The Effect of Bankruptcy on Unrecorded Leases

July 31, 2009

One of the unexpected issues a tenant may face when its landlord declares bankruptcy is whether a landlord that is a Chapter 11 debtor in possession may avoid an unrecorded lease under the “strong arm” clause of Section 544(a) of the Bankruptcy Code, instead of rejecting that lease under Section 365(a) of the Bankruptcy Code.

The strong arm clause grants a trustee in bankruptcy the rights of a hypothetical judgment lien creditor and the rights of a bona fide purchaser for value as of the date of the filing of the bankruptcy petition. See 11 U.S.C. 544(a). A debtor in possession has all the rights and powers of a bankruptcy trustee pursuant to 11 U.S.C. 1107(a). Although the rights arise pursuant to federal law, the scope of these strong arm powers is governed by the substantive laws of the state in which the property is located. See Sovran Bank/DC Nat’l v. United States, 168 B.R. 811, 817 (Bankr. D.C. 1994).

In Watts Contrs., Inc. v. Watts (In re Watts Contrs., Inc.), 360 B.R. 489 (Bankr. E.D. Va. 2007), the court held that a debtor in possession could avoid an unrecorded twenty-year lease of the debtor’s property under the strong arm provisions of the Bankruptcy Code. Upon the filing of the bankruptcy petition, the debtor in possession acquired the powers of a bankruptcy trustee, which powers include the ability to act as a bona fide purchaser of real property from the debtor, without regard to the knowledge of the bankruptcy trustee or any creditor. Under Virginia law, an unrecorded lease for a term of more than five years is void as to all purchasers for valuable consideration without notice and not parties to the lease, and as to lien creditors. See §55-96(A)(1) of the Code of Virginia (1950), as amended. Although the debtor in possession was a party to the lease and therefore had actual knowledge of the lease, the strong arm provisions of the Bankruptcy Code specifically provide that the debtor in possession’s rights are without regard to the actual knowledge of the debtor in possession. Accordingly, since an unrecorded lease is void as to a bona fide purchaser, the debtor in possession had the right to avoid the lease under the strong arm provision.

The protections granted to bona fide purchasers and lien creditors against unrecorded interests vary from state to state; therefore, the ability of bankruptcy trustees and debtors in possession to avoid unrecorded leases will depend on the location of the property and the application of state law.

Please contact us if you have concerns or questions. For more information, visit our Greater Washington-Baltimore Region Transactional Real Estate practice.