Ground leases are a crucial - if somewhat uncommon - part of the realty financing market. Because they usually cover big expensive residential or commercial properties like Rockefeller Center and The Empire State Building, to call 2, and last a very long time (99 years and approximately begin) the probability of something unforeseen or unintended taking place is high. This probability increases drastically if, as highlighted listed below, one or both of the lease parties' files for personal bankruptcy. Accordingly, property specialists should keep in mind and make sure when entering into any deal involving a ground lease.

* * * *

Ground leases have actually been around since the Middle Ages and bankruptcy laws have actually existed because a minimum of Roman Times. Given this long history, it is not a surprise that a lot of law has established on the interaction of personal bankruptcy and ground leases. This is particularly so since the advent of the "modern-day" United States Bankruptcy Act in 1898 and the substantial changes to title 11 of the United States Code implemented to it in 1978, when Chapter 11 of the United States Bankruptcy Code (the "Code") was enacted. [1] In particular, Section 365 of the Code supplies special rules 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 guidelines is important to any real-estate professional. Here are the fundamentals:

A ground lease, in some cases referred to as a "land lease," is a distinctive system for the development of industrial real estate, taken pleasure in by those charged with establishing the Rockefeller Center and the Empire State Building, for example. The plan enables extended lease terms frequently up to 99 years (with the alternative of renewal) for the landowner to keep ownership of the land and collect rent while the designer, in theory, may surpass the land to its benefit also. Both traditionally and currently, this atypical relationship in the real estate area generates adequate conversation weighing the structure's advantages and disadvantages, which naturally grow more complicated in the face of a ground lessor or ground lessee's insolvency.

According to the majority of courts, consisting of the Second Circuit, the threshold concern in examining the abovementioned possibilities regarding a ground lease in personal 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, presumption or rejection, just if it is a "real lease." [2] While exactly what constitutes a "real lease" will differ state by state, it is extensively accepted that "the proper inquiry for a court in determining whether § 365 [] governs an arrangement fixing residential or commercial property rights is whether 'the celebrations planned to enforce commitments and provide rights considerably various from those emerging from the normal landlord/tenant relationship.'" Intl. Trade Ad. v. Rensselaer Polytechnic, 936 F. 2d 744 (2d Cir. 1991). This "intent" is identified based upon that of the parties 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 profess to be,'" the economic substance of the lease is the main decision of whether the lease is considered "true" or not, and in some states (like California), is the only suitable 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 additional away those "economic realities" are from the common landlord/tenant relationship, the less likely a lease will be thought about a "real lease" for the function of Section 365. Id. For instance, if residential or commercial property was acquired by the lessor specifically for the lessee's use or exclusively to secure tax advantages, or for a purchase rate unassociated to the land's value, it is less likely to be a true lease.

If the ground lease remains in reality figured out to be a "true lease" (and based on court approval), the designated trustee or debtor-in-possession in a bankruptcy case might then either presume or turn down the lease as it would any other unexpired lease held by the debtor.

However, exceptions apply. These greatly count on a debtor's "appropriate assurances" to the remaining parties to the agreements. Section 365 of the Code offers that if there has actually been a default on a debtor's unexpired lease, the DIP may not presume the abovementioned lease unless, at the time of assumption, the DIP: (i) cures or provides "appropriate guarantee" that they will in truth "promptly treat [] such default"; (ii) compensates or supplies "adequate guarantee" that they will "quickly compensate" parties to the contracts (other than the debtor) for any budgeting loss emerging from such default; and (iii) offers "sufficient guarantee" of their future efficiency under that lease. See 11 U.S.C. § 365(b).

Unrelated to "appropriate guarantee" are the exceptions that further bar task or assumption of leases on the occasion that suitable law excuses a celebration from accepting performance from a party other than the DIP and they decide to work out such right, see 11 U.S.C. § 365(c)( 1 ); the contract's function is to develop a loan or funding to the debtor, see 11 U.S.C. § 365(c)( 2 ); or the lease at problem is of nonresidential real 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 wish to presume or designate the lease, it can decline any existing unexpired arrangements held by the debtor. The most typically cited arrangement governing rejection of a lease affected by a bankruptcy case is Section 365(d)( 4 ), which offers:

"If the [DIP] does not presume or decline 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 considered rejected, and the [DIP] shall instantly surrender such nonresidential real residential or commercial property to the lessor." See 11 U.S.C. § 365(d)( 4 ). [3]

Courts have actually just recently held that this rejection "has the exact same repercussion as a contract breach outside bankruptcy," offering the counterparty a claim for damages, "while leaving undamaged the rights the counterparty has actually gotten under the contract." Mission Product Holdings, Inc. v. Tempnology, LLC, 587 U.S. ___ (2019 ). While this "breach-by-rejection" (a term created by the courts) will frequently cause the agreement's termination, it is crucial to keep in mind that rejection alone will not terminate the obligations imposed by the lease.

Real residential or commercial property is idiosyncratic, and also, real estate financing alternatives are countless and modification daily as the market changes. Ground leases are all unique.

As can easily be recognized from the summary above, handling a particular ground lease in the context of a Chapter 11 bankruptcy can be legally and factually complicated. Therefore, when drafting or modifying ground leases, landlords, leasehold financiers, and mortgagees must seek advice from experienced legal counsel and industrial property experts who understand and can discuss what can happen to a particular lease in a Chapter 11 case.

To learn more, 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 reach out to another member of our Financial Restructuring and Bankruptcy Practice.

[1] "Apart from particular special provisions, the Bankruptcy Code generally leaves the decision 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 "finance lease," in which the trustee or debtor-in-possession ("DIP") owns the land and the property manager is dealt with as the loan provider.

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