Ground leases are an essential - if somewhat unusual - part of the genuine estate finance market. Because they generally cover large costly residential or commercial properties like Rockefeller Center and The Empire State Building, to name 2, and last a long period of time (99 years and approximately start) the possibility of something unexpected or unintended occurring is high. This probability increases dramatically if, as highlighted below, one or both of the lease parties' apply for insolvency. Accordingly, real estate experts ought to keep in mind and take care when participating in any transaction including a ground lease.

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Ground leases have been around since the Middle Ages and insolvency laws have existed since at least Roman Times. Given this long history, it is not a surprise that a great deal of law has established on the interplay of bankruptcy and ground leases. This is especially so because the arrival of the "modern-day" United States Bankruptcy Act in 1898 and the comprehensive changes to title 11 of the United States Code carried out 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 provides special guidelines for the presumption or rejection of a ground lease-as well as its possible sale and transfer by a debtor to a 3rd party.

Knowing these rules is critical to any real-estate specialist. Here are the fundamentals:

A ground lease, in some cases referred to as a "land lease," is an unique mechanism for the advancement of business realty, delighted in by those tasked with developing the Rockefeller Center and the Empire State Building, for example. The plan permits prolonged lease terms often approximately 99 years (with the option of renewal) for the landowner to retain ownership of the land and gather rent while the developer, in theory, might enhance upon the land to its advantage too. Both historically and currently, this atypical relationship in the real estate space produces adequate 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 personal bankruptcy.

According to many courts, consisting of the Second Circuit, the threshold question in examining the abovementioned possibilities concerning a ground lease in bankruptcy court is whether the ground lease in concern is a "true lease" for the function of Section 365. Section 365 uses, making the ground lease eligible for, assumption or rejection, only if it is a "true lease." [2] While what exactly constitutes a "real lease" will vary state by state, it is widely accepted that "the correct questions for a court in determining whether § 365 [] governs a contract fixing residential or commercial property rights is whether 'the celebrations intended to impose obligations and give rights significantly different from those emerging from the regular 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 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 profess to be,'" the financial substance of the lease is the main determination of whether the lease is thought about "real" or not, and in some states (like California), is the only proper aspect to weigh. Liona Corp., N.V. v. PCH Associates (In re PCH Associates), 804 F. 2d 193 (2d Cir. 1986) mentioning Fox v. Peck Iron & Metal Co., 25 Bankr. 674, 688 (Bankr. S.D. Cal. 1982). Generally, the further 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 purpose of Section 365. Id. For instance, if residential or commercial property was acquired by the lessor particularly for the lessee's use or solely to protect tax advantages, or for a purchase cost unrelated to the land's value, it is less most likely to be a real lease.

If the ground lease is in truth figured out 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 reject the lease as it would any other unexpired lease held by the debtor.

However, exceptions use. These greatly count on a debtor's "sufficient guarantees" to the staying celebrations to the contracts. Section 365 of the Code supplies that if there has actually been a default on a debtor's unexpired lease, the DIP might not assume the abovementioned lease unless, at the time of assumption, the DIP: (i) treatments or offers "sufficient guarantee" that they will in fact "immediately cure [] such default"; (ii) compensates or supplies "appropriate guarantee" that they will "without delay compensate" parties to the contracts (other than the debtor) for any pecuniary loss developing from such default; and (iii) uses "adequate assurance" of their future performance under that lease. See 11 U.S.C. § 365(b).

Unrelated to "appropriate guarantee" are the exceptions that further bar task or presumption of leases in case suitable law excuses a party from accepting performance from a celebration besides the DIP and they decide to work out such right, see 11 U.S.C. § 365(c)( 1 ); the agreement's function is to create a loan or financing to the debtor, see 11 U.S.C. § 365(c)( 2 ); or the lease at concern is of nonresidential real residential or commercial property and has actually been ended 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 appoint the lease, it can decline any existing unexpired arrangements held by the debtor. The most normally cited arrangement governing rejection of a lease impacted by a personal bankruptcy case is Section 365(d)( 4 ), which supplies:

"If the [DIP] does not assume or decline an unexpired lease of nonresidential real 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] will 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 effect as a contract breach outside personal bankruptcy," providing the counterparty a claim for damages, "while leaving intact the rights the counterparty has received under the contract." Mission Product Holdings, Inc. v. Tempnology, LLC, 587 U.S. ___ (2019 ). While this "breach-by-rejection" (a term coined by the courts) will frequently cause the contract's termination, it is very important to note that rejection alone will not terminate the obligations imposed by the lease.

Real residential or commercial property is distinctive, and likewise, property funding options are many and change daily as the market fluctuates. Ground leases are all special.

As can easily be recognized from the summary above, handling a specific ground lease in the context of a Chapter 11 personal bankruptcy can be legally and factually complicated. Therefore, when preparing or amending ground leases, property managers, leasehold investors, and mortgagees should speak with educated legal counsel and industrial real estate specialists who understand and can explain what can occur to a particular 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 may reach out to another member of our Financial Restructuring and Bankruptcy Practice.

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

[2] If the lease analyzed is not a "true lease," it will be thought about a "finance lease," in which the trustee or debtor-in-possession ("DIP") owns the land and the proprietor is dealt with as the lender.

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