sheIn a divided opinion Tuesday, the Court of Appeals held that a lease and guaranty are separate contracts, even when the guaranty is incorporated into the lease. See Friday Investments, LLC v. Bally Total Fitness of the Mid-Atlantic, Inc.  For this reason, the court held, a guaranty might be discharged in bankruptcy – even where the tenant assumes the lease to which it is attached and incorporated.

The lease at issue was originally executed in 2000. As is common in commercial leases, the landlord required the tenant to provide a guarantor willing to guaranty the tenant’s lease obligations, and the tenant put up its parent company.  Several years into the lease term, the tenant and guarantor were contemplating a bankruptcy petition.  Under the bankruptcy rules, the tenant would then have the option to assume or reject the lease agreement in its Chapter 11 plan.  With the intent of assuming the lease, the tenant and landlord executed two amendments to the lease which provided for reduced rent schedules that would apply in the event of tenant’s filing a Chapter 11 petition.

The tenant and the guarantor, along with a number of related companies, ultimately filed two Chapter 11 petitions, which were consolidated. The bankruptcy court consolidated the debtors’ estates solely for distribution purposes but specifically stated that the consolidation would have no effect on any guaranty agreements that were “required to be maintained post-Effective Date” in connection with any unexpired leases that were assumed by the tenant.  The tenant expressly assumed the lease at issue.

Fast-forward several years, when the tenant stopped making its rent payments. The landlord filed suit against the tenant and guarantor for breach of the lease and the guaranty.  It moved for summary judgment on all claims.  The trial court granted partial summary judgment in favor of the landlord against the tenant, leaving only the question of damages for trial.  However, it granted summary judgment in favor of the guarantor on the breach of guaranty claim, concluding that the guaranty had been discharged in the bankruptcy.  The court certified the summary judgment order on the breach of guaranty claim for immediate appeal.

On appeal, the landlord argued that the guaranty could not have been discharged because the lease itself was assumed and the guaranty was a part of that lease agreement. As in many commercial leases, the parties had gone to great lengths to tie the lease and guaranty together.  The lease stated that it was to be guaranteed by the guarantor.  The guaranty was attached as an exhibit to the lease and expressly incorporated into the terms of the lease.  The guaranty recited that the guarantor’s intention in entering into the guaranty was to induce the landlord to enter into the lease.  The guarantor guaranteed all of the tenant’s obligations under the lease.  Such characteristics are typical in commercial leasing, as are terms that require certain notice for guarantors and trigger default of the tenant’s obligations if certain things relating to the guarantor (such as bankruptcy or receivership) occur.

The majority rejected the landlord’s argument, relying on case law stating that a guarantor “makes his own separate contract . . . and [he] is not bound to do what the principal has contracted to do, except in so far as he has bound himself by his separate contract.”  Thus, the Court concluded, it was possible that the liability under the guaranty had been discharged even though the lease had been assumed.  However, the Court also concluded that there were material issues of fact as to whether the discharge had occurred and remanded it to the trial court.

(Side note here: The guarantor seems to have argued that its liability was discharged not only through the bankruptcy but also by virtue of the fact that the guarantor was not a party to and did not consent to one of the lease amendments.  The majority rejected this contention, noting that the guaranty itself stated, as many guarantees of commercial lease agreements do, that it would “remain and continue in full force and effect as to any modification of the lease so long as notice of the modification was provided to the guarantor as provided in the lease.  This discussion suggests that the courts will enforce these common provisions in commercial guaranties despite the general rule that a guarantor’s liability is extinguished where he or she does not consent to changes to the guaranteed obligations.)

Judge Elmore dissented, finding that the lease and guaranty reflected a clear intention of the parties to treat the instruments as component parts of a single executory contract. Such a contract, he said, would have to be assumed in its entirety.  Noting that it is a fundamental principle of bankruptcy law that a debtor-in-possession cannot assume an executory contract without its burdens, he concluded that the guarantor “could not sever the Lease, electing to avoid its obligations on the Guaranty while leaving the more favorable provisions intact.”

If a tenant can assume a lease in bankruptcy without the guaranty required by the lease (particularly where, as here, the tenant and guarantors are closely related entities and both debtors in the bankruptcy), a landlord’s remedies might be significantly impacted. Isn’t a landlord denied the benefit of his bargain if it has no right to require a tenant to provide the very consideration it promised – a guarantor acceptable to the landlord to cover the tenant’s debts if the tenant fails?  This rule also has implications far beyond the landlord-tenant context.

It’s worth noting that the guarantor raised these issues with the state trial court rather than ask the bankruptcy court – arguably, the court best positioned to determine whether the guaranty was in fact discharged – to determine whether the landlord’s lawsuit violated the discharge injunction.

With a dissent, we will watch to see if either party asks the Supreme Court to resolve the case.

–Liz Hedrick