In 2014 Revel AC, the operator of a casino in Atlantic City, New Jersey filed a Chapter 11 case. It had a tenant, IDEA Boardwalk, LLC ("IDEA") which operated two nightclubs and a beach club at Revel’s casino. Revel attempted to sell its property “free and clear” of IDEA’s lease under 11 U.S.C. §363(f). IDEA filed a complaint against the debtor to preserve its rights to maintain occupancy of the premises, a right guaranteed by 11 U.S.C. §365(h) upon rejection of a lease.

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In 2015 the Bankruptcy Court ruled that the property could be sold free and clear of IDEA’s lease, and IDEA filed a motion for a stay of that order pending appeal, in order to preserve its occupancy rights. The motion for stay pending appeal was denied by the District Court, but was granted by the Third Circuit Court of Appeals, which found that the IDEA was almost "assured" of prevailing on appeal. In re Revel AC, Inc. 802 F.3d 558 (3rd Cir. 2015).

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As a result of the Third Circuit’s 2015 ruling the sale order was revised to add “two carve out provisions that expressly preserved rights relating to IDEA's continued use of the casino premises for 'any rights' (including rights of setoff and recoupment), claims and defenses of IDEA … with respect to [IDEA's adversary proceeding against Revel]. … [and] any rights elected to be retained by [IDEA or other tenants] pursuant to Section 365(h) of the Bankruptcy Code".

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It is critical to note that this 2015 ruling, and the carve-outs in the sale order, are diametrically opposed to current practice in both the Ninth Circuit and the Seventh Circuit. In In re Spanish Peaks Holdings II, LLC 872 F.3d 892 (9th Cir. July 2017) the Ninth Circuit held that a bankruptcy estate may sell property free and clear of leases notwithstanding the protections of §365(h), at least where the lease has not already been rejected and where the lease was subordinate to existing mortgages. The Ninth Circuit did, however, hold out the prospect of adequate protection for commercial tenants who provide evidence of the harm they would suffer if forced to move.

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In stark contrast the Third Circuit is thus far the only Circuit Court of Appeal to have indicated that it is likely to rule in favor of commercial tenants under these circumstances. As a result, commercial tenants will be better served if their financially troubled landlords file for bankruptcy in Delaware. In contrast landlords should consider filing for bankruptcy in the Ninth or Seventh Circuits to the extent they contemplate selling real property free and clear of leases.

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At issue in the 11/30/2018 Third Circuit decision, In re Revel AC 2018 U.S. App. Lexis 34028 (11/30/2018) was whether certain recoupment payments that the landlord was required to pay to IDEA on account of approximately $16 million contributed by IDEA to construction costs could be offset against future rent payments which tenants are required to make pursuant to Section 365(h) of the Bankruptcy Code. As the Third

 

Circuit noted "A tenant who makes an election under this provision [365(h)(1)(A)(ii)] is 'entitled to remain under the same rental terms as are set forth in the lease.' Mega Foods Stores, Inc. v. Flagstaff Realty Assocs. … 60 F.3d 1031, 1034 (3rd Cir. 1995) …'". The Third Circuit went on to note that the rental terms include the right to receive recoupment payments under the Lease. Accordingly and "by virtue of its election under § 365(h), IDEA is permitted to reduce its rent obligations by the recoupment amounts applicable under the Lease for the balance of the term of the Lease after the date of rejection …". It is important to note that the Third Circuit also ruled that the tenant would have been entitled to this credit because section 365(h)(1)(B) of the Bankruptcy Code gives a tenant a right to reduce its rent obligations under a rejected lease based on the landlord's non-performance of its obligations.

 

This new case is a victory for IDEA, as it will likely reduce rent payments to $0 for an extended period of time. This new decision highlights just how critical (to tenants) rights under 11 USC §365(h) are, and why it is imperative that both landlords and tenants carefully consider the import of the location of a bankruptcy filing prior to planning case strategy.