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:

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

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:

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

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.

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Footnotes

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.