A Delaware Bankruptcy Court recently ruled that a debtor cannot assume only certain portions of a real property lease covering several, separate properties; instead the debtor must assume the entire lease (cum onere) or reject the entire lease. See In re Contract Research, Inc., 12-11004 (Bankr. D. Del. May 1, 2013) (KJC). This case is a good example of how state law intersects with the Bankruptcy Code’s restructuring provisions.
After filing bankruptcy, one of the debtors, Allied Research International, Inc. (Allied), filed a motion to sever and reject a third amendment to a prepetition lease agreement, which governed two non-adjacent buildings. The original lease and the first two amendments to the lease agreement, which Allied intended to keep in place, governed the original building leased to the Debtor. The third amendment added an unattached building to the original lease agreement. Because Allied was not utilizing the building covered by the third amendment, it sought to sever this amendment from the original lease agreement and reject the amendment, thereby relieving the Debtor from any further obligations to the additional building.
Assumption or Rejection
Section 365 of the Bankruptcy Code permits a bankruptcy trustee or debtor-in-possession to assume or reject an unexpired lease. When a debtor-in-possession (debtor) assumes a lease, it essentially reaffirms its existence and agrees to continue the lease as if the lease was not affected by the bankruptcy. When a debtor rejects a lease, it essentially is released from honoring the lease terms moving forward.
However, pursuant to case law, assumption or rejection of a lease must be done in its entirety, i.e., the lease generally cannot be assumed or rejected in part. See, e.g., In re Fleming Co., Inc., 499 F.3d 300, 308 (3d Cir. 2007). The rationale underlying this bankruptcy principle is that a debtor may not retain the benefits of a lease without accepting its burdens.
Notwithstanding this principle, bankruptcy often affords a court the opportunity to re-characterize the nature of an agreement. Indeed, a court can review a single contract to determine whether it includes multiple agreements that are severable, thereby allowing a debtor to assume portions of the contract while rejecting other severable parts. See, e.g., In re Buffet Holdings, Inc., 387 B.R. 115, 120 (Bankr. D. Del. 2008). This exception seems to fly in the face of the general rule that a lease must be assumed or rejected in its entirety.
However, the key to understanding the exception is understanding the implications of state law in determining a debtor’s rights and interests in a bankruptcy case. As a general matter, state law determines a debtor’s rights and interests in property, contracts, licenses, leases, etc. Except in certain areas specifically addressed by the Bankruptcy Code, these rights and interests are not altered merely because a debtor files bankruptcy. For example, if a lease expired prior to a bankruptcy filing, such lease generally cannot be revived by the mere act of filing bankruptcy. In such instance, the only rights that a debtor’s estate inherits are the rights under an expired lease, as defined by state law.
The threshold issue in the Contract Research case was whether (a) the original lease agreement and third amendment represented two independent agreements or (b) such agreements were part of a single, integrated contract between the parties. The bankruptcy court turned to state law for the correct characterization.
The original lease agreement contained a provision that instructed that the lease was to be interpreted and enforced under Florida law. Under Florida law, whether a contract is severable turns on the intent of the parties. See Local 234 of United Ass’n of Journeymen & Apprentices v. Henley & Bockwith, Inc., 66 So.2d 818, 822 (Fla. 1953). Absent ambiguity, the intent of the parties is gleaned from the four corners of the contract. See Gardinier, Inc., 831 F.2d 974, 976 (11th Cir. 1987). To determine the parties’ intent from the four corners, a court may examine whether:
- the nature and purpose of the agreements are different;
- the consideration for each agreement is separate and distinct; and
- the parties’ obligations under the agreements are interrelated.
At first blush, one might think that the third amendment appears to be a separate agreement because, unlike the first two amendments and the original lease, the third amendment adds a separate building to the original lease, with additional rent and additional obligations. The bankruptcy court did not see it this way, however.
The bankruptcy court focused on two provisions in the lease to arrive at the parties’ intent. Section 1 of the third amendment stated that “the following provisions [in the third amendment] shall either be deleted from the [original] Lease or amended and restated as hereinafter set forth.” Section 2 of the third amendment stated:
Except as modified by this Third Amendment, all other terms and conditions of the [original] Lease shall be unmodified and shall remain in full force and effect and are hereby ratified, confirmed and approved in all aspects.
According to the bankruptcy court, these provisions suggest a direct connection between the original lease and the third amendment, demonstrating the integrated nature of these documents.
The bankruptcy court also was not persuaded by the argument that a severability clause made the lease severable, as such clause only applied in instances where certain provisions in the lease are not legally valid and enforceable.
Finally, the bankruptcy court distinguished a leading case in the 11th Circuit Court of Appeals, where the Circuit Court held that a single instrument for the sale of land was severable. See Gardinier, 831 F.2d at 974-75. The term in the instrument that was severable was a provision that instructed how the real estate broker would be compensated. According to the bankruptcy court, the 11th Circuit in Gardinier focused on the separateness of the promisor and promisee, as well as the separate consideration involved for each transaction. In other words, one agreement was between the buyer and seller for the sale of real property and another agreement was between the seller and the broker (with no obligations running between the buyer and broker) for the payment of the commission.
The bankruptcy court distinguished Gardinier from Allied’s lease situation on several grounds. First, there were many interrelated provisions that applied to both buildings, including the extension of the lease term for both buildings. Second, the same promisor and promisee were involved with the original lease and the third amendment. Third, apart from the lease agreement in question, the same parties had a separate lease for another building, which demonstrated that the parties knew how to create separate agreements. The bankruptcy court therefore concluded that the third amendment could not be severed from the original lease and rejected.
This case demonstrates how state law can never be ignored even when confronted with situations where specific provisions in the Bankruptcy Code, i.e., section 365, enable a debtor to restructure its pre-bankruptcy rights and obligations. While the debtor did not prevail in this case, one can easily contemplate a situation where the debtor could prevail; such as when an amendment contains less detailed integration language or where there are different promisors and promisees involved in different agreements. Other states may also use different factors to determine when a contract is severable, and such factors must be taken into consideration. But, under Florida law, it appears that an integrated lease that covers different properties is not severable, per se, and therefore must be assumed or rejected in its entirety.