Consumer Leases in Chapter 7

Consumer Leases in Chapter 7

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In consumer chapter 7 cases, the debtor frequently will be the lessee under an unexpired residential or a vehicle lease. Because these leases rarely, if ever, benefit the estate, the trustee generally will not assume a residential or consumer personal property lease. Section 365(d)(1) of the Code provides that residential real property and personal property leases are deemed rejected if not assumed by the trustee within 60 days after the petition is filed. But are they? This past August, in a case where the trustee sought turnover of a security deposit on a residential lease, the Ninth Circuit held that §365 does not apply where the debtor has claimed the leased property as exempt after the court held that a residential lease qualified under the Oregon "homestead" exemption. Sticka v. Casserino (In re Casserino), 379 F.3d 1069, 1075 (9th Cir. 2004). The trustee argued that since the lease had not been assumed within the 60-day window provided by §365(d), the rights of the debtor had been changed to that of a tenant at sufferance. The court disagreed, holding that, as exempt property, the lease was removed from the estate and therefore not subject to assumption or rejection by the trustee. Thus, the lease continued in effect.

This leaves open the question of the rights and obligations or duties between the lessor and the debtor under an unexpired lease that has been neither assumed nor rejected. The Code is silent on this point. Is there really a problem? Experience indicates that in most cases, the parties simply go on their respective ways ignoring the fact that a bankruptcy has occurred; the debtor continues making rental payments, and the lessor continues accepting them. In that situation, both parties to the transaction are satisfied with continuing the relationship. However, a problem may arise when either the debtor is in default (not making the lease payments) or the lessor refuses to accept payment and desires to end the relationship. What are the lessor's remedies in the first case, and what rights, if any, does the debtor have in the second?

If the debtor does not make the rental payments, two separate and distinct situations exist. First, the debtor may have been current when the petition was filed, but has fallen behind post-petition. Second, the debtor may be delinquent in the pre-petition rent, but current with post-petition rent.

The first case, a post-petition default, also presents two separate issues: possession and collection of unpaid rent. A lessor should be entitled to proceed with an action in state court (after obtaining relief from stay if it has not already been terminated), thereby recovering possession. But may the lessor also recover the unpaid rent or other damages? Courts have uniformly held that, irrespective of when the payment may otherwise come due, if the obligation arose out of a pre-petition transaction, a debtor's personal liability is discharged under §727(b). Thus, it would seem that any attempt by a lessor to recover unpaid post-petition rent would be barred and a violation of the discharge injunction under §524 (see, e.g., In re Miller, 247 B.R. 224 (Bankr. E.D. Mich. 2000)).

Casserino did leave one avenue open for the lessor to recover, at least in part, unpaid rent and other damages: the security deposit. Under the lease and Oregon law, the security deposit (one month's reserved rent plus $400) in Casserino could only be used for unpaid rent and up to $400 in repairs. (Note: The same result would also follow in states adopting the Uniform Residential Landlord and Tenant Act, §2.101(b).) The security deposit cannot be detached from the rest of the lease and properly remains with the lessor, available to the lessor to apply to unpaid rent and repairs. The extent to which the lessor could retain any part of the security deposit that did not represent prepaid rent to delinquent rents will depend on the lease and applicable state law.

Another potential theory for recovery is whether a lease is severable into increments of time equal to the rental payments under the terms of the lease and applicable state law—as in severing a 24-month lease into 24 separate one-month increments. Under this approach, one might treat each month as creating a "new post-petition" obligation. Here, again, there are two scenarios: a lease that is for 24 months specifying a rent of $12,000 payable in 24 monthly installments of $500 each, and a lease for 24 months payable in 24 monthly payments of $500 each but not specifying the total reserved rent for the term of the lease. Attempting to construe the former as being severable into 24 separate monthly leases will likely be met with a significant degree of judicial skepticism. On the other hand, one might logically argue that the latter is, by its terms, severable and each month creates a "new" obligation to pay the reserved rent. However, there is a caveat: A lessor advancing this argument incurs no small degree of risk. The lessor may face a contempt action brought in the bankruptcy court for a violation of the discharge injunction—an unpleasant experience.

The second situation, a pre-petition default, paints a substantially different picture. A lessor should have a claim against the estate for any unpaid pre-petition rents. On the other hand, any personal liability of the debtor for the pre-petition rents, since that liability clearly arose pre-petition, is discharged under §727(b) (see, e.g., In re Dabrowski, 257 B.R. 394 (Bankr. N.D.N.Y. 2001)). Although there is authority to the contrary—mostly dicta—upon a misreading of §365(b), it is highly questionable whether under the law of any state a lessor can evict a debtor for nonpayment of an obligation that was discharged in bankruptcy. The debtor cannot be delinquent in making rental payments because the debtor no longer owes the rent. In addition, the lessor in this situation will almost certainly be faced with the prospect of answering to the bankruptcy judge for violating the §524 discharge injunction in attempting to collect a discharged debt (the unpaid pre-petition rent). In this situation, the lessor's remedy is to resort to the security deposit—applying the customary one month's rent, paid in advance, to the pre-petition arrearage and demanding that the debtor replenish the security deposit or be in default. Casserino explicitly left this option open and, at least implicitly in dictum, sanctioned it.

It thus appears in the Ninth Circuit (and those courts following Casserino) that while the lessor may terminate the possessory interest and the lease for nonpayment of post-petition rent, the lessor is limited to collection of any monetary damages to the security deposit and may not recover them from the debtor as personal liability. If the debtor is solely in arrears on pre-petition rent, it is unlikely that the lessor has the right to terminate the lease and evict, or collect the pre-petition arrearage from, the debtor.

A debtor wanting to continue the lease and faced with a recalcitrant lessor entails a threshold issue: Does the discharge of personal liability give the lessor the right to terminate the lease in the absence of some other default recognized under the terms of the lease and state law? In states that have adopted the Uniform Residential Landlord and Tenant Act, deeming oneself insecure, unless it is contained in the lease agreement, does not constitute a breach of the lease. Even if a lease were to contain such a clause, enforceability is questionable. A clause of that nature in the lease is the functional equivalent of an ipso facto bankruptcy clause, void as against public policy (see, e.g., §365(e)), although the Ninth Circuit referred to §365 in its entirety as inapplicable, not just §365(d). Since the decision only involved a rejection under §365(d), it is highly unlikely that the court would interpret Casserino as extending to §365(e).

Although this article has addressed primarily residential leases, the holding in Casserino is equally as applicable to other long-term consumer leases (e.g., automobiles). Leases involving "open-ended" or "closed-ended" leases having excess mileage surcharges will be most likely the ones affected the most (see, e.g., In re Beck, 272 B.R. 112 (Bankr. E.D. Pa. 2002)). Lessors and lessees of those types of automobile leases will face situations similar to those facing landlord-tenants, most likely with similar results.

What is the solution? In those courts that follow Casserino where the "fourth option" does not exist, lessors may want to consider a reaffirmation agreement. The language of §524(c) is certainly broad enough to encompass leases (a "claim" as defined in §101(5)). The problem is that the Code in §365 specifically provides the treatment to be given to unexpired leases: assumption, not reaffirmation. Trying to apply §523(c) to a lease runs afoul of the specific trumps of the general rule of statutory construction. There is also no statutory authority for a chapter 7 debtor to assume a lease (see Stoltz v. Brattleboro Housing Authority (In re Stoltz), 315 F.3d 80 (2nd Cir. 2002)). One should note that Casserino does not apply to chapter 13 (see §1322(b)(5)).

Let Consumers Assume Leases

A few years back, this author suggested amending §365 to provide for the assumption of consumer leases by chapter 7 debtors. If an amendment of that nature would violate some public policy, I have yet to hear it articulated. There is no logical reason for permitting a consumer debtor to reaffirm the remaining four years of an obligation secured by the family car, but not assume the remaining four-year lease of a family car. Even if one rejects Casserino, since a majority of courts hold that the deemed rejection of a residential or personal property lease, unlike the rejection of a non-residential real property lease, does not terminate the lease, the lessor and the debtor face the same situation they do under Casserino.

Journal Date: 
Monday, November 1, 2004