Rent-Controlled Rejection?

New York is home to many great things, such as Broadway, museums, fashion, and some of the nation’s tallest buildings.[2] Just like some of its highest buildings, New York is also home to some of the country’s highest rent prices. As of April 2019, the average monthly rent for an apartment in New York City was $3,519.[3] However, many apartments are subject to rent-stabilization and rent-control. This means that the landlord is limited in the amount of rent that can be charged for the apartment. It is estimated that over one million apartments in New York City are subject to either rent stabilization or rent control.[4] Rent-controlled apartments are favored by tenants due to the protections. However, such protections are disfavored by landlords because they result in much lower-than-market rent prices and are difficult to terminate, even upon default.

May a landlord file chapter 11 and simply reject its rent-controlled leases in order to obtain a greater value for the leasehold and benefit to the landlord’s creditors? To answer the question requires consideration of both federal and state laws.

The Bankruptcy Code is federal law. Section 365 of the Bankruptcy Code allows a trustee to assume or reject an executory contract or unexpired lease of real property.[5] If a landlord files chapter 11, § 365 permits the landlord to reject its unexpired leases. When analyzing whether a debtor may reject a contract, courts utilize the business-judgment standard, which assumes that the debtor’s estate will only reject contracts where the benefit to the counterparty would be a detriment to the estate.[6]

Rent control and rent stabilization are creatures of state law. “As an exercise of its police power, the City of New York promulgated certain laws regarding the regulation and control of residential rents and evictions necessary to protect the public health, safety and general welfare.”[7]

Section 28 U.S.C. § 959(b) provides for a symbiotic relationship between federal bankruptcy laws and state laws. This section provides that

[e]xcept as provided in section 1166 of title 11, a trustee, receiver or manager appointed in any case pending in any court of the United States, including a debtor-in-possession, shall manage and operate the property in his possession as such trustee, receiver or manager according to the requirements of the valid laws of the state in which such property is situated, in the same manner that the owner or possessor thereof would be bound to do if in possession thereof.[8]

Accordingly, although the debtor may use federal bankruptcy powers, the debtor must not run afoul of state law.

In In re Friarton Estates Corp., the bankruptcy court noted that under New York law a statutory tenant is not deemed one under a contract or agreement and therefore does not hold a lease.[9] The Friarton court continued to reason that if rejection of a real property lease is permitted, then, pursuant to § 365(h)(1), the lessee “may treat the lease as terminated by such rejection, or in the alternative, may remain in possession for the balance of the term of such lease and any renewal or extension of such term that is enforceable by such lessee under applicable nonbankruptcy law.”[10] This would preclude the landlord from collecting rent.

While the Friarton court has not been overturned, the Second Circuit Court of Appeals interpreted the tenancy differently, finding a contractual leasehold interest. In 1995, the Second Circuit in Resolution Trust Corp. v. Diamond determined that although “the landlord/tenant relationship has been made subject to a variety of laws, including the obligations imposed by New York’s rent regulations, the tenancy itself — the interest in the property — was created by the lease.”[11] The Second Circuit recently ratified this determination in Santiago-Monteverde v. Pereira (In re Santiago-Monteverde).[12] In Santiago-Monteverde, the court reinforced its ruling in Diamond that a rent-stabilized tenancy would be covered by § 365 because the tenancy is the product of a lease under federal law.[13] The Santiago-Monteverde court ultimately ruled, however, that the trustee could not sell a debtor’s interest in her rent-stabilized lease because it qualified as a local public assistance benefit under New York state law.

Not all courts have followed Santiago-Monteverde. In In re Toledano, for example, the court found that a debtor’s rent-stabilized or rent-controlled lease may be assumed pursuant to § 365 and assigned to a third party to generate value to the debtor’s estate.[14]

Despite the Santiago-Monteverde court’s ruling that the rent-stabilized lease was exempt from the trustee’s reach because it was deemed a local public assistance benefit, this issue has not been addressed in a rejection scenario at the direction of a debtor. The implications indeed seem similar. Recently, on March 13, 2019, New York Attorney General Letitia James announced that the City and the State will be joining an “action in the United States Bankruptcy Court for the Southern District of New York on behalf of tenants at 444 East 13th Street in Manhattan.”[15] The owner of the building, 444 East 13 LLC, filed for chapter 11 protection seeking to reject its tenants’ leases “on the grounds that a proposed $8.2 million sale of the property can’t go through while the rent-stabilized leases are in place.”[16]

The interesting issue seems to hinge on whether a chapter 11 debtor’s rejection of leases would be impermissible based on a local public assistance exemption. In Toledano, the court permitted the trustee to assume a rent-controlled lease. Yet in Santiago-Monteverde, the court deferred to the New York Court of Appeals’ ruling that found that a rent-stabilized tenancy qualified as a public assistance benefit due to its purpose and efficacy. Certainly, the purpose and efficacy of bankruptcy are similar. The goal of bankruptcy is a fresh start, but it seems that ousting innocent tenants who may be unable to afford current New York rents is a harsh means to attain that goal. We will have to await the bankruptcy court’s decision in In re 444 East 13 LLC to find out how the court will address rejection initiated by the debtor.