Third Circuit Upholds Right of Tenant to Continued Possession of Rejected Lease Premises and Reduced Rent Payable to Purchaser After Sale of Premises

The Bottom Line

Recently, in IDEA Boardwalk, LLC v. Revel Entertainment Group, LLC; Polo North Country Club, Inc. (In re Revel AC Inc.), No. 17-3607 (3d Cir. Nov. 30, 2018), the Third Circuit held that Section 365(h) of the Bankruptcy Code and the doctrine of equitable recoupment entitled a tenant to continue paying rent on the same terms under the lease even after its landlord rejected the lease and sold the premises. The net effect was that the purchaser acquired property subject to continued possession by a nondebtor tenant who, in turn, was not required to pay rent per the terms of the lease (which had a formula limiting the circumstances under which rent was payable for the first four years of the lease).

What Happened?

Revel AC Inc. ("Revel") entered Chapter 11 in 2014. One of Revel’s tenants, IDEA Boardwalk LLC ("IDEA"), continued to operate two nightclubs and a beach club venue on the Revel casino premises under a long-term lease (the "Lease"). Under the Lease, Revel would make certain “recoupment” payments to IDEA in the first four years of the Lease term. (Note that the court observed that the rent reduction/abatement provision in the Lease was called a “recoupment” and this was coincidental to the doctrine of “equitable recoupment” also discussed by the court: “[T]his contractual obligation is not the same as the concept of ‘equitable recoupment’ which is an equitable doctrine from the common law.”) These occurred every three months for IDEA’s two nightclubs and twice a year for the beach club. For each of these calculation dates, if the IDEA venue met a certain threshold in gross sales but did not have a positive return to capital net of depreciation, Revel would refund to IDEA the amount necessary to cause IDEA to break even for that period. The net effect of this was a rent reduction such that IDEA would pay rent during the first four years only if and when the IDEA venue “turned a profit” (per a formula in the Lease).

IDEA sought to protect these rights under the Lease by filing an adversary proceeding in the Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"). IDEA initially filed against Revel as the owner, but Polo North Country Club Inc. ("Polo") became the defendant in the proceeding (and IDEA’s landlord under the Lease) when it purchased Revel’s assets, including the casino premises, pursuant to a purchase agreement (the "Purchase Agreement"). The Purchase Agreement provided that Polo would purchase Revel’s assets free and clear of all liabilities, except for those listed in the Purchase Agreement, and would acquire certain legal claims against IDEA, including the right to receive rent payments from IDEA. In addition, in connection with the sale, the Lease was to be rejected, subject to IDEA’s rights under Section 365(h) of the Bankruptcy Code. Notably, under Section 365(h), a nondebtor tenant has the option to treat the rejected lease as terminated (and pursue a rejection damage claim) or, despite rejection, elect to retain rights under the lease to continue to occupy the premises for the duration of the lease. 

The Bankruptcy Court approved the Polo sale (the "Sale Order"). The Sale Order generally authorized Polo’s purchase of Revel’s assets “free and clear of all liens, claims, encumbrances and other interests of any kind” under Section 363(f) of the Bankruptcy Code. However, the Sale Order also contained two carve-out provisions that expressly preserved certain rights relating to IDEA’s continued use of the casino premises under the Lease. The first carve-out preserved any rights (including rights of setoff and recoupment), claims and defenses of IDEA with respect to IDEA’s adversary proceeding against Revel. The second reserved any rights elected to be retained by IDEA pursuant to Section 365(h) after Revel’s rejection of the Lease.

Shortly after entering the Sale Order, the Bankruptcy Court granted Revel’s motion to reject the Lease. In response, IDEA filed a notice of its election to retain its rights as a tenant under Section 365(h). IDEA also asked the Bankruptcy Court to clarify its rights as a tenant after Revel’s rejection of the Lease and sale to Polo. The Bankruptcy Court clarified major aspects of the post-petition landlord–tenant relationship between IDEA and Polo in an omnibus order, however, left open whether IDEA is permitted to deduct from its outstanding rent obligations certain “recoupment” amounts owing to IDEA under the Lease. 

To seek the Bankruptcy Court’s clarification on this point, IDEA filed a motion for summary judgment. The Bankruptcy Court granted in part IDEA’s motion for summary judgment, holding that IDEA may reduce its rent obligations by the recoupment amounts under the Lease for two reasons. First, the tenant rights that IDEA retained by making an election under Section 365(h) include the right to reduce its rent obligations by the recoupment amounts. Second, even if Section 365(h) did not extend to the recoupment amounts, IDEA would be permitted to reduce its rent obligations under the doctrine of equitable recoupment. Polo appealed to the district court, and the district court affirmed on the same two grounds. On appeal, the Third Circuit Court of Appeals affirmed on the same grounds as well. 

First, under Section 365(h), a tenant whose landlord files for bankruptcy and then rejects the tenant’s lease may retain its rights, including those “relating to the amount and timing of payment of rent and other amounts payable by the lessee.” The court explained that a tenant that makes an election under Section 365(h) is “entitled to remain under the same rental terms as are set forth in the lease.” Megafoods Stores, Inc. v. Flagstaff Realty Assocs. (In re Flagstaff Realty Assocs.), 60 F.3d 1031, 1034 (3d Cir. 1995) (citations omitted). Accordingly, the court held that by virtue of IDEA’s election under Section 365(h), IDEA is permitted to reduce its rent obligations by the recoupment amounts applicable under the Lease for the balance of the term of the Lease after the date of rejection.

Second, even if Section 365(h) did not extend to the recoupment amounts, the court agreed that IDEA would be permitted to reduce its rent obligations under the doctrine of equitable recoupment. Recoupment means “the setting up of a demand arising from the same transaction as the plaintiff’s claim or cause of action, strictly for the purpose of abatement or reduction of such claim.” In re Univ. Med. Ctr., 973 F.2d 1065, 1079 (3d Cir. 1992) (citations omitted). The court observed that recoupment “avoids the usual channels in bankruptcy” and enables the creditor to obtain more than its pro rata distribution from the estate by “netting obligations between a creditor and the debtor without regard to the bankruptcy priority of the claim.” Because of this effect, recoupment should be narrowly applied to the same transaction. The court concluded that the rental obligations and recoupment amounts at issue set up an integrated framework, as the payment of rent and the contractual “recoupment” amount worked together to ensure that IDEA paid rent only once the venue turned a profit; thus, it would be inequitable to require IDEA to pay the full amount of its rental obligations without applying the countervailing downward adjustments contemplated by the recoupment provisions. In addition, the court observed that, even if the Sale Order had not expressly preserved IDEA’s rights to the rent “recoupment,” the doctrine of equipment recoupment is an affirmative defense, and the sale of assets “free and clear” of claims under Section 363(f) “does not include defenses to claim.” 

Why This Case Is Interesting

On the one hand, the decision is tied to the particular facts before the court. Notably, the tenant timely preserved its claims, through both an adversary proceeding and the Sale Order, to enforce its contractual right to “recoupment” of amounts otherwise owing under the Lease to reduce or eliminate the payment of rent. This was held to permit the tenant to continue to remain in possession of the premises — even though the property is now owned by the asset purchaser — and, accordingly, reduce rent payable. It also affected the claim of the purchaser against the tenant for payment of rent. All of this was per the Lease terms and the protections obtained by the tenant as part of the Sale Order, that is, that the sale would not affect the tenant’s rights under Section 365(h). To this extent, the decision underscores the need to proactively evaluate the impact of a sale on the rights of a nondebtor tenant from a lease rejection as part of a sale and, in turn, the asset purchaser should factor this risk into its purchase price. (In this instance, the purchaser owns property subject to a continuing possession right in favor of a tenant that does not need to pay rent per the terms of the rejected Lease). The case also holds that the tenant’s right to equitable recoupment could not be eliminated by the “free and clear” language of the Sale Order — irrespective of the negotiated language in the Sale Order — since equitable recoupment is an affirmative defense that is not subject to being barred.