                                                                                                                           Opinions of the United
1995 Decisions                                                                                                             States Court of Appeals
                                                                                                                              for the Third Circuit


7-31-1995

IN RE: Flagstaff Realty
Precedential or Non-Precedential:

Docket 94-5650




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Recommended Citation
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http://digitalcommons.law.villanova.edu/thirdcircuit_1995/202


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          UNITED STATES COURT OF APPEALS
              FOR THE THIRD CIRCUIT
              _____________________

                      No. 94-5650
                 _____________________

        IN RE:    FLAGSTAFF REALTY ASSOCIATES
                  t/a F.R.A. LIMITED PARTNERSHIP
                             Debtor


             MEGAFOODS STORES, INC.,



                               Appellant,

                          v.

             FLAGSTAFF REALTY ASSOCIATES,
             t/a F.R.A. LIMITED PARNERSHIP;
             MAURICE L. MCALISTER;
             J.E. ROBERT COMPANY, INC.;
             KENNETH D. HINSVARK
               _____________________

  On Appeal from the United States District Court
          for the District of New Jersey
               (D.C. No. 93-cv-1713)
               _____________________

                 Argued June 27, 1995

Before: MANSMANN, GREENBERG, SAROKIN, Circuit Judges

                 (Filed July 31, 1995)
                 _____________________

                         Peter W. Sorensen, Esq. (argued)
                         Robbins & Green
                         3300 North Central Avenue
                         Norwest Tower, Suite 1800
                         Phoenix, AZ 85012

                         Joseph E. Sales, Esq.
                         Norris, McLaughlin & Marcus, P.C.
                         721 Route 202-206
                         P.O. Box 1018
                         Somerville, NJ 08876-1018


                          1
                                     Attorneys for Appellant




                                Roger B. Kaplan, Esq. (argued)
                                Deborah Del Nobile Tanenbaum, Esq.
                                Wilentz, Goldman & Spitzer, P.C.
                                90 Woodbridge Center Drive
                                P.O. Box 10
                                Woodbridge, NJ 07095

                                     Attorneys for Appellee Flagstaff Realty

                                         ____________

                                     OPINION OF THE COURT
                                         ____________

SAROKIN, Circuit Judge:


           A landlord defaulted on its responsibility to make necessary repai

demised premises, and the commercial tenant, as provided in the lease, cured

by making the repairs.    The lease permitted the tenant to offset the cost of

improvements against future rents.    The issue presented is whether the monie

the tenant before bankruptcy can be recouped or otherwise credited against r

due thereafter, where the landlord, now debtor-in-possession, rejects the le

conclude that they can, and thus reverse.


                                                I.

           In August 1991, tenant Megafoods Stores, Inc. became a lessee of c

property located in Flagstaff, Arizona. Under the lease, landlord Flagstaff

Associates was obligated to maintain the parking area and exterior of the b

repair.   Property Lease at ¶¶ 9, 14.   Tenant notified landlord of the need t

roof and parking lot and learned of landlord's "financial inability to perfo

obligations under the lease."    App. at 136.    As early as February 1992, ten


                                 2
landlord that if it did not confirm that it would perform the repairs at its

tenant would repair the property and exercise its right of offset against th

Tenant performed the work and in July 1992 notified landlord of its intent

rent.   In response, landlord declared that failure to pay rent constituted d

the lease, and tenant subsequently agreed to remit the July rent and express

willingness to cooperate with landlord in resolving this dispute either thro

reimbursement, offset against rent, or otherwise.   Having failed to hear fro

tenant gave notice in mid-August 1992 that it would commence withholding ren

paragraph 29 of the lease and again expressed its willingness to cooperate.

provides in pertinent part:


            [i]n the event the Landlord shall . . . fail to perform any obliga
            specified in this lease, then Tenant may . . . do all necessary wo
            and make all necessary payments in connection therewith, and Landl
            shall on demand pay Tenant forthwith the amount so paid by Tenant
            together with interest thereon at the rate of six per cent (6%) pe
            annum, and Tenant may withhold any and all rental payments and ot
            payments thereafter due to Landlord and apply the same to the paym
            of such indebtedness.


App. at 95.

            A little more than two weeks later, landlord filed a voluntary ban
petition under Chapter 11 of the Bankruptcy Code, and in October 1992, file

reject the lease. The specific bases for rejection were that the rent provid

lease was below market value and that tenant had asserted a claim for $477,9

listed tenant's claim in its petition as a disputed prepetition unsecured cl

priority.   Tenant commenced a separate adversary proceeding seeking a declar

rights of the parties with respect to the rental payments and repair issue,

bankruptcy court decided to address this issue together with the motion to r

bankruptcy court granted landlord's motion to reject and denied tenant's app

offset its repair claims pursuant to the recoupment doctrine or, in the alte


                                 3
U.S.C.A. § 365(h)(2) (West 1993).    It also determined that tenant had exerci

statutory prerogative to remain in possession of the property for the balanc

and therefore owed landlord, as debtor-in-possession, its prerejection amoun

U.S.C.A. § 365.

          Tenant appealed, and the district court, exercising jurisdiction

U.S.C.A. § 158(a) (West 1993), affirmed the bankruptcy court's ruling.    Tena

timely notice of appeal.    We have jurisdiction over this appeal pursuant to

158(d) and 1291 (West 1993).

          During the pendency of this appeal, the bankruptcy court confirmed

landlord's plan of reorganization.    Tenant did not appeal the confirmation o

it seek a stay pending the resolution of this appeal.


                                             II.

         We exercise plenary review over the legal issues presented in this

There are no disputes as to the material facts.

          Section 365(h)(2) provides in pertinent part:


     [i]f such lessee . . . remains in possession as provided in paragraph (
     this subsection, such lessee . . . may offset against the rent reserve
     such lease . . . any damages occurring after such date [of rejection]
     the nonperformance of any obligation of the debtor under such lease . .


11 U.S.C.A. § 365(h)(2) (emphasis added).    Therefore, our first inquiry is

reserved under the lease.

          The phrase, "rent reserved under such lease," plainly refers to th

under the lease.   See Consumer Product Safety Com. v. GTE Sylvania, Inc., 44

108 (1980)("plain meaning of legislation should be conclusive"); see also I

House Partners, 97 B.R. 819, 823 (Bankr. E.D. Pa. 1989)("tenant is entitled
under the same rental terms as are set forth in the lease")(citations omitte


                                 4
          Here, paragraph 29 of the lease plainly provides for a reduction i

when the tenant cures the landlord's default.   In essence, the parties agree

tenant advanced certain costs which were the obligation of landlord, the ren

reduced accordingly.   The reduced rent is the "rent reserved," and it is tha

the tenant is required to pay.

          "Rejection does not alter the substantive rights of the parties to

and thus does not alter the continuing vitality of terms affecting the amoun

as paragraph 29.    In re Chestnut Ridge Plaza Associates, L.P., 156 B.R. 477,

W.D. Pa. 1993).    The primary function of rejection is to "allow[] a debtor-

escape the burden of providing continuing services to a tenant."   In re Lee

155 B.R. 55, 60 (Bankr. E.D.N.Y. 1993)(citing cases), aff'd, 169 B.R. 507 (

Rejection affects the lessor's duties to the tenant.    See also In re Stable

Associates, Inc., 41 B.R. 594, 597 (Bankr. S.D.N.Y. 1984)(rejection "reliev

from covenants requiring future performance, such as the provision of utilit

maintenance and janitorial services by the debtor")(citation omitted); 2 Co

Bankruptcy §365.09, at 356-58 (15th ed. 1995)(rejection "results merely in

cancellation of covenants requiring performance in the future by the landlor

Chestnut Ridge court emphasized that


               [t]he obligations under the lease and rights associated with
          tenant's leasehold interest do not just vanish because a debtor ha
          rejected the lease. The leasehold interest remains intact and the
          lease remains operative between the parties.


156 B.R. at 485 (citations omitted).   Thus, although the rejection of the le

debtor-landlord relieves it of prospective obligations to perform under the

not relieve it of its obligation to accept the agreed upon reduced rent prov

the terms of the lease.




                                 5
          Although not the type of transaction traditionally recognized as c

security interest, this situation is analogous to the assignment of rents to

loan.   If the landlord had borrowed the money to make the repairs and assign

to a lender, the landlord could not disavow the assignment after filing a ba

petition and insist that it receive the rent payments.    See, e.g., In re Whe

Office Partners Limited Partnership, 27 F.3d 1234, 1239-41 (7th Cir. 1994)(a

rents to secure mortgage is an interest in real property and hence a lien g

security interest); Prudential Ins. Co. of America v. Boston Harbor Marina

616, 619 (D. Mass. 1993)(lien on rents gives rise to security interest in fu

payments); In re Buckley, 73 B.R. 746, 749 (D.S.D. 1987)(interest in rent gi

perfected security interest where lender obtains possession of property).

Tavern Motor Inn, Inc., 80 B.R. 659, 660-62 (D. Vt. 1987)(landlord's assignm

to receive future rent gave lessee bank a security interest in real propert

the debtor in this case, in effect, assigned to the tenant its own interest

payments and thus permitted tenant to reimburse itself.

          From yet another perspective, paragraph 29 can be interpreted as t

monies so advanced by the tenant as more akin to prepaid rent, rather than a

landlord or a debt the landlord owes the tenant.   Certainly if a tenant paid

in advance and the landlord filed for bankruptcy during the course of that y
tenant should not be required to pay the rent a second time for the remainin

that year.   Cf. In re M.W. Ettinger Transfer Co., 1988 WL 129334, *4 (Bankr

1988)(concluding it is "wholly unjust, improper and foolish" to require debt

spent more than $300,000 in capital improvements in form of prepaid rent to

to force tenant to sue separately for a prepaid rent claim).    Thus, on statu

we conclude that the "rent reserved" under the lease is the fixed rent less
and customary cost of the improvements, to be apportioned towards tenant's m

obligation by the bankruptcy court on remand.


                                6
          Even if statutory grounds were not available, we hold that the doc

recoupment would provide relief to tenant. A claim subject to recoupment avo

bankruptcy channels and thus, in essence, is given priority over other credi

Recoupment, which has its origins as an equitable rule of joinder, permits c

out of the same transaction to be adjudicated in one proceeding.    Lee v. Sch

F.2d 870, 875 (3d Cir. 1984); In re B & L Oil Company, 782 F.2d 155, 157 (1

This common law doctrine is not codified in the Bankruptcy Code, but has bee

through decisional law.

          The "trustee of a bankruptcy estate 'takes the property subject to

recoupment.'"   In re Holford, 896 F.2d 176, 179 (5th Cir. 1990)(quoting In r

Consultants, Inc., 84 B.R. 419, 426 (Bankr. E.D. Va. 1988)); In re Universit

Center, 973 F.2d 1065, 1080 (3d Cir. 1992).   In recognition of the special n

recoupment, courts have permitted its application even in situations where t

not permit application of the related doctrine of setoff, 11 U.S.C.A. § 553

Thus, postpetition funds owing to the landlord may be recouped against prepe

owed by the landlord despite the usually inflexible automatic stay provision

11 U.S.C.A. §362(a) (West 1993).    See, e.g., In re Klingberg Schools, 68 B.

(N.D. Ill. 1986), aff'd, 837 F.2d 763 (7th Cir. 1988).

          However, recoupment is not available without limitation.    As noted
contending claims must derive from the same transaction.   Recoupment also ca

basis for asserting an independent claim against the estate.    In re American

Airlines, Inc., 60 B.R. 587, 590 (Bankr. N.D. Iowa 1986)(citation omitted).

          This case satisfies the "same transaction" test.     We have required

debts must arise out of a single integrated transaction so that it would be

for the debtor to enjoy the benefits of that transaction without also meetin
obligations."   University Medical Center, 973 F.2d at 1081.    Both the claim




                                7
costs and the rent arise from the lease, and it would be inequitable for the

receive rent without compensating tenant for undertaking the repairs.

          Although the usual posture of recoupment cases involves a defensiv

of recoupment in response to a landlord or trustee filing suit to recover s

the estate, the creditor may take the "offensive" as in this case.   See Publ

107 B.R. at 445-46 (landlord's argument that recoupment may be raised only i

"misplaced"); B & L Oil, 782 F.2d at 156 (creditor brought suit for adjudic

right to recoupment).   Although the creditor is the tenant here, this does n

the essentially defensive nature of tenant's position.   It is not seeking af

recovery of the repair costs, but rather an adjudication that it may deduct

costs from its post-rejection rent.

          Thus, at the time of filing, tenant had a valid recoupment claim,

landlord had no interest in the future rental income to the extent of tenant


                                            III.

          Having concluded that the tenant has the right to reduce future re

the extent that it expended monies to make improvements which were the oblig

debtor-landlord, we must next consider the impact of confirmation from whic

neither appealed nor sought a stay.
          Section 1141 of the Bankruptcy Code states, in pertinent part and

exceptions not relevant herein:


          (a) . . . the provisions of a confirmed plan bind the landlord .
          and any creditor . . . whether or not the claim or interest of suc
          creditor . . . is impaired under the plan and whether or not such
          creditor . . . has accepted the plan.

          *****

          (c) . . . except as otherwise provided in the plan or in the orde
          confirming the plan, after confirmation of a plan, the property de


                                  8
          with by the plan is free and clear of all claims and interests of
          creditors, equity security holders, and of general partners in the
          landlord.


11 U.S.C.A. § 1141(a,c) (West 1993).   Landlord posits this as a per se bar

assertion of its right to now reduce the rent where the plan listed tenant a

creditor without any special rights to offset against rental income. Debtor

that the plan has been implemented such that the court can no longer provid

relief to tenant without jeopardizing the success of the plan, which depends

the unreduced rental flow.   We reject these contentions for the following re

          This is not a situation where a creditor has slept on its rights w

has been proposed, confirmed, and relied upon by others.   Tenant's position

and pursued from the outset.   The equities are clearly with tenant.   It made

improvements which were the obligation of landlord.    It was entitled by agr

deduct the cost of those improvements from the rent.   To now prohibit it fro

would create a windfall for the debtor.   The approximately 15 partners have

only $50,000 to the plan.    Debtor and its other creditors proceeded to impl

under the specter of potential reversal of the district court in favor of gr

tenant's recoupment claim and consequent reduction in rent.   In fact, in its

confirmation of the reorganization plan, tenant specifically noted the pende

appeal. Objection to Confirmation of Proposed Third Amended Plan of Reorgani

n.1.

          We conclude that all parties proceeded to implement the plan with

the district court's determination was subject to reversal upon appeal.   Thu

challenging the plan or seeking a stay pending appeal was preferable, tenant

do so does not render this appeal moot.   Tenant otherwise diligently pursued

gave landlord early indication of its intent to abate rent if landlord defau

duties.   See also In re Rooster, Inc., 127 B.R. 560 (Bankr. E.D. Pa. 1991)(c



                                 9
permitted to recoup despite failure to appeal from the confirmation order no

pending appeal); In re Maine, 32 B.R. 452, 453 (Bankr. W.D.N.Y. 1983)(credi

to recoup despite failure to object to confirmation of the plan nor appeal t

confirmation order).   Cf. In re De Laurentiis Entertainment Group Inc., 963

1271 (9th Cir.)(creditor had right to setoff although it did not object to r

plan nor challenge confirmation order), cert. denied sub nom Carolco Televis

National Broadcasting Co., __ U.S. __, 113 S.Ct. 330 (1992); In re Ford, 35

(Bankr. N.D. Ga. 1983)(creditor permitted to setoff despite failure to objec

reorganization plan nor appealed the confirmation).

          Thus, although we recognize the importance of maintaining the inte

confirmed plans from later attack, these unique circumstances permit the pla

reopened and readjusted.   We reach this conclusion, recognizing that the con

the lease has been at the instance of tenant and not the debtor-landlord.

          Furthermore, permitting tenant to pay the rent reserved or to rec

rent payments will not necessarily upset the successful implementation of th

Landlord assumes that tenant would be able to withhold all rental payments u

recovers the $325,000.   Under such a scenario, the plan would indeed fail.

bankruptcy court has considerably more flexibility in fashioning an equitabl

debtor acknowledges.   On remand, we suggest that the district court return t
the bankruptcy court for a determination of whether there is an amount of re

which would best balance ensuring the ultimate, if more gradual, success of

reorganization plan with reimbursing tenant for the repair costs. Tenant's m

this court indicates that it has no immediate plans to vacate the premises,

considering tenant's other substantial improvements to the property, and so

monthly payments appears to be a viable option.

          In sum, we conclude that confirmation and implementation of the re
plan does not prevent tenant from paying the "rent reserved" under the lease


                                10
asserting its right to recoupment.     As we have held that tenant may pay redu

statutory and recoupment grounds, we need not reach tenant's other contenti

issue.


                                              IV.

           We now clarify one remaining issue.      The bankruptcy court conclude

has elected to remain in possession of the lease "and any renewals or exten

March 25, 1993 Order at ¶ E (emphasis added), and the district court affirm

argues that the bankruptcy court erred in holding that it had elected to rem

possession for the remaining term of the lease and for all extension periods

therein.   We agree with tenant that the language of §365(h)(1) is permissiv

mandatory:    the lessee "may remain in possession of the leasehold . . . for

such term and for any renewal or extension of such term . . . ."      11 U.S.C.A

There is no statutory requirement that a tenant who elects to remain on the

remain throughout all possible renewal periods nor that tenant must exercise

as to renewal periods at the time it elects to remain in possession.
                                               V.

             For the foregoing reasons, we will reverse the district court and

bankruptcy court for reconsideration of its order confirming the reorganizat
for a determination of the amount of monthly rent.




                                  11
