Ground leases are an essential - if somewhat uncommon - part of the realty financing industry. Because they normally cover large pricey residential or commercial properties like Rockefeller Center and The Empire State Building, to call 2, and last a very long time (99 years and up to begin) the probability of something unexpected or unintended taking place is high. This possibility increases significantly if, as highlighted listed below, one or both of the lease celebrations' files for insolvency. Accordingly, realty specialists need to bear in mind and take care when entering into any transaction including a ground lease.

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Ground leases have been around given that the Middle Ages and bankruptcy laws have actually existed given that at least Roman Times. Given this long history, it is not a surprise that a lot of law has established on the interplay of personal bankruptcy and ground leases. This is particularly so because the introduction of the "modern-day" United States Bankruptcy Act in 1898 and the comprehensive changes to title 11 of the United States to it in 1978, when Chapter 11 of the United States Bankruptcy Code (the "Code") was enacted. [1] In specific, Section 365 of the Code supplies unique guidelines for the assumption or rejection of a ground lease-as well as its prospective sale and transfer by a debtor to a third celebration.

Knowing these rules is critical to any real-estate expert. Here are the basics:

A ground lease, sometimes described as a "land lease," is a distinctive mechanism for the development of commercial genuine estate, taken pleasure in by those charged with developing the Rockefeller Center and the Empire State Building, for instance. The plan allows for prolonged lease terms frequently as much as 99 years (with the choice of renewal) for the landowner to keep ownership of the land and gather rent while the developer, in theory, might surpass the land to its benefit too. Both traditionally and currently, this irregular relationship in the real estate area produces sufficient conversation weighing the structure's advantages and disadvantages, which inherently grow more made complex in the face of a ground lessor or ground lessee's bankruptcy.

According to most courts, including the Second Circuit, the threshold question in analyzing the previously mentioned possibilities regarding a ground lease in bankruptcy court is whether the ground lease in question is a "true lease" for the purpose of Section 365. Section 365 uses, making the ground lease eligible for, assumption or rejection, only if it is a "real lease." [2] While exactly what constitutes a "real lease" will vary state by state, it is extensively accepted that "the correct questions for a court in identifying whether § 365 [] governs a contract fixing residential or commercial property rights is whether 'the parties meant to enforce commitments and provide rights considerably different from those arising from the normal landlord/tenant relationship.'" Intl. Trade Ad. v. Rensselaer Polytechnic, 936 F. 2d 744 (2d Cir. 1991). This "intent" is figured out based upon that of the celebrations at the time of the lease's execution. In re Big Buck Brewery Steakhouse, Bkrptcy No. 04-56761-SWR, Case No. 05-CV-74866 (E.D. Mich. Mar. 9, 2006). Despite there being "a 'strong anticipation that a deed and lease ... are what they purport to be,'" the financial compound of the lease is the primary determination of whether the lease is thought about "true" or not, and in some states (like California), is the only proper element to weigh. Liona Corp., N.V. v. PCH Associates (In re PCH Associates), 804 F. 2d 193 (2d Cir. 1986) pointing out Fox v. Peck Iron & Metal Co., 25 Bankr. 674, 688 (Bankr. S.D. Cal. 1982). Generally, the more away those "financial realities" are from the regular landlord/tenant relationship, the less likely a lease will be thought about a "real lease" for the function of Section 365. Id. For example, if residential or commercial property was purchased by the lessor specifically for the lessee's use or entirely to protect tax benefits, or for a purchase price unassociated to the land's worth, it is less likely to be a true lease.
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If the ground lease is in truth identified to be a "true lease" (and subject to court approval), the designated trustee or debtor-in-possession in a bankruptcy case may then either presume or decline the lease as it would any other unexpired lease held by the debtor.
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However, exceptions use. These heavily rely on a debtor's "adequate guarantees" to the remaining parties to the contracts. Section 365 of the Code offers that if there has been a default on a debtor's unexpired lease, the DIP might not presume the abovementioned lease unless, at the time of presumption, the DIP: (i) treatments or supplies "appropriate guarantee" that they will in truth "quickly treat [] such default"; (ii) compensates or provides "appropriate assurance" that they will "without delay compensate" celebrations to the contracts (aside from the debtor) for any pecuniary loss emerging from such default; and (iii) provides "adequate assurance" of their future efficiency under that lease. See 11 U.S.C. § 365(b).

Unrelated to "appropriate guarantee" are the exceptions that even more disallow task or assumption of leases in the event that applicable law excuses a party from accepting efficiency from a party other than the DIP and they choose to work out such right, see 11 U.S.C. § 365(c)( 1 ); the contract's purpose is to create a loan or funding to the debtor, see 11 U.S.C. § 365(c)( 2 ); or the lease at problem is of nonresidential genuine residential or commercial property and has actually been terminated under other (non-bankruptcy) law prior to the order for relief, see 11 U.S.C. § 365(c)( 3 ).

If, on the other hand, a DIP does not want to assume or designate the lease, it can turn down any existing unexpired agreements held by the debtor. The most typically mentioned provision governing rejection of a lease affected by an insolvency case is Section 365(d)( 4 ), which offers:

"If the [DIP] does not presume or turn down an unexpired lease of nonresidential genuine residential or commercial property under which the debtor is the lessee within [sixty] 60 days after the date of the order for relief ... then such lease is deemed declined, and the [DIP] will instantly surrender such nonresidential genuine residential or commercial property to the lessor." See 11 U.S.C. § 365(d)( 4 ). [3]
Courts have actually recently held that this rejection "has the same effect as a contract breach outside personal bankruptcy," supplying the counterparty a claim for damages, "while leaving undamaged the rights the counterparty has gotten under the agreement." Mission Product Holdings, Inc. v. Tempnology, LLC, 587 U.S. ___ (2019 ). While this "breach-by-rejection" (a term coined by the courts) will frequently lead to the agreement's termination, it is very important to keep in mind that rejection alone will not end the duties imposed by the lease.

Real residential or commercial property is idiosyncratic, and similarly, realty funding choices are numerous and change daily as the market fluctuates. Ground leases are all distinct.

As can easily be recognized from the summary above, dealing with a specific ground lease in the context of a Chapter 11 insolvency can be lawfully and factually complicated. Therefore, when preparing or changing ground leases, property managers, leasehold investors, and mortgagees must consult well-informed legal counsel and industrial property professionals who comprehend and can explain what can happen to a specific lease in a Chapter 11 case.

For more details, contact Christopher F. Graham, Partner at grahamc@whiteandwilliams.com or 212.714.3066; or Morgan A. Goldstein, Associate at goldsteinm@whiteandwilliams.com or 475.977.8302. Or you might connect to another member of our Financial Restructuring and Bankruptcy Practice.

[1] "Apart from specific special arrangements, the Bankruptcy Code normally leaves the determination of residential or commercial property rights in the properties of an insolvent's estate to state law." See Butner v. United States, 440 U.S. 48 (1979 ).

[2] If the lease examined is not a "real lease," it will be considered a "financing lease," in which the trustee or debtor-in-possession ("DIP") owns the land and the property manager is treated as the lending institution.

[3] Generally, "... a debtor in possession shall have all the rights ... and powers and will perform all the functions and duties ... of a trustee serving in a case under this chapter." See 11 U.S. Code § 1107(a).