3 Selected Cases On Ground Leases

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1 3 Selected Cases On Ground Leases 3.1 INTRODUCTION Certain problems arise again and again in the world of ground leases. Most of this book seeks to prevent those problems by recognizing that they can occur and suggesting specific language that would have prevented problems that have already occurred. This Chapter, in contrast, focuses in detail on how some reported cases have dealt with problems that have already occurred. The discussion of each area begins with the story that each case tells, then turns to a discussion of how the particular case dealt with the problem, and concludes with an analysis of lessons learned and points that drafters should keep in mind for future leases. The consistent theme of this Chapter is that lease drafters cannot rely on the courts to get it right and drafters therefore need to go into full detail on every possible issue that can arise in a lease. That theme is not at all consistent with transactional efficiency, speed, cost control, and quick and dirty lease drafting. It is, however, consistent with the real world, in which most courts do not necessarily understand complex commercial real estate transactions no surprise given how many judges come from the personal injury bar, prosecutor s and public defenders offices, and public interest organizations rather than from commercial real estate practices. This Chapter covers only a selected handful of problem areas believed to be the most important ones that arise again and again and examines only a small number of selected cases in each area. Many more problem areas exist, and many more cases could be discussed in 235

2 236 Guide to Ground Leases 3.1 each of the problem areas presented here. This Chapter does little more than offer a flavor of each area. It should not be relied on as an authoritative treatise on the law of ground leases. It does, however, offer the ground lease practitioner a valuable and rather efficient introduction to the case law in a few crucial areas. In each case the lesson relates not so much to the governing law in a particular area, but to the importance of understanding the issues in that area and writing a lease that covers them, rather than leaving gaps to be filled in randomly by a judge. As a practical matter, it is usually not safe to assume that the next case will be decided the same way as the previous case, even though that s how the common law system is supposed to work. Drafters of leases and all other contracts know that courts are unpredictable and, among other things, can always find a way to distinguish the next case from the previous case based on the result the court wants to achieve. As a result, those drafters will often try to provide expressly for a particular outcome rather than rely on governing law. The recurring lesson of all these cases is that judges don t always get it right, don t understand the dynamics of commercial real estate, and cannot be relied upon. Moreover, the reported cases, particularly in New York, often offer only the most minimalistic statement of the facts and governing legal principles, meaning that the reader of any case can read into it almost whatever implications he or she wants. That characteristic of the reported cases, combined with the sui generis nature of most of the facts of these cases, further demonstrates the inadequacy of case law as a foundation for ground lease transactions (or perhaps real estate transactions generally). The pressure on drafters to cover everything (because the courts reasoning can t be relied upon or predicted) further explains the length and complexity of modern American real estate documents. As a brief venture into comparative law, in Germany and other civil law jurisdictions, comprehensive statutes define the relationship between a landlord and a tenant or between a borrower and a lender. The parties generally live with those statutes and know that the courts will apply them as written. As a result, documents can be, and are, much shorter and simpler (and the parties rely much less on lawyers) than in the United States. Moreover, the same lawyers who draft transactional documents also litigate transactions that go bad. That increases the connection between the process of negotiating and closing trans-

3 3.2 Cases On Ground Leases 237 actions and the process of interpreting and applying legal documents. Except perhaps for the diminished role of lawyers in transactions, the European system has a certain appeal to it. Readers are encouraged to submit to the author particularly interesting cases on ground leases for possible inclusion in future editions of this book. Although reported cases are preferred, unreported cases are also invited. Submissions of the latter should include copies of all interesting rulings and briefs. 3.2 BANKRUPTCY OF TENANT What happens to the leasehold mortgagee and its mortgage when the tenant rejects a ground lease in the tenant s bankruptcy proceeding? Traditionally, lenders and their lawyers have assumed that under these facts the collateral vanishes and hence the leasehold mortgage attaches to nothing at all. They reach that result by assuming that the tenant s rejection of a lease results in the extinguishment or termination of the lease. Once the lease is extinguished, any interest that the tenant had in the leased property is eliminated. If the tenant has no remaining interest in the leased property, then, absent special arrangements or agreements to protect a leasehold mortgagee, the leasehold mortgagee s security, which attached to the tenant s property interest in its lease, would be wiped out. Though that result is widely accepted (or at least assumed or feared) by those who work in this area and this possibility was originally what drove the new lease clause found in nearly every set of leasehold mortgagee protections some recent decisions suggest that the consequences of a tenant s lease termination may not be as bad as everyone assumes. In In re Austin Development Co., 1 the Fifth Circuit found that even though the lease had been rejected, the leasehold mortgagee s claim against the property survived. The tenant in this case, Austin, had failed to assume or reject the lease within the requisite 60 days. Hence, under Bankruptcy Code 365(d)(4), the lease was deemed rejected. But was it terminated? The lease in question stated that any leasehold mortgagee would be a third-party beneficiary of the lease, with rights similar to those found in a nondisturbance agreement. The problem for the leasehold mortgagee, though, was that if the rejection caused a total termination 1 19 F.3d 1077 (5th Cir.), cert. denied, 513 U.S. 874 (1994).

4 238 Guide to Ground Leases 3.2 of the lease, then the total termination would also do away with the leasehold mortgagee s special rights as a third-party beneficiary. The court held, however, that rejection of a lease or executory contract under Bankruptcy Code 365 does not constitute a termination, but merely a breach. The judge stated: Rejection is treated as a breach to preserve the rights of the party whose lease with the debtor has been rejected by providing a prepetition claim; if rejection were deemed a complete, immediate termination, it is not clear what the measure of the creditor s claim would be. 2 Because the rejection breached the lease but did not terminate it, the leasehold mortgagee s special rights under the lease survived. Those rights included the familiar rights to cure a tenant s defaults and to obtain a new lease from the landlord on the same terms as the terminated lease. A California bankruptcy court reached much the same conclusion in In re Locke. 3 Here, the Lockes and a nondebtor entity were cotenants under a ground lease. A judgment creditor held a lien on the Lockes interest under the lease, and on the Lockes share of the income earned from subleases. As in Austin, the Lockes failed to accept or reject the lease and co-tenancy agreements within 60 days; hence, under section 365(d)(4) both were deemed rejected. If a rejection resulted in the termination of these agreements, then the judgment creditor s lien would attach to nothing at all. Following the Fifth Circuit s reasoning in Austin, the bankruptcy court determined that the rejection terminated neither the co-tenancy agreement nor the lease. The doctrine of rejection was created to enable [bankruptcy trustees] to free the estates under their control from the onerous obligations of executory contracts and leases. To accomplish that goal, it is not necessary to conclude that the rejection of executory contracts and leases results in the extinguishment of those executory contracts and leases. 4 Because the lease and the joint tenancy agreement remained intact despite their rejection in bankruptcy the judgment creditor remained entitled to the Lockes share of subrentals. In 2004, a California state court decided to follow what it saw to be the trend on this issue. In McLaughlin v. Walnut Properties, Inc., 5 it 2 Id. at B.R. 245 (Bankr. C.D. Cal. 1995). 4 Id. at Cal. Rptr. 3d 369 (Cal. Ct. App. 2004).

5 3.2 Cases On Ground Leases 239 was not a third party (a leasehold mortgagee) that was at risk of suffering a loss from the tenant s bankruptcy, but the landlord. The tenant, Walnut, was a movie theater developer. In 1994 Walnut filed for Chapter 7 bankruptcy. As in the above cases, Walnut neither accepted nor rejected its ground lease within the requisite period. Principals of Walnut assured the landlord, McLaughlin, that the movie theater development project would be completed. McLaughlin continued to accept rent. By 1997, Walnut was far behind in rent and it became clear that Walnut could never finish its project. In April 1998, Walnut abandoned the property. McLaughlin sued for damages. Walnut countered that, because of its bankruptcy filing, its lease was deemed rejected and terminated as of August 1994 and that as a result McLaughlin s damages were cut off at that time. The court disagreed with Walnut. Citing Austin and Locke, the court held that Walnut s (deemed) rejection of the lease in bankruptcy was a breach, but not a termination, of the lease. The court also found that McLaughlin had waived that breach by accepting rents and assurances that the project would be completed. Finally, the court found that Walnut breached a second time when it abandoned the property in As a result, the rejection of the lease did not cut off Walnut s liability for damages in 1994 and the court ordered Walnut to pay more than $2.6 million in damages. These cases throw some doubt onto the need for the new lease clause that leasehold mortgagees always like to see. Such clauses were originally designed to deal with the risk that the tenant s bankruptcy and lease rejection might terminate the lease, leaving the leasehold mortgagee with no collateral for its mortgage. Leasing lawyers addressed that concern by requiring the landlord to grant the leasehold mortgagee a new lease under these circumstances. These new lease clauses often include language saying that the new lease right survives any termination of the old lease. If, however, a rejection of the lease does not terminate the lease as against holders of liens on the lease, then do leasehold mortgagees really need new lease clauses? As in so many other areas, the answer is obvious but ultimately not so obvious, because other cases go the other way. If only a handful of cases out of a hundred might rule against leasehold mortgagees on these issues, then leasehold mortgagees should insist on having new lease clauses that will survive the termination of the old lease. And in fact a number of cases have concluded that a rejection ter-