Rejection Is Not Eviction: Section 365(h) of the Bankruptcy Code and the Deadline to Make an Election

Three Key Takeaways

• Rejection of a lease by a debtor-landlord is a breach, not a termination. Section 365(h) of the Bankruptcy Code lets the tenant stay in possession for the balance of the term, with a right to offset rent against the value of the landlord's post-rejection nonperformance.
• In a matter of first impression, the AllStar court held that the tenant's choice between treating the lease as terminated and retaining possession must be made at the time of rejection. A tenant cannot remain in place while holding the termination option open indefinitely. The court gave the tenant forty-five days to decide.
• Section 365(h) is not self-executing in every circuit. In the Seventh and Ninth Circuits, a "free and clear" sale pursuant to section 363(f) of the Bankruptcy Code can extinguish possessory rights, so a tenant must raise and protect its rights during the sale process rather than assume the statute will do the work.

One of the greatest powers available to a debtor in bankruptcy is the ability to “assume” or “reject” contracts and unexpired leases pursuant to section 365 of the Bankruptcy Code. Rejection allows a debtor to get rid of contracts and leases that do not make economic sense. Oftentimes, a landlord will seek to reject an under-market lease to make a property more attractive to potential buyers. To a tenant, rejection can appear to mean eviction, but that does not have to be the case pursuant to the Bankruptcy Code. Rejection of a lease is not the same as termination of a lease and a tenant does not lose its premises simply because a landlord rejected the agreement. That distinction is the entire subject of section 365(h) of the Bankruptcy Code and recently played out in In re AllStar Properties, LLC, No. 25-41314-BEM, 2026 WL 1739523 (Bankr. N.D. Ga. June 15, 2026).

What Section 365(h) Preserves

In AllStar, the debtor was the lessor of real property and landlord to Edward D. Jones & Co. When a debtor who is also a landlord rejects a lease, section 365(h) of the Bankruptcy Code gives the tenant the option to: (a) treat the lease as terminated and vacate the premises (giving rise to an unsecured claim for rejection damages); or (b) retain its rights under the lease for the balance of the term and any renewals. A tenant that stays in possession may also offset against rent the value of any damage caused by the landlord's failure to perform after rejection. This protection is meaningful to a tenant, particularly one in an under-market lease, as rejection does not (by itself) mean that the tenant must leave the property.

The Section 363(f) Issue

The protection provided by section 365(h) of the Bankruptcy Code is often said to conflict with another tool that a debtor may use under the Bankruptcy Code. Section 363(f) of the Bankruptcy Code permits a debtor to sell estate property "free and clear" of liens, claims, and interests, and a buyer in a 363 sale generally expects to take the property unburdened. When a debtor both rejects a lease and sells the underlying property free and clear, the purchaser and/or debtor often argue that any rejected lease is an “interest” that is completely wiped out by the sale and requires the tenant to vacate the space. Section 365(h) and section 363(f) are therefore in conflict, as section 365(h) allows the tenant to remain in the premises, while section 363(f) arguably allows a sale “free and clear” of the tenant’s interest to remain.

There is substantial case law addressing the potential conflict between sections 363(f) and 365(h) of the Bankruptcy Code. Most courts treat section 365(h) as the more specific provision and hold that a free-and-clear sale does not override a tenant’s possessory rights. The buyer takes title subject to the lease and steps into the landlord's shoes. See, e.g., In re Revel AC, Inc., 532 B.R. 216, 227 (Bankr. D.N.J. 2015). The Seventh Circuit (which includes Illinois), on the other hand, has held differently. In Precision Industries, Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003), the Seventh Circuit held that section 363(f) and section 365(h) do not conflict and that a sale free and clear can extinguish a tenant's possessory interest, leaving the tenant to seek adequate protection of that interest under section 363(e) of the Bankruptcy Code rather than remaining in possession. For a tenant in Chicago or the Seventh Circuit (which includes Illinois), that distinction is important because section 365(h) protection may not survive a free-and-clear sale unless the tenant affirmatively raises and protects its rights in the sale process.

The AllStar Opinion

In AllStar, the Chapter 11 debtor moved to sell a commercial property in Rome, Georgia, and to reject the lease of Edward Jones on the property after determining the lease was under market. The proposed buyer would not close on the sale unless the lease was rejected. The tenant did not oppose the sale or the rejection. Instead, the tenant objected to the sale on the grounds that its rights pursuant to section 365(h) of the Bankruptcy Code would be stripped away and requested that the court confirm that it could elect to retain possession for the balance of its term notwithstanding the sale. However, the purchaser requested a date certain for the tenant's decision, as the sale could collapse if the tenant delayed making that election indefinitely.

The bankruptcy court began its analysis by examining Mission Product Holdings, Inc. v. Tempnology, LLC, 587 U.S. 370 (2019), which held that rejection of a contract operates as a breach, not termination, and carries the same consequences a breach would carry outside of bankruptcy. Thus, the tenant retained all nonbankruptcy remedies as a result of that breach, including the ability to make an election to rescind or to continue performing under the lease and sue for damages. The bankruptcy court therefore confirmed that Edward Jones could not be evicted by the rejection and that the tenant would retain its section 365(h) rights to remain in possession.

In a holding that may only be interesting to bankruptcy attorneys, the court then reached the question of when the tenant had to choose between terminating the lease or retaining possession, noting that it was a novel question of first impression. Section 365(h) presents two mutually exclusive options, to treat the lease as terminated and file a damages claim, or retain possession. The tenant cannot hold both options open indefinitely while the estate waits to close a sale. The requested deadline therefore did not threaten whether the tenant could remain in the premises. Rather, the deadline simply required the tenant to decide whether to remain in the premises and exercise its rights under section 365(h). The bankruptcy court ultimately held that the election is made at the time of rejection and rejected the tenant's argument that it could retain its rights while keeping the option to terminate open indefinitely. However, the court found that nothing in the Bankruptcy Code barred it from allowing the tenant a reasonable period to decide, giving the tenant forty-five days from entry of the order to make its election. This holding was intended to strike a balance between the debtor's need to close the sale and the tenant's right to remain in the space it bargained for.

What Parties Should Take From This Opinion

Two lessons are clear from the AllStar case. First, for tenants, a landlord's bankruptcy and rejection of the lease does not mean that the tenant’s right to remain in place ceases. Section 365(h) of the Bankruptcy Code preserves a tenant’s right to remain in possession for the balance of the lease’s term, along with the right to offset rent for the new landlord's nonperformance. However, a tenant must make that election and act on it promptly. At least in the Seventh Circuit, a tenant facing a free-and-clear sale cannot sit on its rights. As Qualitech illustrated, a tenant must raise and protect its rights (often via an adequate protection request) during the sale process or risk losing them. For purchasers and debtors, there is also a lesson. In most jurisdictions outside the Seventh Circuit, a section 363(f) sale which is coupled with rejection of a lease does not necessarily kick out all tenants. A buyer who has not accounted for an in-place tenant may find itself a non-consenting landlord and a debtor who has promised a clean sale may find the deal in jeopardy.

Whether you are a tenant whose landlord has filed bankruptcy, or a purchaser or debtor structuring a sale around a rejected lease, the attorneys at FactorLaw can help you understand how section 365(h) affects your rights before the order is entered.

By: Sean P. Williams