In the Matter of Austin Development Company, Debtor. Eastover Bank for Savings v. Sowashee Venture v. Austin Development Company and J.C. Bell, TrusteeIn the Matter of Austin Development Company, Debtor. Eastover Bank for Savings v. Sowashee Venture v. Austin Development Company and J.C. Bell, Trustee
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, Appellants.
No. 93-7127.
United States Court of Appeals,
Fifth Circuit.
May 3, 1994.
Pat H. Scanlon, John S. Simpson, Young, Scanlon & Sessum, Jackson, MS, for appellant.
Thomas E. Schwartz, Hattiesburg, MS, for Bell.
Thomas L. Webb, Bourdeaux & Jones, Meridian, MS, for Sowashee Venture.
Robert H. Compton, Witherspoon & Compton, Meridian, MS, for R & S Theaters, Inc.
P. Scott Phillips, William & Glover, Meridian, MS, for United Artists.
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 stream 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. Sec. 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 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 then 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, of 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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.,
Flawed by their failure to analyze Sec. 365(d)(4) in harmony with the rest of Sec. 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 Sec. 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,
Turning to Sec. 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,
The decision to reject is thus correctly viewed only 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 Sec. 365. "Termination" is used in Sec. 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, Sec. 365(h)(1), or a license, Sec. 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. Sec. 365(h)(1) and Sec. 365(n)(1). In Sec. 365(h)(1), rejection is used synonymously with "disaffirmance" for these purposes; in none of these subsections is rejection or disaffirmance equated with termination. Under an objective reading, the provisions of Sec. 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.,
The cases that equate rejection with lease termination under Sec. 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 within 60 days is "so serious" that Sec. 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,
If, notwithstanding the foregoing discussion, a Sec. 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 operation of law. This result has no policy rationale within the scope of Sec. 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. Secs. 544, 547 and 548, the avoidance power read into Sec. 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 Sec. 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 rights 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 power 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 Sec. 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, Sec. 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 the premises. Sowashee became entitled to file a proof of claim based on a "breach" effective immediately before Austin's bankruptcy. 11 U.S.C. Sec. 502(g). Sowashee was also entitled to receive rent from the filing of bankruptcy to the date of lease rejection. 11 U.S.C. Sec. 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 p 21 of the Austin-Sowashee lease. The extent of Eastover'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. Sec. 1334(b).
CONCLUSION
The judgments of the district and bankruptcy courts are REVERSED and the case is REMANDED for further proceedings consistent herewith.
Notes
11 U.S.C. Sec. 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.
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 Sec. 365(d)(4) on the theater's sublease from the debtor
Compare In re Gillis,
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
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 Sec. 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,
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 Sec. 365(d)(4) on mortgagees of a debtor's leasehold. It is true that Sec. 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,
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
In Wainer v. A.J. Equities, Ltd.,
A particularly thoughtful bankruptcy court opinion recently concluded that under 11 U.S.C. Sec. 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.,