresidential real
property under which the debtor is the lessee within 60 days after the date of the
order for relief, or within such additional time as the court, for cause, within such
60-day period, fixes, then such lease is deemed rejected, and the trustee shall
immediately surrender such nonresidential real property to the lessor.
2
The theater obtained a nondisturbance agreement with Sowashee, and its lease remained in
place notwithstanding Austin's Chapter 11 proceeding. We do not need to consider the impact of
§ 365(d)(4) on the theater's sublease from the debtor.
into a long-term ground lease from the predecessor of Sowashee Venture, a general partnership
(Sowashee). After borrowing funds from another bank and building a motion picture theater on the
property, Austin subleased the property to the predecessor of R & S Theaters, Inc. (R & S), the
theater's current operator. Austin borrowed money from Eastover Bank for Savings (Eastover) to
pay off its first lender and for other purposes in 1986. As security for the Eastover loans, Austin
granted Eastover a deed of trust on its tenant-leasehold interest in the ground lease from Sowashee
and an assignment of Austin's interest in the sublease to R & S. Before Austin's bankruptcy, R & S
paid about $11,085 in monthly rental and taxes directly to Eastover. Eastover t hen applied about
$9,000 of this sublease payment to Austin's debt, paid Sowashee about $1,500 as monthly rent under
the ground lease, and escrowed money for ad valorem taxes.
On January 2, 1991 Austin filed for reorganization under Chapter 11. Austin did not assume
the Sowashee ground lease within 60 days after it filed its bankruptcy petition, nor did Eastover file
a motion to compel Austin to assume or reject. Sowashee thereupon filed a motion and complaint
requesting that the bankruptcy court terminate 1) Austin's interest as lessee in the ground lease, 2)
Eastover's deed of trust on Austin's leasehold interest, and 3) Eastover's interest in the sublease with
R & S. Eastover's counterclaim asked the bankruptcy court to order Sowashee to enter into a ground
lease with Eastover, as provided for under paragraph 21 of the ground lease. That lengthy
"paragraph" granted Austin permission to mortgage all or part of its leasehold estate and granted any
future leasehold mortgagee numerous rights as a third-party beneficiary of the ground lease. These
creditor rights, similar to those found in nondisturbance agreements between landlords and leasehold
mortgagees, included: 1) a requirement that the parties to the ground lease obtain the leasehold
mortgagee's written consent prior to cancellation, surrender, or modification of the ground lease; 2)
the right to cure lessee's defaults; 3) the right, if termination were to be declared by the landlord, to
nullify the termination or indefinitely postpone it by curing all conditions of default; and 4) the right,
if termination were to be realized, o f the leasehold mortgagee to enter into a new lease with the
landlord on the same terms as the terminated lease.
The bankruptcy court found for Sowashee and against Eastover in all respects. It ruled that
§ 365(d)(4) of the Bankruptcy Code did not result in a breach, but rather a termination of the ground
lease, the termination of Eastover's interest in the sublease payments, and the termination of
Eastover's rights under the ground lease as a third-party beneficiary. The district court affirmed.
DISCUSSION
The question presented in this case is what it means when a debtor as a lessee of
nonresidential real property fails within 60 days after filing a Chapter 11 case to assume an unexpired
lease. Under § 365(d)(4) of the Bankruptcy Code, the lease is "deemed rejected." Does the rejection
terminate the lease and thus extinguish a security interest taken in the debtor's interest in the lease,
a sublease by the debtor-lessee, or similar rights that accrued by and among third parties?
This question, although arising infrequently, has generated starkly conflicting opinions among
the bankruptcy courts.3 The bankruptcy and district courts here relied upon the line of cases that
construe rejection under § 365(d)(4) essentially as an avoiding power against such holders of security
interests in the debtor's leases.4 Those cases deduce that when a lease is "deemed rejected," the
further requirement of § 365(d)(4) that the trustee "shall immediately surrender such nonresidential
real property to the lessor" effects a termination of the lease. Under these cases, the lease is
terminated by operation of federal law and not because of any breach of its terms. They conclude that
when the lease terminates, security interests in the lease are extinguished. See In re Giles Associates,
Ltd., 92 B.R. 695 (Bankr.W.D.Tex.1988). Somewhat inconsistently, these courts also state that if
the lienholders had come into court within the 60-day period for assumption or rejection of
3
Compare In re Gillis, 92 B.R. 461 (Bankr.D.Haw.1988); In re Giles Assocs. Ltd, 92 B.R.
695 (Bankr.W.D.Tex.1988); Chatlos Sys., Inc. v. Kaplan, 147 B.R. 96 (D.Del.1992), aff'd
without opinion, 998 F.2d 1005 (3d Cir.1993) (having no precedential value, however, under
Internal Operating Procedures of the Third Circuit, IOP 5.6, reprinted at 28 U.S.C.A. Rules, Part
1 (West Supp.1993)); In re Hawaii Dimensions, Inc., 39 B.R. 606 (Bankr.D.Haw.1984), aff'd 47
B.R. 425 (D.Haw.1985) with In re Storage Technology Corp., 53 B.R. 471(Bankr.D.Colo.1985); In re Picnic 'N Chicken, Inc., 58 B.R. 523 (Bankr.S.D.Cal.1986); Societe
Nationale Algerienne Pour la Recherche v. Distrigas Corp., 80 B.R. 606, 608-09
(D.Mass.1987); In re Blackburn, 88 B.R. 273, 276 (Bankr.S.D.Cal.1988). See generally
William E. Winfield, Rejection of Nonresidential Leases of Real Property in Bankruptcy: What
Happens to the Mortgagee's Security Interest?, 17 Pepp.L.Rev. 429 (1990).
4
See, e.g., In re Gillis; In re Giles Assocs., Ltd.; In re Hawaii Dimensions, Inc.,; Chatlos
Sys., Inc. v. Kaplan—all cited supra note 3.
nonresidential real property leases, they could have avoided the dire consequence of "deemed
rejection." Precisely how the lienholders, such as Eastover, could have protected themselves is not
explained and is highly problematic.5 These opinions circularly conclude that the statutory breach
plus surrender provided in § 365(d)(4) must cause a termination of the trustee's or
debtor-in-possession's rights in the leasehold, because otherwise, "the face of the statute and its
history are meaningless."6 In re Giles, 92 B.R. at 698.
Flawed by their failure to analyze § 365(d)(4) in harmony with the rest of § 365 and applicable
statutory antecedents, these opinions have worked needless and perhaps unconstitutional forfeitures
of security interests. This court's interpretation relies instead on those cases that have construed the
plain meaning of § 365, understood in light of all its terms, which together express the Congressional
purpose behind the trustee's assumption and rejection power.7 Toibb v. Radloff, 501 U.S. 157, ----,
111 S.Ct. 2197, 2199-2200, 115 L.Ed.2d 145 (1991). Section 365 derives from § 70(b) of the
former Bankruptcy Act, a provision that broadly codified the common law doctrine that allowed the
trustee either to assume and perform the debtor's leases or executory contracts or to "reject" them
if they were economically burdensome to the estate. See generally Michael T. Andrew, Executory
Contracts in Bankruptcy; Understanding "Rejection," 59 U of Colo.L.Rev. 845, 874-81 and n. 136
(1988). This court has held that the deemed rejection of a lease under § 70(b) did not terminate the
5
If the debtor had the unfettered right to assume or reject within 60 days, it is hard to see how
the leasehold mortgagee could, by moving within that period to compel the debtor to act, assure
itself of protection. One court held that the mortgagee's protection lies in a § 554 motion to
compel the trustee (or debtor-in-possession) to abandon the leasehold, which would leave all
parties to fight out their relationships in the state court. In re Bernard, 69 B.R. 13(Bankr.D.Haw.1986). This prescription seems unnecessarily contrived as compared with our
straightforward reading of § 365(d)(4).
6
Contrary to the statement in Giles and similar ones by other courts, legislative history
provides very little guidance for the interpretation of the effect of § 365(d)(4) on mortgagees of a
debtor's leasehold. It is true that § 365(d)(4) is part of the 1984 "shopping center" amendments
to the Bankruptcy Code and that it sought to lessen the vacancy period for lessors to debtors in
such cases by requiring a firm 60-day assume/reject decision. See In re Giles, 92 B.R. at 697.
This goal of protecting lessors does not conflict with the protection of leasehold mortgagee's
rights, however, because a mortgagee would have to comply with the lease in order to take it over
from the debtor. The lessor would have to be satisfied.
7
See, e.g., Societe Nationale Algerienne Pour la Recherche v. Distrigas Corp.; In re Storage
Technology Corp.; In re Picnic 'N Chicken—all cited supra note 3.
lease but merely placed the trustee's obligation to perform under the leasehold outside of the
bankruptcy administration without destroying the leasehold estate. In re Garfinkle, 577 F.2d 901,
904 (5th Cir.1978). Consequently, on facts similar to those in the instant case, Garfinkle held that
the mortgage of the original lessee from whom the bankrupt acquired the leasehold was preserved
notwithstanding an attempted rejection. Id. Garfinkle's analysis remains persuasive, as § 70(b) and
§ 365(d)(4) do not materially differ in the way they effectuate the assumption and rejection power.
See In re Storage Technology Corp., 53 B.R. 471, 474 (Bankr.D.Colo.1985); Andrew, supra, 59
U.Colo.L.Rev. at 879 and nn. 136-140.
Turning to § 365, the terms rejection, breach and termination are used differently, but not
inconsistently or interchangeably, as some courts have suggested. See, e.g., In re Giles, 92 B.R. at
698. Throughout § 365, rejection refers to the debtor's decision not to assume a burdensome lease
or executory contract. Section 365(g) states that rejection of a lease "constitutes a breach" except
as pro vided in subsections (h)(2) and (i)(2). Three circuits, including this one, have held that this
language does not mean that the executory contract or lease has been terminated, but only that a
breach has been deemed to occur. In re Continental Airlines, 981 F.2d 1450, 1459 (5th Cir.1993)
("to assert that a contract effectively does not exist as of the date of rejection is inconsistent with
deeming the same contract breached"); In re Modern Textile, Inc., 900 F.2d 1184, 1191 (8th
Cir.1990); Leasing Service Corp. v. First Tennessee Bank, Nat'l Ass'n, 826 F.2d 434, 436-37 (6th
Cir.1987).8 Consistent with this interpretation, § 502(g) permits the creditor on a rejected lease or
executory contract to assert a claim for damages as of the date of bankruptcy , although under §
8
In Wainer v. A.J. Equities, Ltd., 984 F.2d 679, 684 (5th Cir.1993), this court opined that
under § 365, a debtor-tenant "can reject the lease, which is then terminated...." That statement is
immaterial to the court's discussion and holding in Wainer, is inconsistent with Matter of
Continental Airlines, supra, and Matter of Garfinkle, supra, and has no precedential effect.
Likewise, in Sea Harvest Corp. v. Riviera Land Co., 868 F.2d 1077, 1080-81 (9th Cir.1989), the
court stated that, "Surrender of property, whether its use is for a retail store in a mall or a clam
harvesting operation in the tidelands, has the effect of terminating the enterprise that operates
there." The court did not say, as is sometimes suggested, that the effect of § 365(d)(4) was to
terminate the lease, but only the "enterprise" if the debtor is the lessee.
502(b)(6) a landlord's claim may be subject to a cap.9 Rejection is treated as a breach to preserve the
rights of the party whose lease with the debtor has been rejected by providing a prepetition claim;
if rejection were deemed a complete, immediate termination, it is not clear what the measure of the
creditor's claim would be.
The decision to reject is thus not correctly viewed as a "power to breach" the executory
contract or lease. As one commentator put it,
[w]hat the estate's representative is rejecting is the contract or lease asset, which conceivably
could carry continuing obligations with it into the estate on an administrative basis. Rejection
simply prevents the estate from unadvisedly stepping into such liabilities. The liabilities are
not repudiated; to the contrary, as the rejection-as-breach doctrine is designed to insure, the
contract or lease liabilities remain intact after rejection and give the non-debtor party a claim
in the distribution of the estate.
Andrew, supra at 883 (footnote omitted).
Further, Congress knew how to authorize the termination of executory contracts and leases
in § 365. "Termination" is used in § 365(h), (i), and (n) as one option available respectively to the
purchaser of an interest in a timeshare project, the vendee of real property, or the licensee from the
debtor of a right to intellectual property if the trustee has rejected the executory contract.
Accordingly, the trustee may reject any of these contracts, but termination does not occur except at
the other party's option. The option to terminate a timeshare lease, § 365(h)(1), or a license, §
365(n)(1)(A), arises where the trustee's rejection "amounts to such a breach as would entitle the
[party] to treat such lease or [contract] as terminated by virtue of its own terms, applicable
nonbankruptcy law, or other agreements...." 11 U.S.C. § 365(h)(1) and § 365(n)(1). In § 365(h)(1),
rejection is used synonymously with "disaffirmance" for these purposes; in none of these subsections
9
A particularly thoughtful bankruptcy court opinion recently concluded that under 11 U.S.C. §
502(b)(6), all of a landlord's damages arising from the rejection of the debtor's lease, including
those based on a covenant to repair, are capped by that provision. In re Mr. Gatti's, Inc., 162
B.R. 1004 (Bankr.W.D.Tex.1994). The landlord argued that the cap plainly encompassed only
"damages resulting from the termination ...," § 506(b)(2), a phrase that appears to exclude
"consequential" damages. The bankruptcy court, rejecting the landlord's argument, first adopted
the decisions cited supra n. 4, which equate rejection with termination. Alternatively, it pointed
out that even if those decisions are not followed, the landlord's claim is one "against the estate" in
bankruptcy based on the debtor's breach. The precise scope of § 502(b)(6) is not before this
court; while our reasoning does not agree with the first rationale asserted in Mr. Gatti's, the
second rationale might easily be reconciled to this case.
is rejection or disaffirmance equated with termination. Under an objective reading, the provisions of
§ 365 may be redundant and complex, but Congress was not confused in its differing usages of the
terms rejection, breach and termination.
It is also worth pointing out, as several courts have done, that breach and termination of
leases or executory contracts are not synonymous terms under state law. See e.g., In re Storage
Technology, supra; In re Picnic 'N Chicken, Inc., 58 B.R. 523, 525 (Bankr.S.D.Cal.1986)
(California law); Resolution Trust Corp. v. Cramer, 6 F.3d 1102, 1108 (5th Cir.1993) (describing
options available to landlords under Texas law). Congress could have chosen to depart from the state
law meanings of these terms, but taken as a whole, § 365 suggests that it did not do so.
The cases that equate rejection with lease termination under § 365(d)(4) ultimately rest on
a manufactured definition of termination as "breach plus surrender of the premises." Thus, the breach
caused by the trustee's failure to assume or reject the lease wit hin 60 days is "so serious" that §
365(d)(4) requires the debtor to surrender the leased premises immediately, and the breach plus
surrender "can only be seen" as a termination of the trustee's rights. In re Giles, 92 B.R. at 698.
Contrary to this line of reasoning, the word "termination" does not appear in § 365(d)(4). Moreover,
that a lease is "deemed rejected" in § 365(d)(4) cannot uniquely cause it to be "terminated," when no
such consequence follows a "deemed rejection" in § 365(d)(1), and termination precedes a "deemed
rejection" under the terms of § 365(d)(5) (providing that an air carrier's lease of an aircraft terminal
or gate may be "deemed rejected" five days after the occurrence of a "termination event"). Section
365 o ffers no textual support for equating "breach plus surrender" with "termination;" to the
contrary, it furnishes good reasons for deducing that Congress did not collapse breach or rejection
into the termination of a lease or executory contract.
If, notwithstanding the foregoing discussion, a § 365(d)(4) deemed rejection of a lease or
executory contract automatically brings about its termination, it is peculiar that the most adverse
consequences of that statutory interpretation are reserved not for the lessor or lessee—either of which
may be the party opposite the debtor—but for the third-party mortgagee whose rights have been held
forfeited by o peration of law. This result has no policy rationale within the scope of § 365's
adjustment of rights between the parties to the lease. Moreover, it is a capricious result that makes
no bankruptcy sense. While the Bankruptcy Code expressly authorizes avoidance of certain liens and
other preferential rights against the debtor, see, e.g., 11 U.S.C. §§ 544, 547 and 548, the avoidance
power read into § 365 is, uncharacteristically, an implied authority. See Andrew, supra, 59
U.Colo.L.Rev. at 901-02. Moreover, the trustee's avoidance powers may ordinarily be exercised only
by means of an adversary proceeding, with its attendant procedural protections, whereas the §
365(d)(4) "forfeitures" of security interests have occurred automatically, by operation of law, without
procedural protections. Finally, in eliminating the rights of a mortgagee of the debtor-lessee's interest
in a lease, the policies justifying avoidance—to enhance the pot of unencumbered assets available to
creditors and to discourage a race to the courthouse before bankruptcy—have not been served. The
only right s affected by this implied avoidance power are outside of the bankruptcy court's realm
because after rejection, the debtor's estate is no longer involved in the leasehold transaction. This
extraordinary implied po wer does not reduce claims against the debtor's estate; if anything, it
increases the unsecured claims by the amount of the mortgagee's claim in the "terminated" lease.
For these reasons, we conclude that a debtor's inaction in timely deciding to assume or reject
a lease of nonresidential real property under § 365(d)(4), which leads to a deemed rejection, does not
effect a termination of that lease, or, consequently, an implied forfeiture of the rights of third parties
to the lease.
As applied to the case at hand, § 365(d)(4) stipulates that when Austin failed timely to
assume or reject its lease from Sowashee, the lease was breached and Austin was required to
surrender t he premises. Sowashee became entitled to file a proof of claim based on a "breach"
effective immediately before Austin's bankruptcy. 11 U.S.C. § 502(g). Sowashee was also entitled
to receive rent from the filing of bankruptcy to the date of lease rejection. 11 U.S.C. § 365(d)(3).
Because the lease did not terminate upon its deemed rejection, Eastover retained rights in it
against Sowashee as a third-party beneficiary of ¶ 21 of the Austin-Sowashee lease. The extent of
East over's rights, an issue not adjudicated below, should be decided in state court, because after
rejection the debtor's estate had no remaining interest in the outcome of that controversy, which is
not "related to" the bankruptcy as is required for federal jurisdiction. 28 U.S.C. § 1334(b).
CONCLUSION
The judgments of the district and bankruptcy courts are REVERSED and the case is
REMANDED for further proceedings consistent herewith.