Austin Development Co., Matter of

• Decision Date: 03 May 1994
• Docket Number: No. 93-7127,93-7127
• Citation: 19 F.3d 1077
• Parties: , Bankr. L. Rep. P 75,867 In the Matter of AUSTIN DEVELOPMENT COMPANY, Debtor. EASTOVER BANK FOR SAVINGS, Appellant, v. SOWASHEE VENTURE, et al., Appellees, v. AUSTIN DEVELOPMENT COMPANY and J.C. Bell, Trustee, Appellants.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 1077

19 F.3d 1077

62 USLW 2691, Bankr. L. Rep. P 75,867

In the Matter of AUSTIN DEVELOPMENT COMPANY, Debtor.

EASTOVER BANK FOR SAVINGS, Appellant, v. SOWASHEE VENTURE, et al., Appellees, v. AUSTIN DEVELOPMENT COMPANY and J.C. Bell, Trustee, Appellants.

No. 93-7127.

United States Court of Appeals Fifth Circuit.

May 3, 1994.

Pat H. Scanlon, John S. Simpson, Young, Scanlon & Sessum, Jackson, MS, for appellant.

Thomas E. Schwartz, Hattiesburg, MS, for Bell.

Thomas L. Webb, Bourdeaux & Jones, Meridian, MS, for Sowashee Venture.

Robert H. Compton, Witherspoon & Compton, Meridian, MS, for R & S Theaters, Inc.

P. Scott Phillips, William & Glover, Meridian, MS, for United Artists.

Appeal from the United States District Court for the Southern District of Mississippi.

Before HIGGINBOTHAM, DAVIS, and JONES, Circuit Judges.

EDITH H. JONES, Circuit Judge:

The debtor was a lessee under a ground lease and sublessor of a movie theater it built; it assigned its interest in the ground lease and the theater's income stream to a bank as security for various loans. During its Chapter 11 proceeding, the debtor's inaction led to an automatic rejection of its ground lease. 11 U.S.C. Sec. 365(d)(4). ¹ The district court and bankruptcy court held that the "deemed rejection" of the lease effected the termination of the bank's rights under the ground lease and the bank's assignment of the theater sublease. ² We reverse and remand.

BACKGROUND

The facts in this case are straightforward. Austin Development Company (Austin) entered into a long-term ground lease from the predecessor of Sowashee Venture, a general partnership (Sowashee). After borrowing funds from another bank and building a motion On January 2, 1991 Austin filed for reorganization under Chapter 11. Austin did not assume the Sowashee ground lease within 60 days after it filed its bankruptcy petition, nor did Eastover file a motion to compel Austin to assume or reject. Sowashee thereupon filed a motion and complaint requesting that the bankruptcy court terminate 1) Austin's interest as lessee in the ground lease, 2) Eastover's deed of trust on Austin's leasehold interest, and 3) Eastover's interest in the sublease with R & S. Eastover's counterclaim asked the bankruptcy court to order Sowashee to enter into a ground lease with Eastover, as provided for under paragraph 21 of the ground lease. That lengthy "paragraph" granted Austin permission to mortgage all or part of its leasehold estate and granted any future leasehold mortgagee numerous rights as a third-party beneficiary of the ground lease. These creditor rights, similar to those found in nondisturbance agreements between landlords and leasehold mortgagees, included: 1) a requirement that the parties to the ground lease obtain the leasehold mortgagee's written consent prior to cancellation, surrender, or modification of the ground lease; 2) the right to cure lessee's defaults; 3) the right, if termination were to be declared by the landlord, to nullify the termination or indefinitely postpone it by curing all conditions of default; and 4) the right, if termination were to be realized, of the leasehold mortgagee to enter into a new lease with the landlord on the same terms as the terminated lease.

picture theater on the property, Austin subleased the property to the predecessor of R & S Theaters, Inc. (R & S), the theater's current operator. Austin borrowed money from Eastover Bank for Savings (Eastover) to pay off its first lender and for other purposes in 1986. As security for the Eastover loans, Austin granted Eastover a deed of trust on its tenant-leasehold interest in the ground lease from Sowashee and an assignment of Austin's interest in the sublease to R & S. Before Austin's bankruptcy, R & S paid about $11,085 in monthly rental and taxes directly to Eastover. Eastover then applied about $9,000 of this sublease payment to Austin's debt, paid Sowashee about $1,500 as monthly rent under the ground lease, and escrowed money for ad valorem taxes.

The bankruptcy court found for Sowashee and against Eastover in all respects. It ruled that Sec. 365(d)(4) of the Bankruptcy Code did not result in a breach, but rather a termination of the ground lease, the termination of Eastover's interest in the sublease payments, and the termination of Eastover's rights under the ground lease as a third-party beneficiary. The district court affirmed.

DISCUSSION

The question presented in this case is what it means when a debtor as a lessee of nonresidential real property fails within 60 days after filing a Chapter 11 case to assume an unexpired lease. Under Sec. 365(d)(4) of the Bankruptcy Code, the lease is "deemed rejected." Does the rejection terminate the lease and thus extinguish a security interest taken in the debtor's interest in the lease, a sublease by the debtor-lessee, or similar rights that accrued by and among third parties?

This question, although arising infrequently, has generated starkly conflicting opinions among the bankruptcy courts. ³ The bankruptcy and district courts here relied upon the line of cases that construe rejection under Sec. 365(d)(4) essentially as an avoiding Flawed by their failure to analyze Sec. 365(d)(4) in harmony with the rest of Sec. 365 and applicable statutory antecedents, these opinions have worked needless and perhaps unconstitutional forfeitures of security interests. This court's interpretation relies instead on those cases that have construed the plain meaning of Sec. 365, understood in light of all its terms, which together express the Congressional purpose behind the trustee's assumption and rejection power. ⁷ Toibb v. Radloff, 501 U.S. 157, 159-62, 111 S.Ct. 2197, 2199-2200, 115 L.Ed.2d 145 (1991). Section 365 derives from Sec. 70(b) of the former Bankruptcy Act, a provision that broadly codified the common law doctrine that allowed the trustee either to assume and perform the debtor's leases or executory contracts or to "reject" them if they were economically burdensome to the estate. See generally Michael T. Andrew, Executory Contracts in Bankruptcy; Understanding "Rejection," 59 U of Colo.L.Rev. 845, 874-81 and n. 136 (1988). This court has held that the deemed rejection of a lease under Sec. 70(b) did not terminate the lease but merely placed the trustee's obligation to perform under the leasehold outside of the bankruptcy administration without destroying the leasehold estate. In re Garfinkle, 577 F.2d 901, 904 (5th Cir.1978). Consequently, on facts similar to those in the instant case, Garfinkle held that the mortgage of the original lessee from whom the bankrupt acquired the leasehold was preserved notwithstanding an attempted rejection. Id. Garfinkle's analysis remains persuasive, as Sec. 70(b) and Sec. 365(d)(4) do not materially differ in the way they effectuate the assumption and rejection power. See In re Storage Technology Corp., 53 B.R. 471, 474 (Bankr.D.Colo.1985); Andrew, supra, 59 U.Colo.L.Rev. at 879 and nn. 136-140.

                power against such holders of security interests in the debtor's leases. 4  Those cases deduce that when a lease is "deemed rejected," the further requirement of Sec. 365(d)(4) that the trustee "shall immediately surrender such nonresidential real property to the lessor" effects a termination of the lease.  Under these cases, the lease is terminated by operation of federal law and not because of any breach of its terms.  They conclude that when the lease terminates, security interests in the lease are extinguished.  See In re Giles Associates, Ltd., 92 B.R. 695 (Bankr.W.D.Tex.1988).  Somewhat inconsistently, these courts also state that if the lienholders had come into court within the 60-day period for assumption or rejection of nonresidential real property leases, they could have avoided the dire consequence of "deemed rejection."   Precisely how the lienholders, such as Eastover, could have protected themselves is not explained and is highly problematic. 5  These opinions circularly conclude that the statutory breach plus surrender provided in Sec. 365(d)(4) must cause a termination of the trustee's or debtor-in-possession's rights in the leasehold, because otherwise, "the face of the statute and its history are meaningless." 6  In re Giles, 92 B.R. at 698
                

Turning to Sec. 365, the terms rejection, breach and termination are used differently, but not inconsistently or interchangeably, as some courts have suggested. See, e.g., In re Giles, 92 B.R. at 698. Throughout Sec. 365, rejection refers to the debtor's decision not to assume a burdensome lease or executory contract. Section 365(g) states that rejection of a lease "constitutes a breach" except as provided in subsections (h)(2) and (i)(2). Three circuits, including this one, have held that this language does not mean that the executory contract or lease has been terminated, but only that a breach has been deemed to occur. In re Continental Airlines, 981 F.2d 1450, 1459 (5th Cir.1993) ("to assert that a contract effectively does not exist as of the date of rejection is inconsistent with deeming the same contract breached"); In re Modern Textile, Inc., 900 F.2d 1184, 1191 (8th Cir.1990); Leasing Service Corp. v. First Tennessee Bank, Nat'l Ass'n, 826 F.2d 434, 436-37 (6th Cir.1987). ⁸ Consistent with this interpretation, Sec. 502(g) permits the creditor on a rejected lease or executory contract to assert a claim for damages as of the date of bankruptcy, although under Sec. 502(b)(6) a landlord's claim may be subject to a cap. ⁹ 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.

The decision to reject is thus correctly viewed only as a "power to breach" the executory contract or lease. As one commentator put it,

[w]hat the estate's representative is...