In IDEA Boardwalk, LLC v. Revel Entertainment Group, LLC (In re Revel AC Inc.), Case No. 17-3607, –F.3d–, 2018 WL 6259316 (3rd Cir. Nov. 30, 2018), the Third Circuit Court of Appeals recently enforced a tenant’s right to offset rent under a rejected lease of real property, pursuant to section 365(h) of the Bankruptcy Code and the doctrine of equitable recoupment.
Debtor Revel AC, Inc. (“Revel”) owned a casino in Atlantic City, New Jersey. It filed for chapter 11 relief in 2014.
When Revel entered bankruptcy, IDEA Boardwalk, LLC (“IDEA”), a tenant, continued to operate two nightclubs and a beach club on the casino premises. The lease for these premises was a complicated long-term lease that required both Revel and IDEA to make significant capital contributions ($80 million) towards the build-out of IDEA’s venues at the casino. These capital contributions were the foundation for rent and certain recoupment obligations under the Lease. The rent obligations were calculated (using a complex formula) based on the distributable cash flow of each IDEA venue multiplied by a percentage of the capital contributions made by Revel for the build out. The Lease also provided IDEA with a right to collect recoupment payments from Revel during the first four years of the Lease, which payments were calculated (using a complicated formula) based on whether IDEA received a positive return on its capital contributions.
Given the complicated nature of the Lease, IDEA filed a preemptive adversary proceeding against the debtor and, later, its successor (Polo) to protect its tenant rights under the Lease.
During its bankruptcy, Revel closed its doors and sold its assets to Polo North Country Club, Inc. (“Polo”) free and clear of all liens, claims, encumbrances and other interests under § 363(f) of the Bankruptcy Code. But, the Bankruptcy Court’s sale order contained two carve-outs that expressly preserved IDEA’s setoff and recoupment rights under the Lease and the rights under section 365(h) of the Code in the event Revel later rejected the Lease.
Shortly after the sale, the Bankruptcy Court approved the rejection of the Lease retroactive to the date Revel closed its doors postpetition. In response, IDEA filed a notice of its election to retain its rights as a tenant under section 365(h).
In IDEA’s adversary proceeding, the Bankruptcy Court subsequently ruled that IDEA was entitled to setoff its rent obligations to Polo with the recoupment obligations under the Lease. On appeal, the District Court affirmed. Polo then appealed to the Third Circuit.
Section 365(h) of the Bankruptcy Code provides, in relevant part, that if a debtor-lessor of real property rejects an unexpired lease with its tenant,
[T]he lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease ….
11 U.S.C. § 365(h)(1)(A)(ii). The Third Circuit has previously held that a tenant who makes an election under section 365(h) is “entitled to remain under the same rental terms as are set forth in the lease.” Megafoods Stores, Inc. v. Flagstaff Realty Assocs. (In re Flagstaff Realty Assocs.), 60 F.3d 1031, 1034 (3d Cir. 1995).
Based on the foregoing, the Third Circuit in Revel affirmed that, pursuant to section 365(h), IDEA was entitled to setoff the recoupment payments under the Lease (even after rejection) from the rent obligations owed to Polo, the new landlord. The Third Circuit found that the dual recoupment and rent obligations under the Lease created an agreed-upon framework for ensuring that IDEA would pay rent in the first four years of the Lease only when IDEA’s venues turned a profit.
The Third Circuit also held that IDEA was entitled to setoff its rent obligation pursuant to the doctrine of equitable recoupment. Recoupment generally means “the setting up of a demand arising from the same transaction as the plaintiff’s claim or cause of action, strictly for the purpose of abatement or reduction of such claim.” In re Univ. Med. Ctr., 973 F.2d 1065, 1079 (3d Cir. 1992) (emphasis added). For purposes of equitable recoupment, a mere logical relationship or claims involving the same subject matter are not enough. “Rather, both debts must arise out of a single integrated transaction so that it would be inequitable for the debtor to enjoy the benefits of that transaction without also meeting its obligations.” Id. (emphasis added).
In Revel, the Third Circuit found that the recoupment provisions expressly called for a periodic downward adjustment to IDEA’s rent obligations. Given this agreed-upon framework, the Third Circuit held that there was no question that these two obligations “arise from the same transaction” for purposes of equitable recoupment and it would be inequitable to require IDEA to pay the full amount of its rental obligations without applying the countervailing downward adjustments.
Finally, the Court found that the sale order, which provided for a “free and clear” sale, did not change the result, because such order expressly preserved IDEA’s rights under section 365(h). Moreover, the Third Circuit noted that any sale order under section 363(f) cannot eliminate mere defenses to claims such as the affirmative defense of equitable recoupment. Citing Folger Adam Sec. v. DeMatteis/MacGregor, JV, 209 F.3d 252, 257, 258-64 (3d Cir. 2000).
While the Bankruptcy Code does afford chapter 11 debtors with the ability to alter certain parties’ rights, like the rejection of real property leases, in certain instances (e.g., section 365(h)) those rights are protected by the Code. Parties in interest nonetheless must be vigilant in protecting specific rights, as was the case in Revel, because there are often other provisions in the Bankruptcy Code that have a conflicting purpose and broad effect. This appeared to be the case in Revel, when Polo attempted to circumvent the landlord’s Lease obligations by purchasing the debtor’s assets free and clear of any claims or interests, pursuant to section 363(f), which has a broad goal of encouraging bankruptcy sales. Fortunately for IDEA, it contemplated the potential alteration of its rights per other Code sections and proactively, through its adversary proceeding, sought to protect those rights under all circumstances. Future tenants indeed may heed the preemptive strategy employed in Revel.