When a party to a lease files for bankruptcy protection, the effect of bankruptcy laws upon the party's lease can be significant. It is essential for one involved in the leasing of real property to understand the impact of certain bankruptcy laws upon a lease transaction. This is especially true for a subtenant in the context of a sublandlord's bankruptcy. While a subtenant's rights in this circumstance typically are tenuous, a subtenant may employ mechanisms to protect the subtenant's interests.
The Syufy Case
In the recent case of Syufy Enterprises, L.P. v. City of Oakland, 104 Cal. App. 4th 869 (2002), the court held that when a master lease is deemed rejected in a bankruptcy proceeding, a subtenant may lose possession of the subleased premises. Syufy serves as a blaring warning to a subtenant whose sublandlord has severe financial problems and files for bankruptcy.
In Syufy, the master landlord ("Master Landlord") gave its tenant ("Sublandlord") consent to sublease a portion of the premises to a subtenant ("Syufy"). The Master Landlord and the Sublandlord amended the master lease to state that the Master Landlord "understood and agreed" that the Sublandlord was permitted to enter into a sublease with Syufy and that the Sublandlord intended for Syufy to construct improvements on the subleased premises. After Syufy and the Sublandlord executed the sublease, Syufy expended significant funds to construct a movie theater on the site. A few years later, Syufy substantially remodeled the facility. Eventually, disputes arose between the Master Landlord and the Sublandlord because the Sublandlord was in default under the master lease.
While Syufy received copies of notices served upon the Sublandlord relating to the Sublandlord's default, the Master Landlord assured Syufy that it did not intend to disturb Syufy's tenancy. Eventually, the Master Landlord filed an unlawful detainer action against the Sublandlord and the Sublandlord filed for chapter 11 bankruptcy protection. In the bankruptcy proceeding, the Sublandlord's bankruptcy trustee filed a motion to assume the master lease. The bankruptcy court denied the motion based on events that had occurred in course of the unlawful detainer action and ordered the Sublandlord to vacate the premises. The failure to assume the master lease amounted to a "deemed rejection" of the master lease in the bankruptcy proceeding.
Syufy was unaware of the Sublandlord's bankruptcy proceeding until it received a letter from the Master Landlord regarding the bankruptcy court's order for the Sublandlord to vacate the premises. The Master Landlord explained in its letter that the master lease had been terminated and that Syufy's sublease had also been effectively terminated, but the Master Landlord also assured Syufy that Syufy could continue to occupy the premises on a month-to-month basis. The Master Landlord subsequently informed Syufy that it did not intend to disturb Syufy's tenancy and that it planned to formalize a new, direct lease with Syufy. Although the Master Landlord did not prepare a new lease for Syufy, Syufy relied on the Master Landlord's assurances and continued to operate the theater.
Approximately two years later, the Master Landlord decided to market the site and delivered to Syufy a notice of termination, ordering Syufy to vacate the premises within thirty days. In response, Syufy filed suit against the Master Landlord for damages and other redress. The Master Landlord filed a pretrial motion in that proceeding, seeking adjudication of whether the Sublandlord's deemed rejection of the master lease in the bankruptcy proceeding effectively terminated Syufy's rights under the sublease. The trial court decided this issue in the Master Landlord's favor and dismissed Syufy's complaint. On appeal by Syufy, the California Court of Appeal analyzed whether Syufy had a right to remain on the premises despite the deemed rejection of the master lease in bankruptcy. The Court of Appeal's analysis in Syufy hinged upon principles of federal bankruptcy law and California landlord-tenant law.
"Deemed Rejection" in Bankruptcy
United States Bankruptcy Code Section 365 enables a bankruptcy trustee or a debtor in possession in a chapter 11 bankruptcy case to assume or reject an unexpired lease held by a debtor as lessee. However, if the trustee or debtor in possession does not assume or reject the lease within sixty days after the date of the order of relief (or by such other date as the court may order), then the lease is deemed rejected, and the trustee must immediately surrender the real property to the lessor. In Syufy, the bankruptcy trustee's failure to assume the master lease unquestionably resulted in a deemed rejection of the master lease. The novel issue addressed in Syufy was the effect of the deemed rejection on a third party, namely a subtenant, with respect to its rights under the rejected lease.
Bankruptcy courts have developed two divergent views regarding the effect of a deemed rejection of a lease in bankruptcy. The traditional view, and that embraced by several bankruptcy courts, is that a deemed rejection results in a complete termination of the lease, extinguishing the tenant's right to possession, as well as the other covenants, rights and remedies set forth in or appurtenant to the lease. Under this view, a subtenant's rights are automatically extinguished when the lease is deemed rejected. However, the emerging view, and the current trend in Ninth Circuit bankruptcy cases, is that a deemed rejection constitutes a breach of the lease, but not an extinguishment of the tenant's other covenants, rights and remedies in or appurtenant to the lease. Under the emerging view, a third party's rights may not necessarily be extinguished by the debtor's rejection of the lease. Even under the emerging view, however, rejection terminates the tenant's right of possession, although other covenants, rights and remedies may survive.
Syufy adopted the emerging view that a deemed rejection results in a breach rather than a termination. Under this view, despite the deemed rejection of the master lease, Syufy stood a chance of salvaging its interest in the subleased premises. However, the ultimate outcome was dependent upon state law.
Application of State Law
The Syufy court turned to California law to address the extent to which a subtenant retains rights in a master lease after a sublandlord's breach. Under California law, a subtenant's rights are dependent upon and subject to the sublandlord's rights. Thus, the rights of a subtenant sink or float with those of the sublandlord. Syufy, however, claimed that it was more than a typical subtenant. Specifically, Syufy asserted that it was a third party beneficiary of the master lease and that it enjoyed rights greater than those of an ordinary subtenant, particularly the right to continued possession of the subleased premises. Syufy argued that its third party beneficiary status was created by the amendment to the master lease, in which the Master Landlord expressly permitted the Sublandlord to enter into a sublease with Syufy and acknowledged that Syufy would construct improvements on the subleased premises. The Court of Appeal concluded that while Syufy may have been a third party beneficiary with respect to the amendment, the amendment did not provide Syufy with a greater right to remain in possession of the premises than was enjoyed by the Sublandlord. Essentially, the court found that Syufy's right to possession was based entirely on the master lease and its derivative sublease. Consequently, when the master lease was deemed rejected, there was a breach under the master lease pursuant to which the Master Landlord had an unconditional right under California law to regain possession of the entire leased premises, including the subleased premises.
Ultimately, even though (i) the Master Landlord expressly approved the sublease and Syufy's improvements to the leased premises, (ii) Syufy spent substantial funds to build, operate and expand the theater, (iii) the Master Landlord gave repeated assurances that it did not intend to disturb Syufy's tenancy and (iv) Syufy adopted the emerging view that a tenant's deemed rejection in bankruptcy does not result in a complete termination of the master lease, under California law Syufy's right to possess the subleased premises was extinguished along with the master lease.
While Syufy serves as a warning that the rights of a subtenant, particularly in the context of a bankrupt sublandlord, may be quite weak, the case also serves as a guide. Syufy demonstrates that a subtenant cannot simply rely on assurances or other represen-tations by a master landlord. Rather, a subtenant must be proactive and plan ahead by utilizing mechanisms available to ensure its continued possession of subleased premises in the event the master lease is terminated.
Recognition Provisions
The primary tool that a subtenant may employ to protect its interest in subleased premises is a recognition provision. Such a provision typically provides that if the master lease terminates, the subtenant will render performance to the master landlord, and the master landlord will recognize the sublease (i.e., not disturb the subtenant's possession of the premises) so long as the subtenant is not in default under the sublease. When a recognition provision is negotiated between a subtenant and a master landlord directly, it is contained in a separate agreement, typically called a consent to sublease.
Sometimes, a recognition provision is contained in the master lease itself. Therefore, when planning to enter into a sublease, it is imperative for a prospective subtenant to first look to the master lease to see if such a provision exists. If the master lease contains an appropriate recognition provision, in the event of a sublandlord's rejection of the master lease in bankruptcy, a subtenant will be construed as a third party beneficiary of the recognition provision and the subtenant's right to possess the subleased premises will be protected. In Syufy, the master lease contained an amendment in which the Master Landlord agreed to and acknowledged Syufy's sub-tenancy, but the Master Landlord never agreed to recognize Syufy's sublease in the event the master lease was terminated. This was precisely why the Syufy court could not construe Syufy as a third party beneficiary with rights distinct from those of the Sublandlord.
Negotiating a recognition provision generally is not a simple task and a master landlord is often unwilling to agree to such a provision. A master landlord may be very rigid with respect to the terms and conditions upon which it will recog-nize a subtenant. If a subtenant is subleasing only a portion of premises, the master landlord may not want to recognize the subtenant at all. This is because in the event the tenant/ sublandlord vacates the premises, the master landlord may have difficulty procuring a new tenant to rent only the vacated portion of the premises. As an example, if a tenant leases an entire floor of a commercial building but the subtenant subleases only a portion of that floor, the master landlord may resist recognizing the sublease because leasing an entire floor is usually easier than leasing just a portion of a floor.
In addition, a master landlord will often try to condition a recognition provision upon the subtenant's "stepping into the shoes" of the sublandlord and accepting the terms and conditions of the master lease, namely the rental rate. This is because, typically, a commercial subtenant's rental rate is less than that of a tenant, and a master landlord has little or no incentive to recognize the subtenant at a discounted rate. A savvy master landlord may also negotiate for an option to recognize or not recognize the subtenant in its sole and absolute discretion. A subtenant, though, may not want to pay the higher rental rate under the master lease (as opposed to the discounted sublease rate) for its own financial reasons. While a recognition provision is often difficult to obtain, a prospective subtenant should be aware that such a provision does exist and, with skilled negotiating, a subtenant may be able to protect its interest in subleased premises.
Subtenants Are Vulnerable
Ultimately, a subtenant like Syufy should be aware that it is highly vulnerable in the context of a bankrupt sublandlord. Given the risk of losing costly improvements and possession of subleased premises, a subtenant should be cognizant of the tools available to protect its interests and secure its investment in subleased premises. While tools like recognition agreements are not foolproof, they can be effective in some situations. The alternative -- extinguishment of the sublease and the right to possession -- compels meaningful consideration of such tools.
Jackie K. Park is a Partner in the Los Angeles office and may be contacted via e-mail at jackie.park@pillsburywinthrop.com or by phone at (213) 488-7520.
Andrea H. Slutske is an associate in the Los Angeles office and may be contacted via e-mail at aslutske@pillsburywinthrop.com or by phone at (213) 488-7220.
Pillsbury Winthrop LLP is a global law firm with power and presence on both U.S. coasts and abroad, with core practice areas in: real estate, litigation, technology and intellectual property, energy, capital markets and finance. The firm has 17 offices and approximately 800 attorneys worldwide. For further information on the firm's real estate practice, please contact Jim Rishwain at jrishwain@pillsburywinthrop.com or (310) 203-1111.