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In re Flagstaff Realty Associates

filed: July 31, 1995.


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

Before: Mansmann, Greenberg, Sarokin, Circuit Judges.

Author: Sarokin


SAROKIN, Circuit Judge :

A landlord defaulted on its responsibility to make necessary repairs to the demised premises, and the commercial tenant, as provided in the lease, cured the default by making the repairs. The lease permitted the tenant to offset the cost of those improvements against future rents. The issue presented is whether the monies expended by the tenant before bankruptcy can be recouped or otherwise credited against rental payments due thereafter, where the landlord, now debtor-in-possession, rejects the lease. We conclude that they can, and thus reverse.


In August 1991, tenant Megafoods Stores, Inc. became a lessee of commercial property located in Flagstaff, Arizona. Under the lease, landlord Flagstaff Realty Associates was obligated to maintain the parking area and exterior of the building in good repair. Property Lease at PP 9, 14. Tenant notified landlord of the need to repair the roof and parking lot and learned of landlord's "financial inability to perform its obligations under the lease." App. at 136. As early as February 1992, tenant notified landlord that if it did not confirm that it would perform the repairs at its expense, then tenant would repair the property and exercise its right of offset against the rent. Tenant performed the work and in July 1992 notified landlord of its intent to withhold rent. In response, landlord declared that failure to pay rent constituted default under the lease, and tenant subsequently agreed to remit the July rent and expressed its willingness to cooperate with landlord in resolving this dispute either through cash reimbursement, offset against rent, or otherwise. Having failed to hear from landlord, tenant gave notice in mid-August 1992 that it would commence withholding rent pursuant to paragraph 29 of the lease and again expressed its willingness to cooperate. Paragraph 29 provides in pertinent part:

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

App. at 95.

A little more than two weeks later, landlord filed a voluntary bankruptcy petition under Chapter 11 of the Bankruptcy Code, and in October 1992, filed a motion to reject the lease. The specific bases for rejection were that the rent provided in the lease was below market value and that tenant had asserted a claim for $477,969. Landlord listed tenant's claim in its petition as a disputed prepetition unsecured claim without priority. Tenant commenced a separate adversary proceeding seeking a declaration of the rights of the parties with respect to the rental payments and repair issue, and the bankruptcy court decided to address this issue together with the motion to reject. The bankruptcy court granted landlord's motion to reject and denied tenant's application to offset its repair claims pursuant to the recoupment doctrine or, in the alternative, to 11 U.S.C.A. § 365(h)(2) (West 1993). It also determined that tenant had exercised its statutory prerogative to remain in possession of the property for the balance of the lease and therefore owed landlord, as debtor-in-possession, its prerejection amount of rent. 11 U.S.C.A. § 365.

Tenant appealed, and the district court, exercising jurisdiction under 28 U.S.C.A. § 158(a) (West 1993), affirmed the bankruptcy court's ruling. Tenant has filed a timely notice of appeal. We have jurisdiction over this appeal pursuant to 28 U.S.C.A. §§ 158(d) and 1291 (West 1993).

During the pendency of this appeal, the bankruptcy court confirmed the landlord's plan of reorganization. Tenant did not appeal the confirmation order nor did it seek a stay pending the resolution of this appeal.


We exercise plenary review over the legal issues presented in this appeal. There are no disputes ...

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