In a recent decision, the Court of Appeals for the Sixth Circuit held that the election of a tenant, under Section 365(h) of the Bankruptcy Code, to remain in possession of real property governed by a rejected lease causes a third-party guaranty on another rejected agreement to remain in effect, to the extent such agreement and the lease are part of an integrated transaction.
Reversing the district court’s decision, the Sixth Circuit held that the guarantor’s obligations survived the rejection of the agreement as a result of the tenant’s decision to exercise its right to remain in possession of the leased property under Section 365(h), because the rejected lease and the agreement underlying the guaranty were part of a non-severable integrated transaction. EPLET, LLC v. DTE Pontiac N., LLC, No. 20-1434, 2021 WL 37496 (6th Cir. Jan. 5, 2021).
Background
Prior to its bankruptcy filing, General Motors (“GM”) sold a power plant it owned to DTE Energy Pontiac North, LLC (“DTE”), an energy company. In conjunction with the sale transaction, GM leased the land under the power plant to DTE. The parties also entered into a utility services agreement under which DTE agreed to supply utilities to GM and to adhere to certain maintenance and environmental covenants. DTE’s parent (the “Guarantor”), in turn, entered into a guaranty with GM, providing that the Guarantor would step in to fulfill DTE’s obligations under the utility services agreement should DTE fail to meet GM’s utility needs or satisfy its environmental obligations. Both the utility services agreement and the lease contained provisions stating that all contracts, including the guaranty, were part of a single integrated transaction.
Two years later, in 2009, GM filed for bankruptcy and no longer needed the services it received from DTE under the utility services agreement. GM therefore moved to reject the utility services agreement pursuant to Section 365 of the Bankruptcy Code. The parties ultimately stipulated to the rejection of both the lease and the utility services agreement, as well as the plant purchase agreement. However, DTE reserved its right to remain in possession of the leased land notwithstanding rejection. The bankruptcy court entered an order approving the rejections as stipulated.
DTE decided to exercise its right under Section 365(h) of the Bankruptcy Code and remain in possession of the property. As explained by the Court, Section 365(h)(1)(A)(ii) creates a special rule for real property leases under which a “tenant is not required to move out if its bankrupt landlord rejects its lease. Instead, it may stay and pay rent (just as it did before) until the lease term expires.” DTE therefore remained in possession of the premises until the lease expired. At that time, DTE turned the land over to an environmental trust that had been created as part of GM’s reorganization plan.
Upon inspection, the trust discovered that DTE had allowed the power plant to fall into disrepair and contaminate the property. The trust sued DTE and its parent, the Guarantor, for breach of contract and various other claims. The district court dismissed the trust’s claims against the Guarantor, finding that the guaranty terminated upon GM’s rejection of the utility services agreement. The trust appealed.
Discussion
In addition to a discussion regarding piercing the corporate veil, the Sixth Circuit was presented with the following question: did the guaranty, which applied to the rejected utility services agreement, survive the rejection of the underlying agreement just because the tenant under the related lease exercised its right to remain in possession under Section 365(h)?
The Court answered this question in the affirmative. It found that the lease and the utility services agreement were part of a single integrated transaction and were not severable from each other. Following the principle that a contract or lease must be assumed or rejected in its entirety, the Court explained that if an agreement is severable from the remainder of a contract or lease, then that agreement may be assumed or rejected without assuming or rejecting the remainder of the contract. But, at the same time, “two or more contracts or leases may be part of one integrated transaction.” And when agreements are integrated, a party “may not assume one agreement without also assuming all other integrated agreements.”
Analyzing the question of severability under applicable state law, the Court found that the lease and the utility services agreement were part of the same integrated transaction. In fact, DTE itself, the Guarantor’s subsidiary, vigorously advanced this argument in its initial objection to GM’s rejection motion as part of the bankruptcy proceedings. Therefore, the Sixth Circuit found, DTE could not elect to continue the lease under Section 365(h) without its related obligations under the utility services agreement. And because the Guarantor guaranteed DTE’s obligations under the utility services agreement—including its obligations regarding maintenance, environmental costs, and remediation—the Guarantor’s guaranty was “likewise joined” to DTE’s Section 365(h) election. Thus, the Court found, the district court erred in dismissing the trust’s claims against the Guarantor.
Takeaways
The Sixth Circuit’s opinion in EPLET should be a warning sign for guarantors, flagging an issue that must be addressed upfront: a guaranty could survive rejection of the underlying agreement by a debtor if such an agreement is part of an integrated transaction involving a real property lease and the tenant elects to remain in possession under Section 365(h). This risk could have been addressed in the stipulation between DTE and GM.
We wonder, however, whether the opinion survives scrutiny. The power to assume or reject contracts is given to debtors, not their creditors. Section 365(h), not surprisingly, allows the tenant under a rejected lease “to retain its rights” under the rejected lease rather than assume the rejected lease. And Section 365(h) allows the tenant to retain its rights under a rejected lease, not under any other agreements. Yet, the Sixth Circuit analyzed the issue as if the Section 365(h) election is an assumption. Therefore, we wonder whether courts outside of the Sixth Circuit will follow EPLET. Time will tell, but in the meantime and in cases within the Sixth Circuit, parties should address this concern upfront to avoid later surprises.
Read the opinion >>
The authors would like to thank Allyesha Hall for her contributions to this OnPoint.
