Legal Briefs

Protecting Possession

Subtenants need to know their rights in the event of a sublandlord's bankruptcy.

Subtenants that do not employ mechanisms to protect their interests could face devastating consequences if a sublandlord files for bankruptcy protection. In such situations, bankruptcy law can operate to terminate subtenants' rights to possession. In a California case on this issue, Syufy Enterprises, L.P. v. City of Oakland , the subtenant's right to possession was terminated even though the master landlord expressly consented to the sublease, the subtenant spent substantial funds to improve the premises, and the master landlord repeatedly assured the subtenant that its tenancy would continue.

Subtenant Loses Right to Possession

The Syufy case involved a master lease by the Port of Oakland as the master landlord and, through several assignments, the Oakland Airport Hotel Corp. as the master lessee and eventual sublandlord to Syufy Enterprises. When Syufy originally subleased a portion of the premises, the master lease was amended to state that the Port of Oakland agreed to the sublease and to Syufy's construction of improvements. Thereafter, Syufy spent substantial funds remodeling the leased premises.

Decades later, OAHC received a series of default notices on its master lease obligations. However, the Port of Oakland assured Syufy that its tenancy would not be disturbed if OAHC defaulted.

Ultimately, the Port of Oakland filed an unlawful detainer action against OAHC, which then filed for Chapter 11 bankruptcy protection. The bankruptcy court denied the bankruptcy trustee's motion to assume the master lease, which, under bankruptcy law, was ?deemed rejected.? OAHC was ordered to vacate the premises.

Syufy only learned of the bankruptcy proceeding via a letter from the Port of Oakland stating that the court order terminated its sublease. However, the master landlord reiterated its intention to allow Syufy to continue occupancy and even indicated its intent to enter into a month-to-month arrangement. In addition, the Port of Oakland expressed plans to formalize a direct lease with Syufy. Although no new lease ever materialized, Syufy relied on the master landlord's assurances.

Two years later, Syufy received a termination notice ordering it to vacate the premises and subsequently filed suit for declaratory relief and damages against the Port of Oakland . The trial court held that the master lease's deemed rejection effectively terminated Syufy's rights under the sublease.

Appellate Court Decision

On appeal, the court first applied bankruptcy law principles. Generally in Chapter 11 bankruptcy cases, bankruptcy trustees either can assume or reject leases held by debtors as lessees. However, if a lease is neither assumed nor rejected, it is deemed rejected. In Syufy, the bankruptcy court's denial of the bankruptcy trustee's motion to assume the master lease resulted in a deemed rejection. Therefore, the appellate court had to determine the deemed rejection's effect on a third party (Syufy) regarding its rights under the rejected lease.

The court considered two competing views on this issue. It did not apply the traditional view, which holds that a deemed rejection completely terminates a lease and automatically extinguishes a subtenant's rights. Instead, the court applied the emerging view and current trend in California bankruptcy law that a deemed rejection constitutes a breach but does not terminate the tenant's other covenants, rights, and remedies in or appurtenant to the lease. Under this view, a third party's rights may survive a debtor's rejection of the lease.

While the court's adoption of the emerging view provided Syufy hope of saving its interest in the subleased premises, the court also applied California law, under which subtenants' rights are dependent on and subject to sublandlords' rights. Syufy argued that the master lease amendment, in which the Port of Oakland expressly permitted the sublease, made Syufy a third-party beneficiary of the sublease with greater rights than an ordinary subtenant.

However, the court concluded that while Syufy may have been a third-party beneficiary, the amendment did not provide it with a greater right to possession of the premises than was enjoyed by the sublandlord. The court found that Syufy's right to possession was based entirely on the sublandlord's right to possession under the master lease, a right that was extinguished by the sublandlord's breach. Therefore, the master landlord had the right to regain possession of the subleased premises.

Subtenants' Defense

Subtenants' primary method of protecting their interests in such situations is to obtain the master landlord's express written acknowledgment that, if the master lease is terminated, the subtenant will render performance and continue to pay rent to the master landlord and that the master landlord will not disturb the subtenant's possession of the premises. Essentially, the master landlord must agree that the sublease would operate as if it were a direct lease between the master landlord and the subtenant.

In evaluating their positions in sublandlords' bankruptcies, subtenants should examine the master lease to determine whether appropriate protections already exist. However, subtenants must ensure that the language is sufficient to protect their rights to possession. The master lease amendment in Syufy failed because the Port of Oakland never agreed to recognize Syufy's sublease if the master lease was terminated. However, with the appropriate language in the master lease, subtenants can be construed as third-party beneficiaries and their rights to possess subleased premises may be protected.

If a master lease does not contain the required language, subtenants should negotiate the terms directly with the master landlord in a consent to sublease agreement. However, subtenants may encounter resistance from savvy master landlords that will want to maintain flexibility in the event of a tenant's bankruptcy. Moreover, if a sublease contains favorable terms to the subtenant such as a reduced rental rate, a master landlord likely will not agree to recognize the sublease unless the subtenant assumes certain less-favorable obligations.

While a recognition provision is difficult to obtain, subtenants should be aware that their rights in subleased premises are jeopardized by sublandlords' bankruptcies. As demonstrated in Syufy, a master landlord's repeated assurances and substantial investments in improvements are not enough to salvage a subtenant's right to possession.

James M. Rishwain Jr. and Allison K. Gurka

James M. Rishwain Jr. is the leader of Pillsbury Winthrop LLP's global real estate practice section and co-managing partner of the Los Angeles and Century City , Calif. , offices. Contact him at 310.203.1111 or [email protected] Allison K. Gurka is an associate at Pillsbury Winthrop LLP's Century City office. Contact her at 310.203.1109 or [email protected]

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