Section 365 of the Code When Does Being in Possession Not Mean in Possession

Journal Issue

Jul/Aug 2006

Column Name

Feature

Citation

ABI Journal, Vol. XXV, No. 6, p. 50, July/August 2006

Bankruptcy Code

365

Topic Tags

Executory Contracts/Leases

Practice and Procedure

Real Estate

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While not a common occurrence, at times a debtor
in a bankruptcy case will be the lessor under a lease that gives the
nondebtor lessee the option to purchase the leased real property at
some time during the lease term. Upon commencing its bankruptcy case,
the debtor-lessor may seek to reject the lease so that it is not bound
by the option to purchase, most likely because the debtor believes it
can sell the real property for a greater sum than that contemplated by
the option. Whether the debtor can rid itself of the option by
rejecting the lease depends on an interpretation of §365(i) of
the Bankruptcy Code. Until recently, the law on this issue was that if
the nondebtor lessee exercised the option prior to the bankruptcy
filing, it could remain in possession of the real property and force
the debtor-lessor to transfer title to it pursuant to §365(i).
Conversely, if the nondebtor lessee did not exercise the option prior to
the bankruptcy filing, it could not obtain title to the real property
and would be limited to the protections afforded to nondebtor lessees
by §365(h) of the Code. This relatively straightforward
interpretation of §365(i) has been thrown a curve by a recent
decision from the District Court of New Jersey. In In re Nickels
Midway Pier, LLC,1 the district court did not focus on
whether or not the option was exercised but instead examined in what
capacity the nondebtor lessee was "in possession" of the real
property at the time of the bankruptcy filing—i.e., was it
in possession as lessee under the lease or as vendee under the option?
Section 365 Fundamentals Before analyzing the
Nickels decision, it is useful to review some fundamentals of
bankruptcy law in the context of when the debtor is a lessor of real
property. Section 365 of the Code provides that a trustee or
debtor-in-possession (DIP) may, subject to bankruptcy court approval,
assume or reject an unexpired lease or an executory contract.
Generally speaking, the rejection by the debtor of an executory
contract or unexpired lease (so long as it has not previously been
assumed) constitutes a breach of the agreement immediately before the
date of the filing of the bankruptcy petition.2 Thus, the
debtor can rid itself of the burdens of the contract, usually leaving
the nondebtor counter-party with a general unsecured damages claim.

While §365 is a useful tool for debtors, it contains certain
subsections that provide protection to nondebtor entities that are
parties to unexpired leases and executory contracts that have been
rejected by the debtor. For example, §365(h) gives a nondebtor
lessee of an unexpired lease of real property the option of remaining
in possession of the leased premises for the remainder of the term of
the lease, even where the debtor rejects the lease. Additionally,
§365(i) permits a nondebtor party to an executory contract for the
purchase of real property to obtain title from the
trustee—again, even if the debtor rejects the executory
contract, provided that the nondebtor party is in possession of the
real property. Specifically, §365(i) of the Bankruptcy
Code—the statute at issue in Nickels—provides in
relevant part that if the debtor rejects the contract of sale for real
property while the nondebtor purchaser is in possession, the nondebtor
purchaser may treat the contract as terminated or remain in possession
of the real property.3 If the nondebtor purchaser remains
in possession, the debtor is required to deliver title to the purchaser
in accordance with the provisions of the contract, but is relieved of
all other obligations to perform under the contract.4
The Law Prior to Nickels Prior to Nickels,
courts seemed to be in general agreement in how they applied
§365(i) when confronted with an option in an unexpired lease of
real property. They held that if the nondebtor lessee properly exercised
the option prior to the bankruptcy filing, it could choose to remain
in possession of the real property, pay the purchase price and obtain
title even if the debtor-lessor rejected the lease. However, if the
nondebtor lessee did not exercise the option, it could remain in
possession of the real property pursuant to §365(h) for the
remainder of the lease term, but it could not obtain title to the real
property pursuant to §365(i). In re Maier5 is
illustrative of how courts addressed this issue prior to

Nickels. In that case, the debtor leased a farm to the
nondebtor lessee; the lease also gave the lessee the option to
purchase the real property. The lessee exercised the option, but prior
to closing, the debtor-lessor commenced a bankruptcy case and sought to
reject the "alleged purchase contract." The court ultimately
found that "[i]f it is determined that [the nondebtor lessee]
properly exercised the option, he may choose to remain in possession
and pay the purchase price. The trustee will then be obligated to
deliver title to [the nondebtor lessee]. However, if it is determined
that [the nondebtor lessee] did not properly exercise the option or,
by his prior acts, breached the lease and thereby terminated the
option, then he must surrender the property to the
Debtor...."6 So long as the option was exercised, the
nondebtor lessee in Maier was permitted to stay in possession
of the real property and the trustee was obligated to transfer title
to him upon payment of the purchase price. The Added Complexity
Nickels, however, has now added an additional layer of
complexity to this previously straightforward application of
§365(i).7 In that case, Nickels Midway Pier LLC was
the owner of a pier in Wildwood, N.J. In 1999, Nickels entered into a
16-year lease with Wild Waves LLC "in which Wild Waves would
lease 70 percent of the pier...for the purpose of constructing and
operating a water park."8 While the lease did not
contain a provision requiring Nickels to sell the entire pier to Wild
Waves, Wild Waves asserted that it had an oral agreement with Nickels
to buy the pier in 2003. A sale agreement for the pier was drafted,
but it was never executed by Nickels, and Nickels "maintained
that it never agreed to sell the pier to Wild Waves. Wild Waves never
furnished any payment called for by the agreement for sale, and
Nickels never delivered the deed."9 After the
commencement of the lease term, the parties agreed to several
amendments to the lease, but those amendments did not mention any
agreement to sell the pier to Wild Waves. In 2001, Nickels commenced
an action in New Jersey state court, wherein Wild Waves filed a
counterclaim seeking a determination that an oral agreement to
purchase the pier was entered into between itself and Nickels. Although
Nickels' bankruptcy case was commenced while the state court action
was pending, Wild Waves obtained relief from the automatic stay so
that the state court action could continue. The state court judge
ultimately found that an oral agreement to sell the pier existed
between Nickels and Wild Waves. He further found that the "'lease
and sale were two aspects of a thoroughly integrated
agreement.'"10 Stated differently, "the lease was
one component of a transaction that was to culminate in the sale of
the pier...."11 After the state court rendered its
decision, Nickels sought to proceed on its previously filed motion to
reject the lease (which was treated as a motion to reject the written
lease and the oral contract of sale). Although the bankruptcy court
permitted Nickels to reject the lease and oral agreement, it
"concluded that Wild Waves was entitled to the protections of
§365(i) because it was a 'purchaser in possession' within the
meaning of [§365(i)], even though it was only in possession of 70
percent of the pier."12 The district court found that
the bankruptcy court's treatment of the lease and oral contract as one
seamless agreement was in error; instead, it found that the lease and
oral contract were "independent components of the parties'
integrated agreement as to the disposition of the pier." It based
its findings, in part, because the lease was for a term that was
unaffected if the parties failed to close on the purchase agreement.
The district court also found significant that the oral agreement was
not contingent on compliance with the terms of the lease.
"Normally, if a lease contains an option to buy the leased
property, it will also provide that a breach of the lease would
terminate the option to buy. Here, however, the only contingency for
the sale is the receipt of the mortgage loan
commitment."13 It was also important to the district
court that the lease payments were not counted toward the sale price
of the pier.14 The legislative history of §365(i) was
reviewed in Nickels.15 However, the legislative
history—specifically the meaning of the term
"possession"—was also examined in In re Summit Land
Co.,16 a case also discussed in Nickels. The

Summit Land court stated: <blockquote> It is
possible to deduce the type of "possession" which Congress
sought to protect from the statutory scheme and this legislative
history. Allowing the purchaser to remain in possession and to
receive title suggests a concern for buyers whose connection with
the land is more permanent than ephemeral, more continuous than
intermittent, more exclusive than shared, and more personal than
delegable. The Commission's emphasis on dislocation, for example, is
meaningless in the event a contract is transferred to another.
Indeed, the distinction between "purchaser in possession" and
"party not in possession" may reflect congressional
awareness that buyers under land sale contracts often assign their
interest to third parties. Allowing the purchaser to retain the
investment value of the land also has
significance.17</blockquote> In Nickels, Wild
Waves' connection to the pier seemed to be more permanent, continuous
and exclusive than Nickels' connection to it. Apparently, the district
court thought differently. As noted in Summit Land, the
legislative history of §365(i) refers to purchasers of real
property under a land sales contract. However, the district court in
Nickels acknowledged that the application of this statute is
not limited to those types of contracts.18 Nonetheless, it
then stated that while the oral contract at issue could fit within the
definition of land sale contract, "courts have never suggested
that the provision encompasses those purchasers who are in possession
under an agreement other than the land sale
contract."19 Ultimately, the district court held as
follows: <blockquote> Viewing the lease and the oral contract for
sale as separate aspects of the agreement, it is clear that Wild
Waves is in possession of the leased premises under the lease and
not the oral contract for sale. Section 365(i) is thus inapplicable
because there is no contract for sale "under which [Wild Waves]
is in possession" of any part of the pier.20

</blockquote>Accordingly, the district court reversed the
decision of the bankruptcy court and remanded the matter for further
proceedings.21 A Drafting Conundrum The
Nickels case highlights the need when drafting the operative
agreement to integrate the lease and option to purchase sections in
order to establish one integrated, indivisible document. This will
avoid the "in possession" controversy and thereby achieve
the specific performance protection of §365(i). But consideration
should be given to the impact of an integrated document in the
scenario where the option to purchase is not exercised prior to
bankruptcy and there is no §365(i) protection, but the nondebtor
lessee wants to remain in possession of the real property pursuant to
§365(h). In that situation, the nondebtor lessee will not be able
to assert an independent damage claim except as an offset to the rent
obligation. If, however, the rent obligation is small in comparison to
the resulting damage claim caused by the breach of the option to
purchase, the nondebtor lessee may very well be better off having a
transaction where the lease and option to purchase are contained in
separate agreements in order to maximize the damage claim assertable
against the debtor. Since the structuring of the agreement decision is
made up-front (i.e., before bankruptcy and before the option to
purchase is exercised), the Nickels case raises a drafting
dilemma as to whether to create an integrated lease/option agreement
to ensure the specific performance remedy, versus separate lease and
option to purchase agreements to potentially maximize the damage claim
under certain scenarios. If, in structuring the transaction, it is
more advantageous to ensure avoiding the Nickels problem,
consideration should be given to specifically providing that when the
option is exercised, the nondebtor lessee will be deemed in possession
of the real property pursuant to the option and not the lease. Also,
consideration should be given when drafting to specifically integrate
the lease and option provisions by, among other things,
cross-defaulting the two provisions and conditioning the exercise of
the option on lease compliance. <hr><h3>Footnotes</h3> 1 Adv. Proc.
No. 05-5514 (JEI), 2006 WL 1072490 (D. N.J. April 24, 2006)
(Nickels). 2 See 11 U.S.C. §365(g)(1).

3 11 U.S.C. §365(i)(1). 4 11 U.S.C.
§365(i)(2)(B). 5 127 B.R. 325 (Bankr. W.D.N.Y. 1991).
6 Id. at 328; accord, In re Silberkraus, 253 B.R.
890, 907 (Bankr. C.D. Cal. 2000) (upon exercising option to purchase
property contained in lease, the option becomes a binding contract of
sale and the nondebtor lessee "would be entitled to the
protections afforded a purchaser in possession under
§365(i)"). 7 Before the 1994 amendments to the
Bankruptcy Code, §365(h)—which deals with the right of a
nondebtor lessee to remain in possession of a rejected
lease—contained the "in possession" language. The 1994
amendments eliminated the "in possession" concept for
lessees, but did not eliminate the concept for vendees in possession
under §365(i). 8 2006 WL 1072490, at *1. 9 Id.
10 Id. at *2 (quoting state court opinion).

11 Id. 12 Id. at *3. 13 Id. at
*5. 14 Id. at *6. 15 Nickels, 2006 WL
1072490, at *8. 16 13 B.R. 310 (Bankr. D. Utah 1981). 17

Id. at 318. 18 Nickels, 2006 WL 1072490, at *8.
19 Id. 20 Id. at *7. 21 Wild Waves
has appealed the district court's decision to the Third Circuit Court
of Appeals. That appeal is currently pending.

Journal Authors

Arthur J. Steinberg

Scott Ian Davidson

Journal Date

Saturday, July 1, 2006 - 12:00

Bankruptcy Rule

2006

none