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Business Bankruptcy Issues

Protecting IP Rights From A Licensor’s Bankruptcy: What You Need To Know About Section 365(n)

Many companies rely on in-bound licenses of intellectual property, especially those involving patents or trade secrets, and spend millions of dollars on research, development, and ultimately commercialization of drugs or products incorporating the licensed IP. With so much at stake, licensees frequently ask a critical question: Can our license rights be terminated if the licensor files bankruptcy?

Assumption Or Rejection. A license is typically held to be an executory contract. This means that a licensor in bankruptcy (or its bankruptcy trustee) has the option of assuming or rejecting the license. Generally, a debtor licensor can assume a license if it meets the same tests (cures defaults and provides adequate assurance of future performance) required to assume other executory contracts.  Most licensees will not object to the assumption of their license as long as the debtor can actually continue to perform. Instead, the real concern for licensees is whether they risk losing their rights to the licensed IP if the license is rejected.

Bankruptcy Code Section 365(n). To address this concern, in 1988 Congress added Section 365(n) to the Bankruptcy Code to give licensees special protections.  If the debtor or trustee rejects a license, under Section 365(n) a licensee can elect to retain its rights to the licensed intellectual property, including a right to enforce an exclusivity provision. In return, the licensee must continue to make any required royalty payment. The licensee also can retain rights under any agreement supplementary to the license, which should include source code or other forms of technology escrow agreements.  Taken together, these provisions protect a licensee from being stripped of its rights to continue to use the licensed intellectual property.

Some Important Limitations. If the license is rejected, however, the licensor will no longer have to perform under the license. This means the licensor will not have to update or continue to develop the IP, and will not have to make available any updates later developed. In addition, Section 365(n) only applies in a U.S. bankruptcy case. It generally will not be of any help in a bankruptcy or insolvency of a non-U.S. licensor under applicable foreign law.

No Protection For Trademark Licensees. Many people expect intellectual property to include trademarks, but when Section 365(n) was enacted a special, limited definition of "intellectual property" was also added to the Bankruptcy Code. The bankruptcy definition includes trade secrets, U.S. patents and patent applications (less clear as to foreign patents), copyrights, and mask works, but it does not include trademarks. This distinction means that a trademark licensee enjoys none of Section 365(n)’s special protections and is at risk of losing its trademark license rights if the licensor files bankruptcy. For more on the special bankruptcy risk facing trademark licensees, follow the link in this sentence.

Getting The Most Out Of Section 365(n). Although Section 365(n) gives licensees significant comfort within limits, there are a number of approaches a licensee can take to maximize the statute’s benefits while avoiding its pitfalls. Here are a few to consider:

  • Make sure you actually have a granted license. Section 365(n) only applies to actual license rights as they existed at the time the bankruptcy case was commenced. This means that an agreement by the licensor to grant a license to IP at some later date, including a springing license grant on a bankruptcy filing, will likely be unenforceable if a bankruptcy is filed. Get a present grant of a license to any important IP or risk not having a license to it at all.
  • Consider a technology escrow. Licensees sometimes forget that Section 365(n) is not self-executing. This means that Section 365(n) doesn’t require the licensor to deliver the embodiment of the licensed intellectual property to the licensee unless the license or an agreement supplementary to the license expressly provides for such a right. One solution is to include this delivery provision in the license itself. Another common approach is to establish a technology (often a source code) escrow into which the embodiment and updated versions of the embodiment are in fact deposited, to be released to the licensee on specified conditions.
  • Refer to Section 365(n) in the license. Section 365(n) applies to licenses of bankruptcy-defined intellectual property whether it is mentioned in the license or not. That said, including an express reference that the license involves such IP, as the old saying goes, "wouldn’t hurt." A provision in the license that the agreement involves IP covered by Section 365(n), although not binding on the bankruptcy court, may be helpful in persuading a bankruptcy trustee — or the bankruptcy judge — that the IP involved is indeed subject to Section 365(n)’s protections.
  • Save the election until later. If you do include a Section 365(n) reference in the license, it’s usually better to state that no Section 365(n) election is then being made. Things change, and there is always a chance that the IP will turn out to be less important in future years, meaning you might elect to treat a rejected license as terminated.
  • Get bankruptcy advice before you sign the license. As the points above illustrate, even with Section 365(n), protecting your IP license can be tricky if a bankruptcy is later filed. Be sure to seek advice from bankruptcy counsel knowledgeable about IP licenses when the license is being drafted, not just after the licensor gets in financial trouble.

Conclusion. Section 365(n) of the Bankruptcy Code can provide valuable protections for licensees of intellectual property, but those protections have their limitations. Taking steps to maximize your rights when the license is being drafted can make a big difference if the licensor later files bankruptcy.

Business Bankruptcy Issues Recent Developments

U.S. Supreme Court Shows Interest In Deciding Whether The Hypothetical Test Or The Actual Test Should Be Used To Determine If IP Licenses Can Be Assumed In Bankruptcy

It looks like the U.S. Supreme Court, or at least two of the Justices, is interested in deciding whether the "hypothetical test" or the "actual test" should be used in determining whether an intellectual property license can be assumed by a debtor in possession under Section 365(c)(1) of the Bankruptcy Code. That was the clear message from the somewhat unusual statement by Justice Kennedy, with whom Justice Breyer joined, issued on March 23, 2009, in connection with the Supreme Court’s denial of a writ of certiorari in the N.C.P. Marketing Group, Inc. case. You can read a copy of the entire statement by following the link in the prior sentence.

The N.C.P. Marketing Case. As a refresher, in 2005, the U.S. District Court for the District of Nevada issued its first of a kind decision, In re: N.C.P. Marketing Group, Inc., 337 B.R. 230 (D.Nev. 2005), holding that trademark licenses are personal and nonassignable in bankruptcy absent a provision in the trademark license to the contrary. Click here for a copy of the N.C.P Marketing Group decision and here, here, and here to read earlier posts on the case. Last May, the Ninth Circuit affirmed the District Court’s judgment "for the reasons provided by that court" in an order designed as "not for publication."

Assumption And Assignment. A key basis for the District Court’s decision in the N.C.P. Marketing Group case was the way the Ninth Circuit has interpreted Section 365(c)(1), specifically on the question of whether a debtor in possession can assume an intellectual property license. In bankruptcy parlance, assumption means that the debtor gets to keep the license. Usually, debtors are allowed to exercise their business judgment when deciding whether to assume or reject (read: breach and stop performing) an executory contract, as well as to assume and assign one to a third party. However, Section 365(c)(1) of the Bankruptcy Code puts a limit on a debtor’s ability to assign executory contracts, and perhaps even to assume them, when "applicable law" gives the non-debtor party to the contract the right to refuse to deal with someone else. In the N.C.P. Marketing Group decision, the District Court held that federal trademark law under the Lanham Act was such "applicable law" and rendered non-exclusive trademark licenses nonassignable.

The Key Bankruptcy Code Section. Section 365(c)(1) is so important to this debate that it bears careful review. Here’s what it says:

(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—

(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties; and

(B) such party does not consent to such assumption or assignment.

Hypothetical Versus Actual Test. If a debtor cannot assign an IP license without consent of the licensor, can it at least assume the license? That question has led courts to examine ever so closely the first seven words of Section 365(c): "The trustee may not assume or assign…"

  • When the statute says that the trustee may not assume or assign an IP license, does the word "or" really mean "and" too?
  • Put differently, what happens when a debtor is only trying to assume (keep) an IP license and is not actually trying to assign it? Does the Bankruptcy Code language mean that it can neither assume nor assign the license or does it only mean that the debtor cannot assign the license?
  • That, in a nutshell, is the difference between the so-called "hypothetical test" (which reads Section 365(c)(1)’s language as asking whether the debtor hypothetically could assign the license even if it’s only proposing to assume it) and the "actual test" (which interprets the statute’s language as asking only what the debtor is actually proposing to do).
  • The U.S. Courts of Appeals for at least three circuits have adopted the hypothetical test. The Ninth Circuit (covering California, Nevada, Arizona, and a number of other Western states), the Third Circuit (which includes Delaware, the venue of many Chapter 11 cases), and the Fourth Circuit (covering Virginia, West Virginia, Maryland, and North and South Carolina), have held that Section 365(c)(1) gives most IP licensors a veto right over proposals by a Chapter 11 debtor to assign — and even to assume — IP licenses.
  • For a more complete discussion of these issues, take a look at this earlier post, entitled "Assumption of Intellectual Property Licenses in Bankruptcy: Are Recent Cases Tilting Toward Debtors?"

Justice Kennedy’s Statement. N.C.P. Marketing Group petitioned the U.S. Supreme Court for a writ of certiorari, seeking review of the decision denying it the ability to assume the trademark license. Although also voting to deny review, Justice Kennedy issued a three-page statement on that decision to express his view, joined in by Justice Breyer, that the Supreme Court should considering granting certiorari in a future case on the "significant question" of whether the hypothetical test or the actual test should be applied in interpreting Section 365(c)(1) of the Bankruptcy Code. Justice Kennedy summed up his analysis this way:

The division in the courts over the meaning of §365(c)(1) is an important one to resolve for Bankruptcy Courts and for businesses that seek reorganization. This petition for certiorari, however, is not the most suitable case for our resolution of the conflict. Addressing the issue here might first require us to resolve issues that may turn on the correct interpretation of antecedent questions under state law and trademark-protection principles. For those and other reasons, I reluctantly agree with the Court’s decision to deny certiorari. In a different case the Court should consider granting certiorari on this significant question.

Justice Kennedy’s discussion of the two tests suggests that he (and perhaps Justice Breyer) may be leaning toward the actual test. Although noting that the actual test "may present problems of its own," including that it aligns Section 365 "with sound bankruptcy policy only at the cost of departing from at least one interpretation of the plain text of the law," Justice Kennedy aimed most of his criticism in the statement at the hypothetical test.

  • Specifically, Justice Kennedy commented that one "arguable criticism of the hypothetical approach is that it purchases fidelity to the Bankruptcy Code’s text by sacrificing sound bankruptcy policy." He stated that the hypothetical test "may prevent debtors-in-possession from continuing to exercise their rights under nonassignable contracts, such as patent and copyright licenses." Continuing, he noted that without these licenses, "some debtors-in-possession may be unable to effect the successful reorganization that Chapter 11 was designed to promote."
  • He also remarked on what he perceived as a "windfall" to nondebtor parties to valuable executory contracts. While outside of bankruptcy the nondebtor cannot renege on its agreement, if the debtor files bankruptcy "then the nondebtor obtains the power to reclaim–and resell at the prevailing, potentially higher market rate–the rights it sold to the debtor." Although most non-exclusive licenses are not treated as a sale of intellectual property, Justice Kennedy appears to view the potential loss of IP license rights due to a bankruptcy filing as an unfair result.

Conclusion. In denying review in the N.C.P. Marketing Group case, the Supreme Court has let stand the decision of the courts below that, where the hypothetical test applies as it does in the Ninth Circuit, a non-exclusive trademark license cannot be assumed by a debtor in possession. However, given the detailed statement issued by Justice Kennedy, and joined in by Justice Breyer, it appears that the chances of the Supreme Court granting certiorari in a future IP license assumption case have increased. If such a case reaches the Supreme Court, the current split in the circuits on this important intersection between bankruptcy and intellectual property law may finally be resolved.

Business Bankruptcy Issues Recent Developments

Latest Edition Of Bankruptcy Resource Now Available

The Spring 2008 edition of the Absolute Priority newsletter, published by the Cooley Godward Kronish LLP Bankruptcy & Restructuring group, of which I am a member, has just been released. The newsletter give updates on current developments in bankruptcies and workouts with the goal of keeping you "ahead of the curve" on these issues. Follow the links in this sentence to access a copy of the newsletter or to register to receive future editions.

The latest edition covers a range of cutting edge topics, including:

  • The ability of unsecured creditors to recover post-petition attorney’s fees;
  • Key issues when selling claims in bankruptcy;
  • Jury trials and proofs of claim;
  • Assignments for the benefit of creditors; and
  • The impact of post-petition performance on executory contracts.

We have also included information on some of our recent representations of official committees of unsecured creditors in Chapter 11 bankruptcy cases, and unofficial committees in out-of-court workouts, involving major retailers. These include Sharper Image, Lillian Vernon, CompUSA, Wickes Furniture, and The Bombay Company, among others. In addition, a note from my partner Adam Rogoff, the editor of Absolute Priority, discusses the increasing number of bankruptcy filings nationwide and our representation of Bayonne Medical Center in its Chapter 11 reorganization.

I hope you find this latest edition of Absolute Priority to be a helpful resource.

Business Bankruptcy Issues Recent Developments

Bankruptcy Rule Amendments: New Article Reviews The Important Changes

An article my partner Adam Rogoff, associate Seth Van Aalten, and I wrote was recently published in the January 2008 issue of Pratt’s Journal of Bankruptcy Law. The article discusses the significant amendments to the Federal Rules of Bankruptcy Procedure that took effect on December 1, 2007. Those amendments covered a range of procedures from omnibus claims objections to motions to assume executory contracts and real property leases to "first day" motions in Chapter 11 cases. 

If you don’t have a copy of the Journal, you can read the article, entitled "Important Changes To Bankruptcy Rules Take Effect," by clicking on its title in this sentence. For more details on the rule changes, use the links that follow for a copy of the full, "clean" set of rule amendments as well as the redline set showing changes made by the amendments to the existing rules, together with the Advisory Committee’s comments.

Business Bankruptcy Issues Recent Developments

Delaware Bankruptcy Court Adopts New Local Rule For Section 363 Sales

The Delaware Bankruptcy Court has recently adopted amended Local Rules, which became effective on February 1, 2008, and they include meaningful changes to the procedures governing Section 363 sales of assets. New Local Rule 6004-1, entitled "Sale and Sale Procedures Motions," requires additional disclosure and the highlighting of certain key provisions often seen in sale motions.

By following the links in this sentence you can find the redline version and clean version of the new Delaware Bankruptcy Court Local Rules.

The Section 363 Sale. As a reminder, a bankruptcy asset sale often happens in the first few weeks or months of a Chapter 11 case, rather than as part of a plan of reorganization. Frequently this will involve a sale of all or substantially all of a debtor’s business as a going concern. The sale is generally referred to as a "Section 363 sale" because Section 363 is the key Bankruptcy Code section that governs a debtor’s sale of assets in bankruptcy. The debtor must seek bankruptcy court approval of a sale that is not in the ordinary course of business and of any effort to transfer executory contracts, intellectual property licenses, or commercial real estate leases to the buyer.

Sale Motion Requirements. The new local rule first addresses motions to sell property of the estate. A copy of the proposed or near-final purchase agreement must be attached to the motion, as well as a proposed sale order, and any request for a consumer privacy ombudsman under Section 332 of the Bankruptcy Code must be included. The most interesting changes, however, are in the list of provisions which, if included in the motion or sale order, must be highlighted together with a justification for each such provision. These include the following:

  • Sale to insiders
  • Agreements with management
  • Releases
  • Private sale or no competitive bidding
  • Closing and other deadlines
  • Good faith deposit
  • Interim agreements with proposed buyer
  • Use of sale proceeds
  • Section 1146 tax exemption
  • Retention of records
  • Sale of avoidance actions
  • Successor liability findings requested
  • Sale free and clear of leases or licenses
  • Credit bid
  • Waiver of 10-day stay under Rule 6004(h)

A Few Specifics. To get a sense of the changes made, here’s what the amended rule now requires for disclosure of agreements with management included as part of a sale motion:

Agreements with Management. If a proposed buyer has discussed or entered into any agreements with management or key employees regarding compensation or future employment, the Sale Motion must disclose (a) the material terms of any such agreements, and (b) what measures have been taken to ensure the fairness of the sale and the proposed transaction in the light of any such agreements.

Similarly, if a finding is requested regarding a tax exemption under Section 1146(a) of the Bankruptcy Code, the motion must now detail the following:

Tax Exemption. The Sale Motion must highlight any provision seeking to have the sale declared exempt from taxes under section 1146(a) of the Bankruptcy Code, the type of tax (e.g., recording tax, stamp tax, use tax, capital gains tax) for which the exemption is sought. It is not sufficient to refer simply to "transfer" taxes and the state or states in which the affected property is located.

Another part of the new rule requires more disclosure of efforts to sell free and clear of leases and licenses:

Sale Free and Clear of Unexpired Leases. The Sale Motion must highlight any provision by which the debtor seeks to sell property free and clear of a possessory leasehold interest, license or other right.

Sale Procedures Motions. In addition to an actual sale motion, the new local rule includes new provisions addressing motions for approval of sale and auction procedures. Although these provisions are already typically set forth in motions, the rule makes mandatory the highlighting of certain ones, including the following:

  • Financial qualification procedures
  • Deadlines for submitting bids
  • Format of overbids
  • Good faith deposit
  • No-shop or no-solicitation rules
  • Break-up/topping fee and expense reimbursement
  • Bidding increments and use of break-up fees
  • Details of auction procedures

Other Important Local Rule Changes. In addition to a number of minor changes, the amended Local Rules include three significant additions governing (1) discovery motions, (2) service of discovery materials, and perhaps most importantly, (3) electronic or e-discovery. These new rules are found at Local Rules 7026-1, 7026-2, and 7026-3, respectively. Local Rule 3007-1 on omnibus claim objections, discussed in a prior post, has been revised to reflect Delaware’s continued adherence to its local practice notwithstanding the recent national rule changes. (Click on the links in this sentence for more on the national rule amendments and Delaware’s decision to retain its own omnibus claim objection procedures.) Also of note, amended Local Rule 9010-1 now makes explicit the requirement that associated Delaware counsel file all papers and attend proceedings before the Court.

Conclusion. While many of the amended sale motion rules are not new to Delaware practice, Local Rule 6004-1 will change the way sale and sale procedures motions are prepared going forward. Chapter 11 debtors must comply with the new rule and that should give creditors and potential overbidders an easier time spotting the material provisions in these motions.

Business Bankruptcy Issues Recent Developments

Don’t Miss The Important Business Bankruptcy Rule Amendments That Just Took Effect

On December 1st of almost every year, amendments to the Federal Rules of Bankruptcy Procedure — the ones that govern how bankruptcy cases are managed — take effect to address issues identified by an Advisory Committee made up of federal judges, bankruptcy attorneys, and others. Often the changes are relatively minor and of interest only to bankruptcy practitioners, but this year’s set has made some significant changes that will directly impact debtors, creditors and other stakeholders.

A Look At The Amendments. You may find it interesting to see the entire group of amendments together, so I have included two links. The first is to the full "clean" set of the amended rules. The second is to a redline showing the changes made by these amendments to the existing rules, together with the Advisory Committee’s comments.

The Omnibus Objection Problem. One of the most significant amendments will make changes to the popular practice of filing omnibus objections. In large cases the debtor or other estate representative has so many claims to address that they have combined objections to dozens — sometimes hundreds — of different claims in one single motion. The objection may have a name such as “Debtors’ Fourteenth Omnibus Objections To Claims (Substantive)” or some similarly titled document. Click here for one example. In a post last year called "Objections To Claims: Ignore Them At Your Peril," I discussed how it can be hard to tell which claims an omnibus objection is targeting.

  • The format has often meant that the only reference to an individual creditor is buried within the objection’s many pages of text and exhibits, typically in an attached list or chart.
  • If the creditor doesn’t respond to the objection timely, its claim will likely be disallowed and it will recover absolutely nothing from the bankruptcy estate.

The Amended Rule 3007: An "Anti-Gotcha" Solution. The new rules restrict the use of omnibus objections to certain limited circumstances and impose formatting standards. Otherwise, each claim will require its own separate claim objection unless the combined objection covers claims filed by the same person or entity. What grounds for objection can be made by an omnibus objection under the newly revised Rule 3007?

  • Duplicate claims;
  • Claims filed in the wrong case;
  • Original claims that were amended by later claims;
  • Claims that were not timely filed;
  • Claims that have already been paid or released;
  • Claims filed in a form that does not comply with applicable rules;
  • Claims that are really asserting an equity interest in the debtor; and
  • Priority claims that assert an amount in excess of the maximum amount in the Bankruptcy Code.

In short, if the claim is being challenged on substantive grounds, rather than more technical or procedural ones, then the objection will have to be filed one claimant at a time.

When an omnibus objection does make the permitted objections, it will now have to list claimants in alphabetical order, cross-reference claim numbers, give the ground for the objection and cross-reference that to the text of the objection, describe the objector and the reason for the objection in the document’s title, and combine no more than 100 claims in a single objection. This is all designed to make it easier for the creditor to figure out whether its claim is included and the basis for the objection.

Amended Rule 4001: The Clearer Disclosure Rules. Changes have been made to the rule that governs motions and stipulations for use of cash collateral and obtaining debtor in possession (DIP) financing. The amended rules now require that more details about the key provisions of cash collateral and DIP financing terms and conditions be stated in the motion, that proposed forms of order be filed with the motion, and that cross-references be made in the motion to where in the cash collateral or DIP financing agreements and proposed orders the key provisions are reflected. Since some financing agreements can run hundreds of pages long, with complex formulas and provisions, this rule change is designed to make it easier for the court and the parties to understand their material features without wading through the entire document.

New Rule 6003: Putting The Breaks On Some "First Day" Orders. Another major change is the addition of Rule 6003. This new rule provides that "except and to the extent that relief is necessary to avoid immediate and irreparable harm, the court shall not, within 20 days after the filing of the petition, grant relief" regarding three key areas:

  • The employment of professionals;
  • A motion to pay any prepetition claims (read: critical vendors) or to use, sell, lease (Section 363 sales), or incur an obligation for property of the estate, other than cash collateral or DIP financing motions; or
  • Assumption or assignment of any executory contract or unexpired lease (including commercial real estate leases).

As drafted, unless there is an emergency, and then only to the extent it’s really necessary, the bankruptcy court should defer these decisions until after the 20th day following the filing of the Chapter 11 bankruptcy petition (although technically these apply under the other chapters of bankruptcy). One reason for the rule is to give time for a creditors committee to be appointed and retain counsel before important decisions are made. That said, the exceptions for cash collateral and DIP financing, as well as for rejection of leases and other executory contracts, means a lot can still be done during the early part of a case. When Section 363 sale or critical vendor motions come up on an emergency basis, it’ll be interesting to see how often courts, in applying this new rule, find the existence of irreparable harm.

Amended Rule 6006: Assumption, Assignment, And Rejection Of Executory Contracts. Similar to Rule 3007, Rule 6006 has been changed to put limits on when omnibus motions can be used to deal with executory contracts and leases. Under new Rule 6006(e), absent special court authorization, omnibus motions may be used for multiple executory contracts or leases only when all of the executory contracts to be assumed or assigned are (1) between the same parties, or (2) being assigned to the same assignee. This latter provision likely covers most Section 363 asset sales, so non-debtor contracting parties should continue to carefully review those motions, as discussed in this earlier post. An omnibus motion may also be used when a debtor or trustee seeks to assume, but not assign to more than one assignee, real property leases. In addition, omnibus motions may be used to request rejection of multiple executory contracts or leases.

New Rule 6006(f) provides that, when allowed, these omnibus motions can list no more than 100 executory contracts or leases in any one motion (unlike the chart on this fairly typical pre-amendment motion), and multiple motions will need to be numbered consecutively. The new rule also requires that permitted omnibus motions provide a variety of new information, including:

  • An alphabetical listing by party name;
  • The terms of the assumption or assignment, including for curing defaults; and
  • The identity of the assignee and the adequate assurance of future performance to be provided.

A Few Other Changes. The other amendments this year (1) permit a court to consider a change of venue, (2) clarify when corporate ownership disclosure needs to be made, (3) address constitutional challenges to statutes, and (4) specify procedures for protecting social security numbers and other private information in court filings. Check the clean or redline sets linked above to read these additional rule amendments.

Conclusion. This year’s amendments to the Federal Rules of Bankruptcy Procedure have more than their share of real changes and they will have an impact on business bankruptcy cases. The omnibus motion changes should help creditors from missing when their claim is the target of an objection and contract parties from failing to see that their executory contract or lease is part of a motion to assume and assign. Although cash collateral and DIP financing motions are not affected, the new irreparable harm standard for certain relief in the first 20 days of a case may prove interesting when emergency Section 363 sales are attempted. Stay tuned.

Business Bankruptcy Issues Recent Developments

A Fly In The Ointment: Sale Of Property May Cut Off Landlord’s Section 502(b)(6) Lease Rejection Claim For Future Rent

Here’s a scenario frequently seen in Chapter 11 cases. A tenant files bankruptcy and rejects a commercial real estate lease. The landlord files an unsecured lease rejection claim seeking to recover the lost future rent under the rejected lease. The claim amount is capped by Bankruptcy Code Section 502(b)(6) but may still be one of the larger unsecured claims in the case. Now let’s add a small, but relatively common, twist. Sometime later, but before distributions are made on the claim, the landlord sells the real estate that the debtor had occupied under the rejected lease.

The FLYi Chapter 11 Case. That, complete with the twist, was the situation in the In re FLYi, Inc. Chapter 11 case pending in the Delaware Bankruptcy Court. After the landlord sold the property, the liquidation trust established under the debtor’s Chapter 11 plan of reorganization objected to the landlord’s claim, arguing that after the sale of the property the debtor had no further obligations under the lease. Virginia law applied because the property was located in Dulles, Virginia. As described by the Bankruptcy Court, the landlord had three options under Virginia law:

[D]o nothing and sue for the rent remaining under the Lease; reenter the Premises for the sole purpose of re-letting it without terminating the Lease; or re-enter the Premises and exercise full dominion over the premises thereby terminating the Lease and eliminating FLYi’s obligation to pay any future rent.

The landlord argued that this interpretation of the law was wrong but asserted that provisions in the lease protected the landlord’s claim anyway. The Bankruptcy Court rejected those arguments and held that the landlord’s sale of the property terminated both the lease and the landlord’s right to future rent after the date of the sale. A copy of the Bankruptcy Court’s decision is available here.

Be sure to read the Delaware Business Bankruptcy Report’s interesting discussion for more details on the decision, including the arguments advanced and the Bankruptcy Court’s treatment of them.

What Does This Mean For Landlords? A landlord contemplating a sale of the real property will have to consider what impact that sale might have on its lease rejection claim.

  • In states like Virginia where, according to the Bankruptcy Court in the FLYi case, termination of a lease cuts off a landlord’s claim for future rent, landlords will have to be prepared to lose all or a portion of a lease rejection claim if they sell the real property. 
  • The outcome may be different in other states. Section 1951.2 of the California Civil Code, for example, expressly permits a landlord, upon termination of a lease, to recover the present value of the difference between the unpaid future rent under the lease and the amount of rent that could reasonably be avoided through mitigation efforts. This may permit a landlord to sell the property and still retain a lease rejection claim.
  • When state law allows it, landlords may seek to include provisions in a lease to preserve contractually the right to a post-sale lease damages claim.

What Does This Mean For Bankruptcy Estates? Debtors, liquidation trusts, and other estate representatives may have an incentive to determine whether the landlord still owns the property. In states where a post-rejection sale of the property operates to cut off the landlord’s future rent claim, this fact could provide a new ground for an objection to the landlord’s Section 502(b)(6) claim.

Conclusion. Time will tell how frequently this scenario will play out in future cases, but landlords should expect to see the "did you sell the property" question asked more often going forward.