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A Funny Thing Happened to my Ground Lease In Bankruptcy Court

Ground leases are an important — if somewhat uncommon — part of the genuine estate financing market. Because they normally cover big expensive residential or commercial properties like Rockefeller Center and The Empire State Building, to name 2, and last a long time (99 years and as much as begin) the possibility of something unanticipated or unexpected happening is high. This likelihood increases drastically if, as highlighted below, one or both of the lease parties’ files for bankruptcy. Accordingly, realty specialists ought to remember and make sure when participating in any deal including a ground lease.

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Ground leases have actually been around since the Middle Ages and bankruptcy laws have existed given that at least Roman Times. Given this long history, it is not a surprise that a lot of law has actually established on the interaction of personal bankruptcy and ground leases. This is especially so because the development of the «modern-day» United States Bankruptcy Act in 1898 and the substantial changes to title 11 of the United States Code executed to it in 1978, when Chapter 11 of the United States Bankruptcy Code (the «Code») was enacted. [1] In specific, Section 365 of the Code supplies special rules for the presumption or rejection of a ground lease-as well as its potential sale and transfer by a debtor to a 3rd party.

Knowing these guidelines is critical to any real-estate professional. Here are the essentials:

A ground lease, often referred to as a «land lease,» is a distinctive mechanism for the development of commercial realty, taken pleasure in by those entrusted with establishing the Rockefeller Center and the Empire State Building, for example. The arrangement enables extended lease terms typically approximately 99 years (with the choice of renewal) for the landowner to retain ownership of the land and collect rent while the designer, in theory, might surpass the land to its benefit as well. Both traditionally and currently, this irregular relationship in the property space creates adequate discussion weighing the structure’s advantages and disadvantages, which naturally grow more complicated in the face of a ground lessor or ground lessee’s insolvency.

According to a lot of courts, including the Second Circuit, the limit question in analyzing the aforementioned possibilities relating to a ground lease in bankruptcy court is whether the ground lease in concern is a «real lease» for the purpose of Section 365. Section 365 uses, making the ground lease eligible for, assumption or rejection, just if it is a «real lease.» [2] While exactly what makes up a «real lease» will vary state by state, it is commonly accepted that «the proper questions for a court in figuring out whether § 365 [] governs an arrangement fixing residential or commercial property rights is whether ‘the celebrations planned to impose responsibilities and provide rights significantly various from those occurring from the ordinary landlord/tenant relationship.'» Intl. Trade Ad. v. Rensselaer Polytechnic, 936 F. 2d 744 (2d Cir. 1991). This «intent» is figured out based upon that of the celebrations at the time of the lease’s execution. In re Big Buck Brewery Steakhouse, Bkrptcy No. 04-56761-SWR, Case No. 05-CV-74866 (E.D. Mich. Mar. 9, 2006). Despite there being «a ‘strong anticipation that a deed and lease … are what they profess to be,'» the economic substance of the lease is the primary determination of whether the lease is considered «true» or not, and in some states (like California), is the only proper element to weigh. Liona Corp., N.V. v. (In re PCH Associates), 804 F. 2d 193 (2d Cir. 1986) pointing out Fox v. Peck Iron & Metal Co., 25 Bankr. 674, 688 (Bankr. S.D. Cal. 1982). Generally, the further away those «financial truths» are from the common landlord/tenant relationship, the less most likely a lease will be thought about a «true lease» for the function of Section 365. Id. For instance, if residential or commercial property was acquired by the lessor particularly for the lessee’s usage or exclusively to protect tax benefits, or for a purchase price unassociated to the land’s value, it is less likely to be a real lease.

If the ground lease remains in reality determined to be a «real lease» (and based on court approval), the appointed trustee or debtor-in-possession in a personal bankruptcy case might then either assume or reject the lease as it would any other unexpired lease held by the debtor.

However, exceptions use. These greatly count on a debtor’s «appropriate assurances» to the staying parties to the arrangements. Section 365 of the Code supplies that if there has actually been a default on a debtor’s unexpired lease, the DIP may not presume the aforementioned lease unless, at the time of assumption, the DIP: (i) remedies or provides «adequate assurance» that they will in reality «without delay treat [] such default»; (ii) compensates or provides «appropriate assurance» that they will «promptly compensate» celebrations to the agreements (other than the debtor) for any monetary loss developing from such default; and (iii) offers «appropriate guarantee» of their future performance under that lease. See 11 U.S.C. § 365(b).

Unrelated to «adequate assurance» are the exceptions that even more bar assignment or assumption of leases in the event that suitable law excuses a party from accepting performance from a celebration other than the DIP and they decide to exercise such right, see 11 U.S.C. § 365(c)( 1 ); the contract’s purpose is to produce a loan or funding to the debtor, see 11 U.S.C. § 365(c)( 2 ); or the lease at concern is of nonresidential real residential or commercial property and has been terminated under other (non-bankruptcy) law prior to the order for relief, see 11 U.S.C. § 365(c)( 3 ).

If, on the other hand, a DIP does not desire to assume or appoint the lease, it can reject any existing unexpired arrangements held by the debtor. The most usually mentioned arrangement governing rejection of a lease impacted by a personal bankruptcy case is Section 365(d)( 4 ), which supplies:

«If the [DIP] does not presume or turn down an unexpired lease of nonresidential genuine residential or commercial property under which the debtor is the lessee within [sixty] 60 days after the date of the order for relief … then such lease is considered declined, and the [DIP] will instantly surrender such nonresidential genuine residential or commercial property to the lessor.» See 11 U.S.C. § 365(d)( 4 ). [3]

Courts have just recently held that this rejection «has the very same effect as a contract breach outside insolvency,» providing the counterparty a claim for damages, «while leaving undamaged the rights the counterparty has actually received under the contract.» Mission Product Holdings, Inc. v. Tempnology, LLC, 587 U.S. ___ (2019 ). While this «breach-by-rejection» (a term coined by the courts) will typically result in the agreement’s termination, it is very important to keep in mind that rejection alone will not terminate the responsibilities imposed by the lease.

Real residential or commercial property is distinctive, and also, realty financing options are countless and change daily as the marketplace changes. Ground leases are all special.

As can readily be recognized from the summary above, handling a particular ground lease in the context of a Chapter 11 personal bankruptcy can be lawfully and factually complicated. Therefore, when drafting or amending ground leases, property managers, leasehold investors, and mortgagees ought to seek advice from educated legal counsel and commercial property experts who comprehend and can describe what can take place to a specific lease in a Chapter 11 case.

For more info, contact Christopher F. Graham, Partner at grahamc@whiteandwilliams.com or 212.714.3066; or Morgan A. Goldstein, Associate at goldsteinm@whiteandwilliams.com or 475.977.8302. Or you might reach out to another member of our Financial Restructuring and Bankruptcy Practice.

[1] «Apart from certain unique arrangements, the Bankruptcy Code generally leaves the decision of residential or commercial property rights in the possessions of a bankrupt’s estate to state law.» See Butner v. United States, 440 U.S. 48 (1979 ).

[2] If the lease examined is not a «true lease,» it will be considered a «finance lease,» in which the trustee or debtor-in-possession («DIP») owns the land and the proprietor is dealt with as the lending institution.

[3] Generally, «… a debtor in belongings shall have all the rights … and powers and shall carry out all the functions and tasks … of a trustee serving in a case under this chapter.» See 11 U.S. Code § 1107(a).