United States: Buyer Beware - Following A Section 363 Sale And Lease Rejection, Debtor's Tenant May Have Right To Retain Leasehold And Reduced Rent

The Revel decision provides a cautionary tale for purchasers under Section 363. 

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 United States Court of Appeals for the Third Circuit held that, under Bankruptcy Code Section 365(h) and the doctrine of equitable recoupment, a nondebtor tenant could remain in possession following lease rejection and a Section 363 sale to a third party. Further, the court allowed the tenant to reduce its rent under the equitable doctrine of recoupment. The asset purchaser therefore acquired the debtor’s assets subject to the lease with the likelihood of reduced rent payments.

The debtor, Revel AC Inc., operated an Atlantic City casino. IDEA Boardwalk, LLC was a tenant at the casino. The leasehold included two nightclubs and a beach club. Under the lease, both Revel and IDEA were required to make capital contributions to build out the IDEA venues. The rent formula for each venue was based, in part, on the venues’ revenues and the parties’ respective capital contributions. The lease also included a recoupment formula under which IDEA could reduce its rent obligations in the event that, despite reaching targeted gross sales, IDEA failed to realize a positive return on its capital investment.

Revel sold substantially all of its assets to Polo North Country Club, Inc. Prior to the sale, IDEA had filed an adversary proceeding against Revel to determine IDEA’s rights under the lease. Although Polo purchased Revel’s assets “free and clear” of liens, claims and encumbrances, the sale order included two carve-out provisions which preserved: (a) any of IDEA’s rights of setoff and recoupment as alleged in the adversary proceeding; and (b) any rights that IDEA might have under Bankruptcy Code Section 365(h) after a rejection of the Lease.

Postsale, Revel rejected the lease. IDEA elected to retain its rights as a tenant under Section 365(h). In ruling on IDEA’s motion for partial summary judgment in the adversary proceeding, the Bankruptcy Court held that IDEA could: (a) offset against its rent obligations any damages caused to IDEA by the lease rejection; and (b) recoup against the rent any amounts due to IDEA, either presale or postsale, under the recoupment formula set forth in the lease. The district court affirmed. On appeal, the Third Circuit Court of Appeals also affirmed.

With regard to IDEA’s continued possession of the leasehold, Section 365(h) provides in relevant part:

If the trustee rejects an unexpired lease of real property under which the debtor is the lessor… [and] the term of such lease has commenced, the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease… [11 U.S.C. § 365(h)(1)(A)(ii)]

Having made an election to retain its rights under Section 365(h), IDEA was entitled to continued possession. The Third Circuit Court of Appeals had previously held that a tenant who makes an election under this provision 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) (quoting In re TM Carlton House Partners, 97 B.R. 819, 823 (Bankr. E.D. Pa. 1989)). Under the lease, IDEA had a contractual right of recoupment. The sale order had expressly preserved recoupment rights. Notably, the court held that, absent this carve-out, IDEA could still exercise recoupment because a “free and clear” sale under Section 363 does not eliminate recoupment rights. The court noted that recoupment is an affirmative defense and the sale of assets “free and clear” of liens, encumbrances and interests “does not include defenses to claims.” Folger Adam Sec., Inc. v. DeMatteis/MacGregor, JV, 209 F.3d 252, 257, 258-64 (3d Cir. 2000); accord In re Trans World Airlines, Inc., 322 F.3d 283, 289 (3d Cir. 2003); ([A] right of recoupment is a defense and not an interest and therefore is not extinguished by a § 363(f) sale.” (quoting Folger, 209 F.3d at 261))

The Revel decision provides a cautionary tale for purchasers under Section 363. Due diligence needs to identify: (a) all leases under which the debtor is a landlord; and (b) all facts that might give rise to the nondebtor tenant’s recoupment against future rent obligations. Only through such due diligence can a buyer accurately assess the value of the property it is purchasing.

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