Tenant's Election to Retain Possession of Rejected Lease Premises Preserves Obligations Under Related Agreements
Section 365(h) of the Bankruptcy Code provides special protection for tenants if a trustee or chapter 11 debtor-in-possession ("DIP") rejects an unexpired lease under which the debtor was the lessor by giving the tenant the option of retaining possession of the leased premises. Although the provision clearly describes what rights a tenant has if it makes such an election, it does not unequivocally address the extent of the electing tenant's obligations under the rejected lease or any related agreements. The U.S. Court of Appeals for the Sixth Circuit recently examined this question in EPLET, LLC v. DTE Pontiac N., LLC, 984 F.3d 493 (6th Cir. 2021). The court reversed a district court's dismissal of environmental remediation claims asserted by a chapter 11 litigation trust against the guarantor of a tenant's obligations under a services agreement that, together with a rejected lease, was part of an integrated transaction. According to the Sixth Circuit, by electing to retain possession of the leased premises under section 365(h), the guaranty was "likewise joined to [the tenant's] § 365(h) election."
Rejection in Bankruptcy of Unexpired Leases Under Which the Debtor Is the Lessor
Section 365(a) of the Bankruptcy Code provides that, subject to bankruptcy court approval, a bankruptcy trustee or DIP (pursuant to section 1107(a)) "may assume or reject any executory contract or unexpired lease of the debtor." Rejection of a contract or lease that has not been previously assumed by the trustee constitutes a breach of the agreement as of immediately preceding the bankruptcy petition date. See 11 U.S.C. § 365(g).
Section 365(h)(1) provides that, if the trustee or DIP rejects an unexpired real property lease under which the debtor is the lessor, the nondebtor lessee (and any permitted successor or assign, pursuant to subsection (h)(1)(D)) has the option of either treating the lease as terminated or retaining its rights under the lease for the balance of the lease term. In particular, section 365(h)(1)(A) provides as follows:
If the trustee rejects an unexpired lease of real property under which the debtor is the lessor and—
(i) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection; or
(ii) if the term of such lease has commenced, the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable nonbankruptcy law.
11 U.S.C. § 365(h)(1)(A). Pursuant to section 365(h)(1)(B), a tenant electing to retain its rights under a rejected lease may offset future rent against any damages caused by the debtor-lessor's nonperformance after the rejection date, but cannot assert a claim against the estate.
In enacting section 365(h)(1), lawmakers sought to "codify a delicate balance between the rights of a debtor-lessor and the rights of its tenants" by preserving the parties' expectations in a real estate transaction. In re Lee Road Partners, Ltd., 155 B.R. 55, 60 (Bankr. E.D.N.Y. 1993). The provision's legislative history indicates that lawmakers intended that rejection of a lease by a debtor-lessor should not deprive the tenant of its estate for the term for which it bargained. See H.R. Rep. No. 95-595, 349–50 (1977); S. Rep. No. 95-989, 60 (1978).
Rejection of a lease or contract does not relieve any guarantor of the lease or contract from liability, although any claim of a lessor against both the debtor-tenant and any debtor-guarantor of a lease arising from termination of the lease may be capped under section 502(b)(6). See In re Concepts Am., Inc., 621 B.R. 848, 861 (Bankr. N.D. Ill. 2020); See In re Emple Knitting Mills, Inc., 123 B.R. 688, 691 (Bankr. D. Me. 1991).
In 2007, a manufacturer sold a Michigan power plant to energy company DTE Energy Pontiac North, LLC ("Pontiac") and leased the land under the plant to Pontiac for 10 years. In addition to the land lease agreement ("Lease") and the asset purchase agreement ("APA"), the manufacturer and Pontiac entered into a utility services agreement ("UA") whereby Pontiac agreed to provide steam, compressed air and electricity to an adjacent factory owned by the manufacturer and covenanted to adhere to certain maintenance and environmental obligations. Pontiac's corporate parent DTE Energy Services, Inc. ("DTE") executed a guaranty ("Guaranty") of Pontiac's obligations under the UA and granted an indemnity to the manufacturer for any environmental liabilities arising from the operation of the power plant ("Indemnity"). The APA, the Lease and the UA ("Associated Agreements") each contained a provision confirming that all of the agreements documenting the transaction were executed as part of a single "integrated" transaction.
The manufacturer filed for chapter 11 in 2009. Because it no longer required utility services provided from the plant, the manufacturer sought court authority to reject the UA. Pontiac opposed rejection, arguing that the UA could not be rejected alone because the Associated Agreements were part of an integrated transaction. In 2011, after the parties settled the dispute, the court authorized the manufacturer to reject each of the Associated Agreements. Pontiac then filed an unsecured proof of claim for damages arising from the manufacturer's breach of the contracts. However, it later elected to retain possession of the leased premises under section 365(h).
The bankruptcy court confirmed the manufacturer's chapter 11 plan in 2011. The plan created a trust ("Trust") to remediate the manufacturer's environmental liabilities and assume ownership of certain properties owned by the manufacturer, including the land on which the Michigan power plant was located.
Following rejection of the Lease and the other Associated Agreements, Pontiac retained possession of the leased premises until 2017, after which the Trust discovered that the property had not been maintained and required substantial environmental remediation. The Trust accordingly sued Pontiac and DTE (both under a veil-piercing theory and as guarantor) in federal district court for, among other things, breach of the Associated Agreements, breach of the Guaranty and violation of environmental laws.
The district court dismissed the direct claims against DTE, ruling that the Trust failed to plead a valid veil-piercing theory of liability. The court also dismissed the breach of contract and breach of guaranty claims against both Pontiac and DTE, concluding that the Associated Agreements (and, by extension, the Guaranty) had terminated after the manufacturer rejected them in bankruptcy and the limitations period for bringing suit to collect under the documents had expired. The Trust appealed to the Sixth Circuit.
The Sixth Circuit's Ruling
A three-judge panel of the Sixth Circuit considered two issues on appeal: (i) whether the Trust's veil-piercing claims against DTE were adequately pleaded; and (ii) whether Pontiac's section 365(h) election "preserved its obligations under the [UA] and, by extension, [DTE's] obligations under the [Guaranty]."
Writing for the panel, Circuit Judge Richard A. Griffin faulted the district court's dismissal of the Trust's veil-piercing claim against DTE. He determined that the Trust had sufficiently pleaded facts that supported piercing the corporate veil under Michigan law.
Next, Judge Griffin examined whether the Guaranty survived rejection of the Associated Agreements in the manufacturer's bankruptcy. The Trust argued that, when Pontiac elected to continue to occupy the premises under the Lease, "it also preserved its obligations under the [UA], which in turn preserved [DTE's] responsibilities under the [Guaranty]." Pontiac and DTE countered that the Guaranty expired when the UA terminated after being rejected, leaving only the unguaranteed Lease.
Judge Griffin explained that, under section 365(g), rejection of a contract does not terminate it, but instead constitutes a breach. Under section 365(h)(1), he noted, the tenant under a lease rejected by the trustee then has the option to treat the lease as terminated in accordance with its terms or applicable non-bankruptcy law, or to remain in possession for the remaining term of the lease. "In effect," Judge Griffin wrote, "a tenant who elects to continue a lease under § 365(h)(1)(A)(ii) waives the debtor's breach and instead opts to continue under the lease's existing terms and obligations, albeit with a more limited right of recovery against its landlord for breaches."
According to Judge Griffin, a contract or lease must be assumed or rejected in its entirety unless an agreement is "severable" from the remainder of the contract or lease, in which case that agreement may be assumed or rejected without assuming or rejecting the rest of the contract or lease. In addition, he noted, when two or more agreements are part of an "integrated transaction," a trustee may not assume one agreement without also assuming all other integrated agreements. These principles, he explained, are relevant to the analysis under section 365(h):
Typically, the question is whether contracts assumed by the trustee or debtor-in-possession are severable. But we see no reason why the analysis would be any different when evaluating whether a tenant's obligations are severable after a § 365(h) election. If the obligations are part of one contract as a matter of law, and the tenant elects to retain the benefits of that contract through § 365(h), it must also assume the contract's obligations. Defendants offer no reason why § 365 would allow a tenant, but not a debtor, to assume the benefits of a contract while rejecting its burdens or assume integrated contracts on a piecemeal basis.
EPLET, 2021 WL 37496, at *9 n.4 (citing City of Covington v. Convington Landing Ltd. P'ship, 71 F.3d 1221, 1226 (6th Cir. 1995); In re Spanish Peaks Holdings, II, LLC, 872 F.3d 892, 900 (9th Cir. 2017) (section 365(h) evinces "a clear intent to protect lessees' rights outside of bankruptcy, not an intent to enhance them")).
Under Michigan law, Judge Griffin concluded, the UA and the Lease were not severable, but interdependent, based on the parties' intent, the agreements' common subject matter and Pontiac's representations to that effect in the manufacturer's chapter 11 case. The Sixth Circuit accordingly ruled that: (i) the district court erred in finding that the Lease and the UA were severable as a matter of law at the motion to dismiss stage; (ii) Pontiac "could not elect to continue the [L]ease under 11 U.S.C. § 365(h) without its related obligations under the [UA]"; and (iii) because DTE guaranteed Pontiac's obligations under the UA, including environmental remediation obligations, the Guaranty "is likewise joined to Pontiac's § 365(h) election."
In so ruling, the Sixth Circuit rejected the argument that a non-severability finding would lead to an absurd result because, once the manufacturer shut down the factory to which Pontiac was supplying utilities services under the UA, no utilities could be bought or sold under the agreement. According to the court, the UA contemplated not only the provision of utilities, but also environmental and maintenance obligations, the breach of which was the crux of the Trust's lawsuit.
Finally, the Sixth Circuit rejected the argument that Pontiac's assertion of a rejection claim and subsequent nonperformance under the Lease terminated the UA. It also invalidated the district court's statute of limitations ruling, holding that the obligations of Pontiac and DTE under the Associated Agreements and the Guaranty survived until Pontiac vacated the premises in 2017, which was "well within the six-year statute of limitations" for bringing suit.
The Sixth Circuit remanded the case below in light of its ruling.
The Sixth Circuit's decision in EPLET is notable for several reasons. First, given the court's conclusions that the Associated Agreements (and, by extension, the Guaranty) were not terminated after the manufacturer rejected them and that the statute of limitations had not expired, it is unclear why the Sixth Circuit proceeded to find that the obligations of the parties under the UA and the Guaranty were preserved when Pontiac elected to retain possession of the leased premises under section 365(h). If DTE's guaranty of Pontiac's obligations under the UA (including the environmental and maintenance covenants) was still enforceable, the Sixth Circuit's section 365(h) ruling was unnecessary. Why the Trust did not succeed to the manufacturer's rights against DTE under the Indemnity as an independent path to recovery is also unclear.
Second, section 365(h)(1) says nothing about the rights or obligations of parties other than the electing tenant or the debtor. It also does not address what impact the tenant's election has on related agreements (whether severable or not) involving other parties. Thus, the Sixth Circuit's ruling appears to have imposed requirements going beyond the express terms of section 365(h).
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our “Contact Us” form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.