Leased Property in Bankruptcy: Residential vs. Non-Residential

All of the aforementioned code sections pertain to non-residential property. Residential leases are treated more favorably, for the obvious reason that a person who has filed for bankruptcy should not immediately be dispossessed of his home. Bankruptcy petitioners, therefore, have an interest in seeing the properties they have leased categorized as residential, rather than commercial. So, when leased premises are being used by sub-lessees as residences, is the master lease between the landlord and the tenant managing these rental homes a commercial or residential lease? The answer to this question has been different in different jurisdictions. One of the more recent courts to address the issue is the U.S. Bankruptcy Court for the Southern District of West Virginia, in the case of In re Passage Midland Meadows Operations, LLC, 2017 Bankr. LEXIS 4097 (Dec. 1, 2017). There, the court ruled that a master lease of residential retirement homes entered into by two business entities was nonresidential in nature; therefore the master lease, which was effectively terminated pre-petition, was not property of the master lessee's bankruptcy estate and the bankruptcy automatic stay would not operate to prevent the master lessor from obtaining possession of the leased premises.

A Master Lease and the Subleases

Master lessor Welltower Inc. (Welltower), and the master lessee Passage Healthcare Property, LLC (Passage Healthcare), entered into a master lease on Aug. 4, 2015. Passage Healthcare then entered into three sublease agreements with the “Passage Properties”— one in West Virginia and the other two in Pennsylvania — all health care facilities providing assisted living, skilled nursing, independent living and dementia care services to approximately 400 residents. The master tenant and the three subtenants are all owned by Passage Healthcare LLC, which is owned by savvy businessmen Andrew Turner and William F. Lasky, both of whom have decades of experience running a multitude of residential retirement facilities nationwide. Passage Healthcare LLC's only business is its ownership of Passage Healthcare and its management of the three affiliate residential retirement and health care properties. And each of the three subtenants is a guarantor of the Passage master lease obligations.

Soon after the master lease was signed, the lessee breached the lease in a number of ways, including by failing to pay rent. In June of 2016, after the lessee acknowledged its breaches, the parties entered into a forebearance agreement, whereby Welltower agreed to give Passage Healthcare more time to come into compliance with the master lease's terms. The extra time did not help, however, and the lessee soon was in default of the forebearance agreement as well. Welltower sent the first default notice at the end of January, and the second mid-February. On Feb. 27, 2017, Welltower sent Passage Healthcare a termination notice and also brought an action in U.S. District Court seeking appointment of a receiver for Passage Healthcare's businesses.

In March of 2017, all the Passages entities — Passage Healthcare and the three residential retirement/health care facilities that subleased their premises from it — voluntarily filed for bankruptcy protection under Chapter 11 of the U.S. Bankruptcy Code.

A few days later, on March 17, 2017, Welltower sued Lasky and Turner in federal court, seeking $69 million, plus fees and costs. The following day, Lasky and Turner moved for relief based on the Bankruptcy Code's automatic stay provisions.

Was it a Residential Lease?

Bankruptcy debtor Passage Healthcare asked the court to find that the provisions of the Bankruptcy Code exempting nonresidential property from certain protections did not apply because the three properties involved were in fact residential — after all, they were being used by elderly tenants as homes. If Passage Healthcare could win on this point, landlord Welltower would be prevented from taking the properties back and re-leasing them to a third party, as it wanted to do.

So the question of whether the master lease pertained to residential or nonresidential real property would determine what would happen while the case proceeded in bankruptcy court. If, contrary to Passage Healthcare's wishes, the properties were determined to be non-residential real properties then: 1) the leased real property would not be deemed property of the bankruptcy estate; 2) the leases could not be assumed by the estate; and 3) Welltower's re-leasing of the properties to a third party would not violate the Bankruptcy Code's automatic stay provisions.

One problem: the Bankruptcy Code does not define the terms “residential property” or “nonresidential property,” and precedent is not entirely helpful because courts have split on how to decide that question, with some focusing their inquiry on how the property is being use and others on the parties' reasons for entering into the lease.

The Nature-of-the-Property Test

A minority of courts have applied what is called the “nature-of-the-property” test (property test). When this standard is applied, a piece of real property is considered residential if people reside upon it. For example, in In re Care Givers Inc., 113 B.R. 263 (Bankr. N.D. Tex. 1989), a Texas Bankruptcy Court concluded that even though a nursing home had both residential and non-residential purposes, it must be considered a “residential” property for the purposes of the Bankruptcy Code. Similarly, in In re Independence Village Inc., 52 B.R. 715, (Bankr. E.D. Mich. 1985), a Michigan Bankruptcy Court determined that, because people lived on the property in question, it must be considered residential property. Courts in other jurisdictions have also followed this logic. See, e.g., Matter of Terrace Apr. Ltc., 107 B.R. 382 (Bankr. N.D. Ga. 1989; In re Michael H. Clement Corp., 446 B.R. 393 (N.D. Cal. 2011).

The Nature-of-the-Lease Test

The nature-of-the-lease test (income test) looks to the purpose of the leasing parties in entering into the lease. Was the goal to run a commercial operation that would provide income to the lessee rather than to provide the lessee with a place to reside? If so, then the income test says the lease is one concerning non-residential property.

Courts have applied the income test's logic in cases similar to the one between Welltower and Passage Healthcare, as when the Bankruptcy Court for the Eastern District of California found that even though patients were intended to reside on the property, the lease of the convalescent home property in question was non-residential in nature as the home's operators (the lessees) leased the land in order to earn money there, and not to live there themselves. In re Sonora Convalescent Hospital Inc., 69 B.R. 134 (Bankr. E.D. Cal. 1986). Similarly, a lessee operating a hotel saw its lease deemed non-residential in nature despite that fact that some people lived permanently in the hotel, because the lessee was leasing the property in order to run a hotel business on the property that would generate income. In re Emory Properties Ltd., 106 B.R. 318 (Bankr. N.D. Ga. 1989). See also, In re Condo, Admin. Servs. Inc., 55 B.R. 792 (Bankr. M.D. Fla. 1985) (although people lived in mobile homes on the leased property, the lease of the property itself to their landlord was non-residential in nature).

The Court's Analysis

The court in Passage needed to decide which side it was on: Should it apply the property test or the income test?

The main rationale for using the property test, the court explained, is that in Bankruptcy Code section 365(d)(4), Congress specifically modified the term “real property” with the term “non-residential.” Thus, according the proponents of this test, the term “non-residential” must be applied to the nature of the property itself, and not to the nature of the lease. See, In re Lippmann, 122 B.R. 206 (Bankr. S.D.N.Y. 1990). While the Passage court agreed that this way of thinking is “unquestionably correct,” it also found that this reading of the statutes leaves out several other portions of them that must be read in a different way. “The property test analysis thus risks contravening a time-honored principle of statutory construction,” said the court, namely, “that a reviewing court must give meaning and effect to every word of the statute.”

All the statues involved in this case described not only the “real property” but also “the lease of the debtor,” the “interest of the debtor,” and other phrases that put an emphasis not on the nature of the property but on the purpose to which the lessee intends to put the property. Therefore, according to the court, “[t]he substance of the lease, namely the precise purpose the lessee has for the property, must find its way into the analysis.” The court continued:

[T]herein lies the difficulty with the property test. All would appear to agree in the cases applying the property test that the debtor lessees in question never had any intention of making the leased premises his, her or, its residence. And yet that salient fact is sidelined by the property test analysis in favor of focusing, instead, and in isolation, on the use to which unnamed, unknown nondebtor sublessees, perhaps far down the leasing chain, will put the property. And that remote use (e.g., living in a dwelling) will not be the same use (e.g., investment and income production) that the original leasing parties contemplated. Instead, under the property test analysis the lease that drives the analysis, if any, is not the one before the Court. It is instead some other instrument, if any, perhaps between strangers to the original subject lease that were not at all contemplated by the relevant statutory provisions.

The Passage court was also concerned with policy issues and was wary of the unintended consequences of declaring that, because the retirement homes in question were used by some as residences, the background master lease must be deemed “residential” in nature.

First, such an interpretation — the one urged by advocates of the property test — would leave lessors and lessees without certainty as to how they would be treated in bankruptcy situations. Depending upon how the property was put to use, a lessee could thwart a lessor's legitimate business interest in exercising its options upon default on the lease. Would a hotel be considered a residence if some people lived there permanently, or even for long periods of time? Would a mixed-use building containing apartments as well as retail space be considered by the courts a residential property or a non-residential one? “Given the paramount role that informal discussion plays in pre- and post-insolvency negotiations, which might obviate the need for court involvement and a consequential reduction in time and expense, the bright lines occasioned by the income test are most desirable to say the least,” the court stated.

On the other hand, what about the poor innocent tenants who might be summarily evicted by uncaring master lessors? The court largely dismissed such concerns, surmising that two things would stop a master lessor like Welltower from kicking the aged and infirm to the curb. First, the master lessor would likely see the benefit in facilitating an orderly move of a subtenant from its premises to another, in order to avoid the possibility of liability for endangering the subtenant's health and welfare. And, second, since the subtenants would presumably be paying rent, master lessors would also likely wish to take over from the master lessee and simply begin receiving those rents directly from the subtenants, while allowing them to stay in place.

With all this in mind, the Passage court concluded that it should apply the income test to the master lease, and that under this test the Passage lease must be deemed one concerning non-residential real property. As such — and because the lease was terminated by default, termination notices were properly delivered, the lessee failed to cure, and all of this occurred before the lessee filed for bankruptcy — the master lease was not property of the estate and Welltower was not prohibited by the automatic stay from regaining possession of the property and doing with it as it would, the court concluded.

Conclusion

Bankruptcy is a fact of life in the United States. When it happens, the treatment of a lease as either residential or non-residential may be crucial to all parties, so landlords, tenants, subtenants and their counselors should make themselves aware of the precedent in their own jurisdiction. A lessor in a “nature of the property” jurisdiction is not going to be happy to discover that, having allowed a commercial tenant extra time to get its act together, it is going to suffer further losses because the tenant has now filed for bankruptcy and all or part of the leased property was being used as a residence. It is far better to know of the risks ahead of time, and plan accordingly. *****

Janice G. Inman is Editor-in-Chief of this newsletter.