Lease Rejection Damages Under the Bankruptcy Code Cap
By Walter J. Greenhalgh
February 20, 2017
New Jersey Law Journal
The United States Bankruptcy Code, pursuant to 11 U.S.C. Section 502(b)(6), caps a landlord's claim in bankruptcy for damages resulting from the termination of a real property lease. See In re PPI Enterprises U.S., 324 F.3d 197, 207 (3rd Cir. 2003). Under Section 502(b)(6), a landlord-creditor is entitled to rent reserve from the greater of one lease year or 15 percent, not to exceed three years, of the remaining lease term. The cap operates from the earlier of the petition filing date or the date on which [the] lessor repossessed, or the lessee surrendered, the leased property. The landlord also retains a claim for any unpaid rent due under such lease prior to the earlier of those dates. This language reflects Congress's intent to limit lease termination claims to prevent landlords from receiving a windfall over other creditors. Id. at 207.
The Ninth Circuit recently issued an opinion holding that Section 502(b)(6) does not cap damages arising from every breach of a lease. See In re Kupfer, ---F.3d---, 2016 WL 7473790, 63 Bankr. Ct. Dec. 136 (9th Cir. 2016). Konstantin Kupfer and Margarita Kupfer(the debtors) leased two commercial properties. Each lease ran for 10 years. Each lease included an arbitration clause for the resolution of disputes between the landlord and tenant and included a clause under which attorney fees, arbitration fees and costs would be awarded to the prevailing party in the event of a dispute. The debtors stopped paying rent on the properties and eventually vacated the premises. Litigation ensued in the California state court for breach of both leases. The state court stayed the action pending arbitration.
The arbitrators assessed damages against the debtors for breaches of the leases; the damages included both unpaid past rent and future rent discounted to a present value. The arbitrators also awarded attorney fees. Thereafter the debtors filed for Chapter 11 protection. The creditor landlords filed proofs of claim under the arbitration award. The debtors argued that the entire arbitral award, including attorney fees and arbitration fees, should be limited by the cap contained in Section 502(b)(6). The Bankruptcy Court sided with the creditors and allotted amounts that represented the entire arbitration award of past and future rent as limited by the statutory cap, plus the entire uncapped claim for attorney fees and arbitration fees. The district court affirmed in the debtors' appeal.
Circuit Judge Susan P. Graber reversed the lower courts, holding that Section 506(b)(6) does not cap damages arising from every breach of contract. The district court ruling used an all-or-nothing approach, and therefore the Ninth Circuit vacated and remanded for further proceedings. Judge Graber provided a brief history of the case law and the amendments to the statutory cap provided for the under the Code. The court referenced the Ninth Circuit opinion in El Toro Materials Co., 504 F3d., 978 (9th Cir. 2007). Judge Graber summarized the reasoning in El Toro, which established a test for which claims would be capped and which claims would be allowed. The court noted the simple test reveals whether the damages result from the rejection of the lease. Assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it. Id. at 981.
Judge Graber noted the Eighth Circuit's BAP adopted the El Toro reasoning in the decision of Lariat Cos. v. Wigley (In re Wigley) 533 B.R. 267 (B.A.P. 8th Cir. 2015). There, the court capped the creditors' interest on the award of future rent, reasoning that without termination of the lease, there would be no claim for future rent, and without an award for future rent there is no interest. Id. at 272. However, because the asserted damages for unpaid [past] rent, common area maintenance, and late fees had accrued prior to termination of the lease and thus cannot be said to have resulted from termination of the lease, the related attorney fees, costs and disbursements and the prepetition interest thereon, likewise cannot be said to have resulted from the termination of the lease and were not capped. Id. Judge Graber agreed with the Wigley decision utilizing the El Toro test in the context of a pre-petition lease termination. Judge Graber ruled that Section 502(b)(6) does not cap damages resulting from every breach of contract. Only those claims for damages resulting from the termination of a lease are capped. She further noted that fees attributable to litigating creditors' claims for future rent are capped, because such claims would not arise were the leases not terminated. But the arbitration award included damages for past rent which creditors could claim independent of termination. Judge Graber remanded the matter back to the district court to characterize all claims as either directly resulting from termination of the lease or not.
The courts in the Third Circuit have adopted the El Toro test. See In re Filene's Basement, 2015 Bankr. LEXIS 1350; 73 Collier Bankr. Cas. 2d 899 ( Bankr. D. Del. 2015). The Honorable Kevin J. Carey, U.S.B.J., decided Section 502(b)(6) does not prevent a landlord from asserting a separate claim for damages that do not directly arise from termination of the lease. Judge Carey noted that the El Torocourt determined that a landlord's tort claims for removal of tons of dirt and mining equipment left by the debtor were outside the scope of the cap under Section 502(b)(6), El Toro 504 F.3d at 980-81. The El Toro decision focused on whether the damages arose from the rejection of the lease, noting that Section 502(b)(6) caps any claims resulting from the termination of the lease. Judge Carey found the reasoning of the Court of Appeals in El Toro persuasive and agreed with a more narrow interpretation of Section 502(b)(6). The statute does not prevent a landlord from asserting a separate claim for damages that do not directly arise from the termination of lease. Therefore, he proceeded to review each of the additional claims presented to him by the landlord. Id at 26.
Judge Carey determined that El Toro suggests a "simple test" to determine whether the claim results from rejection of a lease: Assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than reject it. Id at 29. He went on further to note that although El Toro focused on whether the damages arose from the rejection of the lease, Section 502(b)(6) caps any claims resulting from termination of the lease. He found it significant that Congress chose to use the word "termination" and not "rejection," in the introductory phrase of Section 502(b)(6) and concluded such choice was intentional. The court should first determine that a claim is for lease termination damages. Once that is determined, it must then decide whether the claim may be included as part of what is "rent reserved" under Section 502(b)(6)(A).
It appears that the trend in both the Ninth and Third Circuits will follow this approach in the interpretation of the Section 502(b)(6) cap.
Reprinted with permission from New Jersey Law Journal, © ALM Media Properties LLC. All rights reserved.