Surrey Hotel Involuntary Bankruptcy: Will Mission Product control the outcome of ground tenant lease rejection and the survival of subordinate interests?
On April 26, 2020, Surrey NY LLC (the Petitioner), the holder of a leasehold mortgage on the Surrey Hotel—an upscale hotel in the heart of Manhattan, filed an involuntary bankruptcy petition against 20 East 76th Street Co., LLC, the operator of the Surrey Hotel.[1] The Surrey was yet another victim of the COVID-19 crisis, and found itself unable to pay its ground lease rent.
The filing of the involuntary raises important questions for commercial real estate owners and lenders, as well as hotel operators. The case has the potential to address certain questions that are highly pertinent in this COVID era, including the ability of a bankruptcy court to abate a rent obligation more willingly than a state court. But equally significant, this case could address potentially unresolved issues in the recent decision of the Supreme Court in Mission Product Holdings, Inc v. Tempnology, LLC., 139 S.Ct. 1652 (2019). The issue—simply stated—is the consequence of a debtor/ground lessee’s rejection of a ground lease and the consequence on the ground lessee’s mortgage lender. More broadly, it raises again the meaning of rejection of an executory contract under bankruptcy law and the long standing judicial split on the meaning of lease rejection.
The ground lease financing: possible risk of leasehold termination
The operator of the Surrey Hotel—20 East 76th Street Co, LLC is the ground tenant under the terms of a long term ground lease with Surrey Realty Associates, LCC (the “ground lessor”). The Surrey had in addition obtained a mortgage from Surrey NY LLC (the “Petitioner”) in the amount of $45 million, which mortgage was secured by the Surrey’s interest as tenant in the ground lease.
According to the pleadings filed in the case, the Surrey “suspended” operations at the hotel on March 23, 2020 due to the COVID-19 pandemic.[2] According to the ground lessor, the Surrey has not paid rent for April, May and June, which totaled $1,575,000.[3]
Given the alleged failure to pay ground rent, the Petitioner, as mortgage lender, was arguably concerned that the ground lessor might seek to declare a default and then terminate the ground lease, and thus possibly impair the mortgage lender’s interest. From the court pleadings, it does not appear that the ground lease was subordinated to the mortgage, meaning in effect, that if the ground lessor terminated the lease, then absent a contractual provision protecting the mortgage lender, the mortgage would be extinguished.
However, the ground lease in this case did contain contractual rights for the mortgage lender that protected it from a termination of the leasehold without the ground lessor having first provided it certain protections. For example, the ground lessor could not have terminated the ground lease without giving notice to the mortgage lender and an opportunity to cure the defaults.[4] According to the ground lessor, the mortgage lender had these contractual provisions, but refused to exercise its cure rights.[5] The pleadings do not disclose, however, whether the Petitioner had the additional right to become a substitute or new ground lessee as a result of the default. The pleadings suggest that earlier discussions about a possible assignment of the ground lease to the Petitioner had not led to an agreement.[6]
The involuntary petition:
The Petitioner apparently believed that it could protect its interest by filing an involuntary bankruptcy petition under § 303 of the Code. As mortgage lender it also had the right to foreclose on the leasehold estate, but for reasons which are not stated, it did not elect to pursue this state law remedy.
The Surrey answered the involuntary petition stating that the petition was defective because the Petitioner failed to join the required three creditors. The answer also contended that the Surrey could not fund nor maintain a chapter 11 case, and did not have the resources to contest the petition beyond the filing of an answer. According to the Surrey, the Petitioner filed the involuntary petition because of the “ground lessor’s wrongful and bad faith attempt to terminate the Ground Lease based on the alleged failure of the [Operator] to pay April rent in the midst of the worldwide COVID-19 pandemic.”[7]
The Ground Lessor filed a response, contending that the involuntary was wrongful; that the Petitioner failed to have three petitioning creditors,[8] that the alleged debtor cannot pay the costs of operating the hotel, including its union employees nor the payment of the ground rent and that the Petitioner, as mortgage lender could simply cure the defaults and or step into the shoes of the ground lessee. The Ground Lessor even stated it would not oppose an assumption and assignment of the ground lease provided it did not require any amendment to the ground lease. The Ground Lessor also denied it had terminated the ground lease as of April 27, 2020.[9]
Judge Glenn signed an order on June 4, 2020 giving the Petitioner until June 22, 2020 to have additional creditors join the petition. A status conference is set for June 30, 2020.
The deemed rejection risk yet again.
The real question with the Surrey bankruptcy is the effect of the possible rejection of the ground lease, and the effect of such rejection on the subordinated interest of the mortgage. If the petition is granted (and the court may not grant it for various reasons) and the court enters an “order for relief,” the Surrey should have to pay the rent on a current basis until it either assumes or rejects the ground lease.11U.S.C. § 365(d)(3). It only has 210 days at most to assume or reject the lease. If it wants to assume the lease it will have to cure all defaults. § 365(b)(1). If it doesn’t meet these time periods, the lease will be deemed rejected, and the debtor will be obligated to immediately surrender “that nonresidential real property to the lessor.” § 365(d)(4)(A).
Given the various statements made by the Surrey in its pleadings, it appears it lacks the resources to pay the rent timely and to cure any pre-bankruptcy defaults. And, if the Petitioner is not willing to cure the defaults, a deemed rejection seems very possible. If so, what happens to the mortgage if the ground lease is rejected?
The meaning of rejection in the ground lease/mortgagee context:
There has been a long standing divide among the courts on whether the rejection of a lease by a bankrupt tenant terminates the interest of subordinate interests, including both subtenants and leasehold mortgagees.[10] “With respect to non-residential real estate, however, a majority of courts have concluded that the express requirement for surrender upon failure to assume within the statutory period necessarily implies a termination of the leasehold estate.” In re Park, 275 B.R. 253, 257 (Bankr. E.D. Va. 2002). And another court added this: “Under this view, i.e., [a] deemed rejection terminates the master lease and all derivative interests in the property. . . .” Syufy Enters. LP v. City of Oakland, 104 Cal. App. 4th 869 (Cal. App. 2002). A bankruptcy court applied the same logic to hold that a rejection terminates the rights of a mortgagee on the leasehold. 366-386 Geary St., L.P. v. Superior Court, 219 Cal. App. 3d 1186, 1197–98, (Ct. App. 1990):
The court order terminating [the debtor’s ] interest in the leasehold extinguished real parties' security interest in the lease as well. (In re Giles Associates, Ltd. (W.D. Tex. 1988) 92 Bankr. 695, 696 [rejection terminates lease as to all parties, including mortgagee of debtor]; In re Gillis (D. Hawaii 1988) 92 Bankr. 461, 465-466 [termination of lease extinguished bank's security interest in lease since there was no remaining leasehold interest to which its security interest could attach]; . . . [S]ee 3 Powell on Real Property (1987) ¶ 461, p. 37-287 [“... a mortgage ceases to have consequence as an interest in land whenever the mortgagor's interest in the premises ends, as where a mortgagor-lessee surrenders the leased premises to his landlord”].)
The citation to Powell on Real Property seems significant. Does the mortgagor’s “surrender” of the property to the landlord mean the tenant ceases to have an interest in the land? The bankruptcy Code requires “surrender” upon termination. None of this has been conclusively established. For example, it appears that the Second Circuit has adopted the more modern view of Professor Michael Andrews. Thus, in In re Lavigne, 114 F.3d 379, 386–87 (2d Cir. 1997), the court stated that rejection does not “completely” terminate the contract, (albeit in a case that did not address either ground leases or § 365(d)(4):
While rejection is treated as a breach, it does not completely terminate the contract. see also 3 Collier on Bankruptcy (Lawrence P. King, et al. eds., 15th ed. 1996) (Collier) § 365.09[3] (breach is not termination of contract because, among other reasons, “[i]f rejection terminates the contract ... such termination may have consequences that affect parties other than [the parties] to the contract”); See generally Michael T. Andrew, Executory Contracts in Bankruptcy: Understanding “Rejection,” 59 U.Colo.L.Rev. 845 (1988) (Andrew). Thus, “[r]ejection merely frees the estate from the obligation to perform; it does not make the contract disappear.” In re The Drexel Burnham Lambert Group, 138 B.R. 687, 703 (Bkrtcy.S.D.N.Y.1992).
The Fifth Circuit addressed the specific issue of the effect of rejection of a ground lease on a ground lease mortgage in Matter of Austin Development Co.,19 F3d 1077 (5th Cir. 1994), cert denied, 513 U.S. 874 (1994). Judge Edith Jones writing for the 5th Circuit, held that rejection of a ground lease does not cause a rescission of the lease nor cause the mortgage holder to lose whatever rights it had under the terms of the ground lease. Judge Jones said that despite the rejection, the subordinate interests were not extinguished; whatever state law contractual rights they had viz a viz the ground lessor remained intact
The rights flowing to the mortgagee in Austin were not found in a separate nondisturbance agreement, but rather were embedded in the ground lease itself, and provided rights that were “similar to those found in nondisturbance agreements,” and made the mortgagee a third party beneficiary of the ground lease. Austin, 19 F.3d 1080. Because of the lack of privity, Judge Jones had to decide whether the rejection extinguished those rights found in the lease itself.
Judge Jones examined the body of case law that had equated rejection with termination, and found it wanting. She rejected the argument that the obligation of a tenant to “surrender” the premises after a deemed rejection meant that the lease was terminated. The rejection as termination view would make rejection of a lease an “avoidance” power, and not merely a breach of contract. She found no legislative nor policy basis for such a view which she saw as working a forfeiture on the rights of subordinate holders, among other issues.
She also held that the notion that the tenant’s rejection of a lease could extinguish the rights of a secured party in that lease was arguably “unconstitutional,”—a point which should not be ignored. 19 F.3d at 1081. Given that the mortgagee had agreed to a subordinate position, and that under state law, a foreclosure by a senior encumbrance extinguishes a junior encumbrance, this constitutional concern seem unfounded.
Regardless, Judge Jones held that whatever rights the mortgage lender had would have to resolved in state court, and that her ruling meant only that such rights were preserved—whatever they may be. 19 F.3d at 1084. This view is not accepted by all courts and seems to overlook the requirement to “surrender” the real property.[11]
Does Mission Product control in the context of leasehold rejection? If so, don’t the parties just return to state court?
The Supreme Court decision in Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019) seems at first to be more in keeping with Austin Development. The Court confirmed that rejection is not an avoidance power, but simply a decision not to assume; simply a breach of contract which gives rise to a damage claim. “For the reasons stated above, we hold that under Section 365, a debtor’s rejection of an executory contract in bankruptcy has the same effect as a breach outside bankruptcy. Such an act cannot rescind rights that the contract previously granted. Here, that construction of Section 365 means that the debtor-licensor’s rejection cannot revoke the trademark license.” 139 S.Ct. 1666.
Does Mission Product now pertain and govern what happens when a ground tenant rejects the ground lease and has granted a mortgage on its ground lease interest? It is certainly possible that the modern view of Mission Product will prevail if the issue is litigated in the Surrey bankruptcy. At least twice the Court noted that its view that rejection is a breach and not a termination or rescission applies to “any contract.” 139 S.Ct. at 1661 and 1662.
However, the question presented in the petition for certiorari in Mission Product did not address “any contract” but instead sought a narrow ruling on the effect of rejection by a licensor on its licensee.[12] There are important differences between what the Court was asked to rule upon, what it did rule upon, and the factual and legal context of a ground lease termination. The issue in Mission Product was a statutory question brought about because the Code’s protections for licensees seemed to omit any reference to trademark licensees. The Court did not consider the distinctive Congressional scheme for real estate leases and the requirement and meaning of the duty to “surrender” the property to the lessor upon the breach.
The Supreme Court in Mission Product answered the question posed in the cert petition by stating that rejection has the same effect as a breach would outside of bankruptcy. This was precisely what the cert petition sought—for application of an outcome that mirrors “applicable nonbankruptcy law.” Cert. Pet. at (i).
The amici in Mission Product said the only effect of rejection is to create a prepetition breach: “Section 365 does nothing more than that.”[13] But section 365 does do more. In the context of a real estate lease it mandates the surrender of possession—a transfer of the real estate interest back to the lessor. In this sense it is an avoidance power and sets the stage for the state law outcome. Recent decisions hold that this duty to surrender is consequential and preempts state law; that is, the ground lessor need not seek relief from the stay nor file an eviction action in state court.[14]
Congress has decided that the effect of a commercial tenant’s breach is to require the tenant to immediately surrender possession to the landlord. The state law outcome in commercial leases for a tenant rejection should flow from this surrender of possession. Doesn’t Powell on Real Property, above, suggest this. So then this question arises—if under the Code the rejection requires the debtor to surrender its possessory interest, and the possessory interests reverts back to the landlord, has the real estate interest terminated under state law?
Mission Product did not truly address this issue. Both the Congressional scheme, and the state law outcome that flow from this scheme, do not mirror the intellectual property scheme. The amicus brief in Mission Product co-authored by Professor Jay Lawrence Westbrook, the leading scholar on the issue of rejection/termination, does not cite nor address § 365(d)(4)(A).[15] Nor is § 365(d)(4)(A) discussed in the principal brief of the Petitioner. Given this, is it correct to view Mission Product as controlling the outcome under a different statutory scheme?
What happens next?
In balance, it is doubtful the court will reach the question of leasehold rejection given the number of barriers to this case continuing. And, if for some reason it does, it would seem that Mission Product and Austin may convince the court that the rights of the mortgage lender survive, but that the enforceability of such rights must be fought out in state court.
The threshold question is whether there are three petitioning creditors who holds claims that are not subject to a bona fide dispute. If not, the petition will be denied. Can the Surrey hotel argue that the rent claim was suspended under New York state law under such theories as force majeure, impossibility or impracticality? As noted above, the bankruptcy court have been somewhat more flexible in permitting rent abatement due to the COVID-19 pandemic. If the petition is denied, the Petitioner may be subject to damages and attorney’s fees, and in some cases, punitive damages.
Second, even if the petition is otherwise valid, if the court finds that the debtor lacks the funds to maintain a chapter 11 case, it is likely to dismiss the case or convert it to a Chapter 7. A bankruptcy court is generally against permitting a case to continue if the costs of the case cannot be funded. A Chapter 7 trustee may have the same issue with administrative insolvency.
Third, if the Surrey cannot pay the ground rent, the court might simply treat the accruals as an administrative claim, and give such claims the same priority as all other administrative claims. This could mean that the ground rent is at risk of never being paid, or of not being paid very much.
Even if the New York bankruptcy court holds that the subordinate rights are not extinguished, I would not count on the New York bankruptcy ruling on the state law consequence—that is, the bankruptcy court may still direct the parties to state court. If so, isn’t the mortgagee right where it started?
My book Retail and Office Bankruptcy is available from the American Bankruptcy Institute at abi.org. Please note I have no economic stake in the sales.
[1] In re 20 East 76th Street Co., LLC., case No. 20-11007 (Bankr. S.D.N.Y.).
[2] Answer of 20 East 76th Street Co., LLC to the Involuntary Chapter 11 Petition, Dkt. ¶ 7, p.1.
[3] Response of Ground Lessor to the Involuntary Chapter 11 petition, Dkt. 10, ¶ 1, p.2.
[4] Response of Ground Lessor, ¶ 7, p.3.
[5] Response of Ground Lessor, ¶ 7, p. 3.
[6] Response of Ground Lessor, ¶ 17, p. 6.
[7] Answer, ¶ 3.
[8] Answer, ¶ 7.
[9] Response of Ground Lessor, ¶ 7.
[10] David R. Kuney, Retail and Office Bankruptcy: Landlord/Tenant Rights, pp. 84 et. seq. (ABI, 2018).
[11] In re Collins, 2019 WL 103774 (Bankr. E.D.N.C. 2019)* 3. (With the deemed rejection of the Lease, § 365(d)(4) requires that the Debtors immediately surrender the Property . . . without the need for relief from the automatic stay and eviction proceedings under state law [because] pursuant to the Constitution’s Bankruptcy Clause, the Bankruptcy’s Code requirement for immediate turnover of nonresidential real property following rejection of lease pre-empts state law regarding landlord-tenant relations.”)
[12] “Whether, under § 365 of the Bankruptcy Code, a debtor-licensor’s rejection of a license agreement—which “constitutes a breach of such contract,” 11 U.S.C. § 365(g)—terminates rights of the licensee that would survive under applicable non-bankruptcy law.” Petition for a Writ of Certiorari filed by Mission Product Holdings, Inc. at (i).
[13] Brief of Law Professor As Amici Curiae Supporting Petitioner, at 3.
[14] See e.g., In re Jeffrey Collins, 2019 WL 103774 (Bankr. E.D.N.C. 2019)(Case No. 18-02021-5-DMW).
[15] See Brief of Law Professor As Amici Curiae Supporting Petitioner.