It is common for landlords to contend with tenants filing for bankruptcy. From restaurants falling out of fashion to a startup failing to find its footing, if you own properties long enough, you will see it all. The legal road map to navigating those situations, however, can be easier to follow than in the opposite scenario—what happens when the landlord files for bankruptcy?

A U.S. Court of Appeals for the Third Circuit decision concerning a tenant in a struggling Atlantic City, New Jersey, casino provides more guidance on this issue and serves as a reminder of the considerations a buyer must make when purchasing a commercial property through bankruptcy, as well as the protections a tenant must secure before it signs a lease.

The Sale

In the decision, the court described a dispute over the tenant's rent payments after Revel Entertainment Group, operating as Revel Casino, filed for Chapter 11 bankruptcy protection and sold its assets through the bankruptcy process to Polo North Country Club, Inc. Meanwhile, Revel's tenant IDEA Boardwalk, LLC was operating three clubs on the casino property. In a 10-year lease with Revel—described by the bankruptcy court as a “bloated morass”—that tied rent calculations to capital contributions to build out the venues, IDEA was owed recoupment payments from its landlord on a venue-by-venue basis, provided the clubs reached a specific sales threshold in a set period of time but did not make enough money to break even.

The purchase agreement between Polo and Revel provided that Polo would purchase the casino's assets “free and clear of all liabilities,” as allowed under the U.S. Bankruptcy Code, Section 363(f). Important exceptions included potential liability to IDEA for administrative expense claims and that Polo would agree to certain legal claims that Revel had against IDEA with respect to lease payments.

While the bankruptcy sale order authorized Polo's purchase “free and clear of all liens, claims, encumbrances and other interests of any kind,” it went on to expressly preserve certain rights regarding tenants' continued use of the leased premises, including any of IDEA's rights with respect to its lease. Although Revel had rejected the lease, IDEA, as it was permitted by the sale order and Section 365(h) of the Bankruptcy Code, elected to continue the rejected lease it had with Revel, remaining a tenant of the casino.

The Litigation

The parties went to litigation over whether IDEA was permitted to deduct recoupment payments it was owed under the lease from its outstanding rent obligations. The bankruptcy court granted summary judgment to the extent of permitting IDEA to “offset” future rent and any damages caused by Polo's potential nonperformance, and it allowed the tenant to “apply and set off the recoupment amount” for the period before and after the purchase.

On appeal, Polo challenged the amount of its obligations that were subject to recoupment, but the Third Circuit agreed that IDEA retained its right to reduce rent obligations because of its election under Section 365(h), entitling the tenant to the same terms set forth in the lease.

Polo's rejected argument to the circuit court claimed that allowing IDEA to retain recoupment rights would create an unfair priority in the bankruptcy administration. The court recognized the imbalance but noted that a prior decision (In re Anes) established that when a claim against a debtor qualifies for equitable recoupment, as it did in this case, the claim “avoids the usual bankruptcy channels.”

The Takeaway

 In conclusion, the Third Circuit affirmed that Section 365(h) limits the ability of a trustee or debtor in possession of property to actually sell property free and clear of leasehold interests under 363(f). The decision in this case did not upend the law, but it serves as a cautionary tale to buyers who purchase commercial property through bankruptcy.

Buyers may unknowingly assume obligations that they may not want, even if they believe they are purchasing a property “free and clear” of liabilities. For that reason and to the extent possible, potential buyers and their counsel should closely examine lease agreements related to properties they are looking to purchase. Any obligations that arise from this review should be clearly noted in the purchase agreement and sale order to avoid ambiguity and further litigation.

In other scenarios regarding the bankruptcy of a landlord, subordination, nondisturbance and attornment agreements (SNDA) may come into play. These describe the rights of landlords, tenants and buyers, so provisions on SNDAs should be included when drafting commercial leases to prevent potentially costly litigation.

The Third Circuit rarely addresses cases involving the bankruptcy of a landlord, so this decision is likely to stand for many years as the most recent analysis on landlord bankruptcy law. All parties entering a lease or involved in the purchase of a commercial property through a bankruptcy sale should be aware of how it can affect them.

Gary M. Sanderson is an attorney with Pittsburgh-based law firm Meyer, Unkovic & Scott. He focuses his practice on a wide range of business matters, including complex real estate and bankruptcy transactions and disputes.