A Tenant with a Rejected Lease Could End Up Paying No Rent, Third Circuit Says

When a bankrupt landlord rejects a tenant’s lease, the Third Circuit will allow the tenant to offset its damages, even if it means that the tenant remains in possession without paying rent.

The dispute arose from the failed chapter 11 reorganization of the Revel casino in Atlantic City, N.J. Costing $2.4 billion to build, the casino was eventually sold for a mere $82 million (no typo).

A chief protagonist throughout was the operator of two nightclubs and a beach club at the casino. The casino lost when the bankruptcy judge ruled that the debtor’s right to sell the project “free and clear” under Section 363(f) would not allow the debtor to reject the lease and evict the nightclub operator. In substance, Section 365(h) trumped Section 363(f) by allowing the tenant to remain in possession.

When the debtor rejected the nightclub leases, the tenant elected to remain in possession and reserved its rights under Section 365(h).

Section 365(h) has several tenant-friendly provisions. Subsection (h)(1)(B) allows the tenant to offset the “value of any damage caused by the [debtor’s] nonperformance” against the “rent reserved” under the lease.

Of importance to the appeal in the Third Circuit, subsection (h)(1)(A)(ii) allows the tenant to retain its rights under the lease, including “the amount and timing of payment of rent.”

In his opinion for the Third Circuit on November 30, Circuit Judge Thomas L. Ambro quoted the bankruptcy judge, who called the lease a “bloated morass.” It was indeed complicated because the debtor and the tenant together were to spend $80 million in building out the nightclubs. The tenant’s share of the capital expense was $16 million.

The lease contained what it characterized as a recoupment provision. Judge Ambro summarized the provision as meaning that the tenant would pay no rent unless the nightclubs turned a profit. The bankruptcy and district courts agreed that the recoupment provision was enforceable, effectively meaning that the tenant was not liable for rent.

The purchaser of the casino appealed to the Third Circuit and lost again in Judge Ambro’s 13-page opinion. He said there was “no doubt” that the recoupment clause was one of the rental terms that remained enforceable after rejection under Section 365(h)(1)(A)(ii).

“To render the ‘recoupment’ component . . . inoperative, while still calculating the ‘rent’ component using the same formula, would upend the rent framework established in the Lease and deny [the tenant’s] statutory right to remain in possession of the premises under the same ‘rental terms,’” Judge Ambro said.

Judge Ambro upheld the two lower courts that had sided with the tenant on an independent ground. He ruled that the tenant also had a common law right of recoupment, sometimes referred to as equitable recoupment, which offsets obligations arising between the same parts in the same transaction.

Judge Ambro said there was “no question” that the rental obligation and the tenant’s recoupment rights arose from the same transaction. He said it would be “inequitable” if the tenant were required to pay rent without the offsetting reductions afforded by the recoupment provision.

In short, Judge Ambro said the tenant “is entitled to reduce its rent obligations by recoupment amounts under the Lease based on the doctrine of equitable recoupment.”

Judge Ambro said that nothing in the opinion should be construed to allow the tenant to realize a recovery from the new owner beyond the reductions afforded in the lease.