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. 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:

[i]n 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. Sec. 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. Sec. 365.

Tenant appealed, and the district court, exercising jurisdiction under 28 U.S.C.A. Sec. 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. Secs. 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 as to the material facts.

Section 365(h)(2) provides in pertinent part:

[i]f such lessee ... remains in possession as provided in paragraph (1) of this subsection, such lessee ... may offset against the rent reserved under such lease ... any damages occurring after such date [of rejection] caused by the nonperformance of any obligation of the debtor under such lease....

11 U.S.C.A. Sec. 365(h)(2) (emphasis added). Therefore, our first inquiry is what rent is reserved under the lease.

The phrase, "rent reserved under such lease," plainly refers to the rent due under the lease. See Consumer Product Safety Com. v. GTE Sylvania, Inc., 447 U.S. 102, 108, 100 S. Ct. 2051, 2056, 64 L. Ed. 2d 766 (1980) ("plain meaning of legislation should be conclusive"); see also In re TM Carlton House Partners, 97 B.R. 819, 823 (Bankr.E.D.Pa.1989) ("tenant is entitled to remain under the same rental terms as are set forth in the lease") (citations omitted).

Here, paragraph 29 of the lease plainly provides for a reduction in the rent when the tenant cures the landlord's default. In essence, the parties agreed that if tenant advanced certain costs which were the obligation of landlord, the rent would be reduced accordingly. The reduced rent is the "rent reserved," and it is that rent which the tenant is required to pay.

"Rejection does not alter the substantive rights of the parties to the lease," and thus does not alter the continuing vitality of terms affecting the amount of rent such as paragraph 29. In re Chestnut Ridge Plaza Associates, L.P., 156 B.R. 477, 483 (Bankr.W.D.Pa.1993). The primary function of rejection is to "allow[ ] a debtor-lessor to escape the burden of providing continuing services to a tenant." In re Lee Road Partners, 155 B.R. 55, 60 (Bankr.E.D.N.Y.1993) (citing cases), aff'd, 169 B.R. 507 (E.D.N.Y.1994). Rejection affects the lessor's duties to the tenant. See also In re Stable Mews Associates, Inc., 41 B.R. 594, 597 (Bankr.S.D.N.Y.1984) (rejection "reliev[es] the estate from covenants requiring future performance, such as the provision of utilities, repairs, maintenance and janitorial services by the debtor") (citation omitted); 2 Collier on Bankruptcy Sec. 365.09, at 356-58 (15th ed. 1995) (rejection "results merely in the cancellation of covenants requiring performance in the future by the landlord"). The Chestnut Ridge court emphasized that

[t]he obligations under the lease and rights associated with the tenant's leasehold interest do not just vanish because a debtor has rejected the lease. The leasehold interest remains intact and the lease remains operative between the parties.

156 B.R. at 485 (citations omitted). Thus, although the rejection of the lease by the debtor-landlord relieves it of prospective obligations to perform under the lease, it does not relieve it of its obligation to accept the agreed upon reduced rent provided for under the terms of the lease.

Although not the type of transaction traditionally recognized as creating a security interest, this situation is analogous to the assignment of rents to secure a loan. If the landlord had borrowed the money to make the repairs and assigned the rents to a lender, the landlord could not disavow the assignment after filing a bankruptcy petition and insist that it receive the rent payments. See, e.g., In re Wheaton Oaks Office Partners Limited Partnership, 27 F.3d 1234, 1239-41 (7th Cir.1994) (assignment of rents to secure mortgage is an interest in real property and hence a lien giving rise to security interest); Prudential Ins. Co. of America v. Boston Harbor Marina Co., 159 B.R. 616, 619 (D.Mass.1993) (lien on rents gives rise to security interest in future rent payments); In re Buckley, 73 B.R. 746, 749 (D.S.D.1987) (interest in rent gives rise to perfected security interest where lender obtains possession of property). Cf. In re Tavern Motor Inn, Inc., 80 B.R. 659, 660-62 (D.Vt.1987) (landlord's assignment of right to receive future rent gave lessee bank a security interest in real property). Similarly, the debtor in this case, in effect, assigned to the tenant its own interest in the rental payments and thus permitted tenant to reimburse itself.

From yet another perspective, paragraph 29 can be interpreted as treating the monies so advanced by the tenant as more akin to prepaid rent, rather than a loan to the landlord or a debt the landlord owes the tenant. Certainly if a tenant paid a year's rent in advance and the landlord filed for bankruptcy during the course of that year, the tenant should not be required to pay the rent a second time for the remaining balance of that year. Cf. In re M.W. Ettinger Transfer Co., 1988 WL 129334, * 4 (Bankr.D.Minn.1988) (concluding it is "wholly unjust, improper and foolish" to require debtor-tenant who spent more than $300,000 in capital improvements in form of prepaid rent to pay rent and to force tenant to sue separately for a prepaid rent claim). Thus, on statutory grounds, we conclude that the "rent reserved" under the lease is the fixed rent less the reasonable and customary cost of the improvements, to be apportioned towards tenant's monthly rental obligation by the bankruptcy court on remand.

Even if statutory grounds were not available, we hold that the doctrine of recoupment would provide relief to tenant. A claim subject to recoupment avoids the usual bankruptcy channels and thus, in essence, is given priority over other creditors' claims. Recoupment, which has its origins as an equitable rule of joinder, permits claims arising out of the same transaction to be adjudicated in one proceeding. Lee v. Schweiker, 739 F.2d 870, 875 (3d Cir.1984); In re B & L Oil Company, 782 F.2d 155, 157 (10th Cir.1986). This common law doctrine is not codified in the Bankruptcy Code, but has been established through decisional law.

The "trustee of a bankruptcy estate 'takes the property subject to rights of recoupment.' " In re Holford, 896 F.2d 176, 179 (5th Cir.1990) (quoting In re Career Consultants, Inc., 84 B.R. 419, 426 (Bankr.E.D.Va.1988)); In re University Medical Center, 973 F.2d 1065, 1080 (3d Cir.1992). In recognition of the special nature of recoupment, courts have permitted its application even in situations where the Code does not permit application of the related doctrine of setoff, 11 U.S.C.A. Sec. 553 (West 1993). Thus, postpetition funds owing to the landlord may be recouped against prepetition claims owed by the landlord despite the usually inflexible automatic stay provision of the Code, 11 U.S.C.A. Sec. 362(a) (West 1993). See, e.g., In re Klingberg Schools, 68 B.R. 173, 178-79 (N.D.Ill.1986), aff'd, 837 F.2d 763 (7th Cir.1988).

However, recoupment is not available without limitation. As noted above, the contending claims must derive from the same transaction. Recoupment also cannot be the basis for asserting an independent claim against the estate. In re American Central Airlines, Inc., 60 B.R. 587, 590 (Bankr.N.D.Iowa 1986) (citation omitted).

This case satisfies the "same transaction" test. We have required that "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." University Medical Center, 973 F.2d at 1081. Both the claim for repair costs and the rent arise from the lease, and it would be inequitable for the landlord to receive rent without compensating tenant for undertaking the repairs.

Although the usual posture of recoupment cases involves a defensive invocation of recoupment in response to a landlord or trustee filing suit to recover sums owing to the estate, the creditor may take the "offensive" as in this case. See Public Service, 107 B.R. at 445-46 (landlord's argument that recoupment may be raised only in defense is "misplaced"); B & L Oil, 782 F.2d at 156 (creditor brought suit for adjudication of its right to recoupment). Although the creditor is the tenant here, this does not contradict the essentially defensive nature of tenant's position. It is not seeking affirmative recovery of the repair costs, but rather an adjudication that it may deduct the repair costs from its post-rejection rent.

Thus, at the time of filing, tenant had a valid recoupment claim, and hence the landlord had no interest in the future rental income to the extent of tenant's claim.

Having concluded that the tenant has the right to reduce future rent payments to the extent that it expended monies to make improvements which were the obligation of the debtor-landlord, we must next consider the impact of confirmation from which tenant neither appealed nor sought a stay.

Section 1141 of the Bankruptcy Code states, in pertinent part and subject to exceptions not relevant herein:

(a) ... the provisions of a confirmed plan bind the landlord ... and any creditor ... whether or not the claim or interest of such creditor ... is impaired under the plan and whether or not such creditor ... has accepted the plan.

* * * * * *

(c) ... except as otherwise provided in the plan or in the order confirming the plan, after confirmation of a plan, the property dealt with by the plan is free and clear of all claims and interests of creditors, equity security holders, and of general partners in the landlord.

11 U.S.C.A. Sec. 1141(a, c) (West 1993). Landlord posits this as a per se bar to tenant's assertion of its right to now reduce the rent where the plan listed tenant as an unsecured creditor without any special rights to offset against rental income. Debtor also contends that the plan has been implemented such that the court can no longer provide effective relief to tenant without jeopardizing the success of the plan, which depends primarily on the unreduced rental flow. We reject these contentions for the following reasons.

This is not a situation where a creditor has slept on its rights while a plan has been proposed, confirmed, and relied upon by others. Tenant's position has been known and pursued from the outset. The equities are clearly with tenant. It made the improvements which were the obligation of landlord. It was entitled by agreement to deduct the cost of those improvements from the rent. To now prohibit it from doing so would create a windfall for the debtor. The approximately 15 partners have contributed only $50,000 to the plan. Debtor and its other creditors proceeded to implement the plan under the specter of potential reversal of the district court in favor of granting tenant's recoupment claim and consequent reduction in rent. In fact, in its objections to confirmation of the reorganization plan, tenant specifically noted the pendency of this appeal. Objection to Confirmation of Proposed Third Amended Plan of Reorganization at p 1, n. 1.

We conclude that all parties proceeded to implement the plan with knowledge that the district court's determination was subject to reversal upon appeal. Thus, although challenging the plan or seeking a stay pending appeal was preferable, tenant's failure to do so does not render this appeal moot. Tenant otherwise diligently pursued its claim and gave landlord early indication of its intent to abate rent if landlord defaulted on its duties. See also In re Rooster, Inc., 127 B.R. 560 (Bankr.E.D.Pa.1991) (creditor permitted to recoup despite failure to appeal from the confirmation order nor seek a stay pending appeal); In re Maine, 32 B.R. 452, 453 (Bankr.W.D.N.Y.1983) (creditor permitted to recoup despite failure to object to confirmation of the plan nor appeal the confirmation order). Cf. In re De Laurentiis Entertainment Group Inc., 963 F.2d 1269, 1271 (9th Cir.) (creditor had right to setoff although it did not object to reorganization plan nor challenge confirmation order), cert. denied sub nom Carolco Television, Inc. v. National Broadcasting Co., --- U.S. ----, 113 S. Ct. 330, 121 L. Ed. 2d 249 (1992); In re Ford, 35 B.R. 277 (Bankr.N.D.Ga.1983) (creditor permitted to setoff despite failure to object to the reorganization plan nor appeal the confirmation).

Thus, although we recognize the importance of maintaining the integrity of confirmed plans from later attack, these unique circumstances permit the plan to be reopened and readjusted. We reach this conclusion, recognizing that the continuation of the lease has been at the instance of tenant and not the debtor-landlord.

Furthermore, permitting tenant to pay the rent reserved or to recoup against rent payments will not necessarily upset the successful implementation of the plan. Landlord assumes that tenant would be able to withhold all rental payments until it recovers the $325,000. Under such a scenario, the plan would indeed fail. However, the bankruptcy court has considerably more flexibility in fashioning an equitable remedy than debtor acknowledges. On remand, we suggest that the district court return the matter to the bankruptcy court for a determination of whether there is an amount of rent abatement which would best balance ensuring the ultimate, if more gradual, success of the reorganization plan with reimbursing tenant for the repair costs. Tenant's memorandum to this court indicates that it has no immediate plans to vacate the premises, particularly considering tenant's other substantial improvements to the property, and so adjusting the monthly payments appears to be a viable option.

In sum, we conclude that confirmation and implementation of the reorganization plan does not prevent tenant from paying the "rent reserved" under the lease nor from asserting its right to recoupment. As we have held that tenant may pay reduced rent on statutory and recoupment grounds, we need not reach tenant's other contentions on this issue.

We now clarify one remaining issue. The bankruptcy court concluded that tenant has elected to remain in possession of the lease "and any renewals or extensions thereof," March 25, 1993 Order at p E (emphasis added), and the district court affirmed. Tenant argues that the bankruptcy court erred in holding that it had elected to remain in possession for the remaining term of the lease and for all extension periods provided therein. We agree with tenant that the language of Sec. 365(h)(1) is permissive, not mandatory: the lessee "may remain in possession of the leasehold ... for the balance of such term and for any renewal or extension of such term...." 11 U.S.C.A. Sec. 365(h)(1). There is no statutory requirement that a tenant who elects to remain on the premises must remain throughout all possible renewal periods nor that tenant must exercise its options as to renewal periods at the time it elects to remain in possession.

For the foregoing reasons, we will reverse and remand to the district court for proceedings in accordance with this opinion.