Restructuring

Contributed by Cristine Pirro
We often assume that rejection of an unexpired lease or executory contract in bankruptcy automatically results in the termination of the lease or contract, even though section 365(g)(1) of the Bankruptcy Code simply states that rejection constitutes a prepetition breach.  Indeed, the only place in section 365 that explicitly cuts off a debtor’s continuing liability is section 365(k) of the Bankruptcy Code, which relieves the estate from any continuing liability under a contract or lease that has been assumed and assigned.  In the real property context, the most specific reference to termination of a lease following rejection is in section 365(d)(4) of the Bankruptcy Code, which provides that, upon  a “deemed rejection” of a non-residential real property lease as a result of a failure by the trustee or the debtor lessee to timely assume the lease, the trustee or debtor in possession must immediately surrender the real property to the lessor.  What happens in other contexts, including the deemed rejection of a residential real property lease?  A bankruptcy court in the Southern District of Florida recently addressed such an issue and determined that, even though a residential real property lease had been deemed rejected under section 365(d)(1) of the Bankruptcy Code as a result of the chapter 7 trustee’s failure to timely assume the lease, the lease remained in effect after the debtor’s no-asset chapter 7 case was closed.  As a result, the individual debtor tenants remained liable to their landlord for unpaid rent incurred after the deemed rejection.
Prior to their chapter 7 filing, the individual debtors entered into a lease with Manatee Bay for the rental of a residential apartment.  After the debtors commenced their chapter 7 cases, they failed to list the lease as an unexpired lease in their schedules, and they failed to list Manatee Bay as a creditor.  Because the trustee determined there were no non-exempt assets to administer for the benefit of creditors, the debtors’ case was deemed a no-asset chapter 7 case.  Pursuant to a local rule, the court did not set a bar date, and creditors were not directed to file proofs of claims.
Perhaps as a result of the omission of the lease from the debtors’ schedules, the trustee failed to move to reject or assume the lease.  As such, the lease was deemed rejected 60 days after the petition date in accordance with section 365(d)(1) of the Bankruptcy Code.  Approximately three months after filing, the debtors received a discharge under section 727 of the Bankruptcy Code.
Presumably unaware of any deemed rejection of the Manatee Bay lease, the debtors continued living in their apartment and paying rent throughout their chapter 7 case.  Two months after their emergence from bankruptcy, though, the debtors defaulted on their rent payments.  Manatee Bay responded by filing a complaint in state court for unpaid rent, costs, attorneys’ fees, and possession of the premises.  The state court entered a final judgment in favor of Manatee Bay and then denied the debtors’ request for a rehearing to determine that any debt to Manatee Bay had been discharged in the debtors’ chapter 7 cases.
Not disheartened by the state court’s rejection of their argument, the debtors turned to the bankruptcy court and moved to reopen their chapter 7 case to amend their schedules to add Manatee Bay as a creditor.  The bankruptcy court reopened the case and allowed the debtors to amend their schedules.  Within a week, the debtors commenced an adversary proceeding, arguing that because they entered into the lease prepetition, all amounts due under the lease – including amounts due after the debtors received their discharge – were prepetition claims that were discharged.  In the alternative, the debtors argued that the deemed rejection of the apartment lease under section 365(d)(1) gave rise to a prepetition breach of the lease agreement pursuant to section 365(g)(1) of the Bankruptcy Code and a corresponding prepetition claim that was discharged under section 727(b) of the Bankruptcy Code.
In rejecting this analysis, the bankruptcy court first turned to Florida law, which governed the lease agreement.  Under Florida law, a claim for rent under a lease arises when rent is due under the terms of that lease, rather than at the time the lease is entered into.  Thus, because the debtors defaulted after entry of the discharge, Manatee Bay’s claim for nonpayment also arose after the discharge.  Thus, Manatee Bay’s claim was not discharged under section 727 of the Bankruptcy Code.
How, then, is it possible that the debtors’ obligations under the lease did not terminate upon the deemed rejection, and the liability under the rejected lease was not discharged upon closure of the case?  The court explained that a close reading of the applicable provisions of the Bankruptcy Code did not support the argument that simply because a lease is rejected, it is also terminated and subject to discharge.  The court first turned to section 502(b) of the Bankruptcy Code, which governs whether a debt that does not arise prepetition may otherwise be treated as a prepetition debt.  If the claim was for damages resulting from the rejection of a lease under either section 502(b)(6) or 502(g)(1), Manatee Bay arguably could have had a prepetition claim.  Manatee Bay’s claim, however, did not arise from the rejection of the lease agreement, and so could not have been for damages resulting from termination of the lease upon rejection.
A breach of the lease, in the debtors’ case, did not lead to termination of the lease.  A non-debtor lessor has the option of treating a rejected lease as still in effect.  Then, should the debtor default in the future, the lease is subject to enforcement under applicable (non-bankruptcy) law.  Interestingly, Florida law provides that the failure to take advantage of a breach leads to the waiver of such a right.  See Fla. Stat. § 83.56 (5)(1999).  The court applied this law and determined that Manatee Bay waived its right to terminate the agreement upon the breach that occurred when the lease was deemed to have been rejected.  Due to this waiver, the lease remained in effect, and the debtors’ post-discharge breach was a new breach not discharged under the court’s prior discharge order.
Although this decision arises in the context of a residential lease in a chapter 7 case of two individuals, the issue of termination of an unexpired lease or an executory contract after rejection, whether deemed or not, remains an issue for all debtors, as well as their contractual counterparties.  Debtors should be clear that rejection results in termination, and counterparties should understand the consequences of possible waiver arguments that result from continued performance.