The slowdown in consumer spending that started with the recent recession continues to have a ripple effect in the commercial real estate industry. Developers find themselves without the capital to complete new projects, lenders and investors lose confidence in the ability to lease new projects, retailers are unable to sustain the high rents to which they committed when sales were higher, and property owners face increasing vacancies and nonperforming tenants. Indeed, tenants are seeking protection under the bankruptcy rules with such frequency that many practitioners, including traditional real estate lawyers, have found it necessary to expand the laws with which they are generally familiar to include certain aspects of the Bankruptcy Code.
With continuing frequency, commercial property owners must calculate their expected damages and determine how those damages may be limited when tenants breach their leases by rejecting them in bankruptcy. While bankruptcy practitioners are familiar with the statutory formulas and case law for these issues, nonbankruptcy lawyers with experience representing owner clients in real estate transactions may feel unprepared to advise the owners on what steps to take when they have a tenant who has filed for bankruptcy protection or is threatening to do so in order to gain leverage in a negotiation.
Real estate practitioners representing owners with tenants who have filed for protection under the bankruptcy laws must become familiar with Bankruptcy Code Section 502(b)(6). This section imposes a somewhat confusing, and often misinterpreted, cap on the damages that a landlord may recover when a tenant breaches its lease by rejecting it in bankruptcy. Counsel must also grasp two additional issues important to landlords when a tenant files for bankruptcy. The first involves determining whether expenses allocated to the tenant under the lease--such as property taxes and insurance costs--are affected by the statutory cap on damages imposed by Section 502(b)(6). The other requires an assessment of the effect on damages of a security deposit.
Section 365 of the Bankruptcy Code provides that parties in bankruptcy have the right to assume or reject their executory contracts and unexpired leases, subject to bankruptcy court approval. The tenant's election to reject an unexpired lease constitutes a breach of the lease, which vests in the landlord a prepetition unsecured claim for damages.1 The landlord files a claim for damages in bankruptcy court. The court, applying state law, determines the amount of damages based on the terms of the lease or contract between the landlord and the debtor tenant.2
When the debtor or a competing creditor objects to the amount of the landlord's claim, Section 502(b)(6) imposes a cap on the amount of the recoverable damages. The cap limits the landlord's claim against the debtor's estate to the extent the claim exceeds the sum of "(A) the rent reserved [under the] lease, without acceleration, for the greater of one year or 15 percent, not to exceed three years, of the remaining term" of the lease, and "(B) any unpaid rent due under" the lease.3 The date on which the reserved rent damages under subsection (A) start to accrue and on which the unpaid rent under subsection (B) is measured is the earlier of the date the tenant files its bankruptcy petition or the landlord regains possession of the premises.
The policy behind the decision by Congress to limit a landlord's damages following rejection of a commercial lease can be traced to well before the Bankruptcy Reform Act of 1978. Legislative history reveals that Section 502(b)(6) was designed to not only compensate a landlord fairly but also to make sure the landlord's claim did not prevent other unsecured creditors from recovering from the estate--particularly when the lease has a long term remaining when the tenant files for bankruptcy protection.4 Congress identified two major reasons for the need to limit a landlord's claim. First, the failure to do so would limit disproportionately the recovery of other creditors. Second, a landlord is not in the same position as other creditors, because usually the landlord is compensated until the date of the tenant's filing for bankruptcy, and the landlord regains possession of the property following the bankruptcy.5
In considering the Bankruptcy Code's limitation on a landlord's claim, it is important to consider what Section 502(b)(6) does not do. Section 502(b)(6) does not provide a formula for calculating damages under a lease. Nor does it establish what constitutes an allowable claim for a landlord. A landlord need not comply with any of the requirements of Section 502(b)(6) in order to file a claim in a bankruptcy proceeding. But once a landlord's damages following a breach by the debtor are calculated, Section 502(b)(6) is used to determine whether the amount of the claim should be limited because it "exceeds the cap calculated under the statute."6
In California, the landlord, following the tenant's breach, is entitled to recover all unpaid rent at the time of the breach as well as the present value of the amount by which the unpaid rent for the remainder of the lease term exceeds the amount of lost rent that the tenant proves could reasonably be avoided through leasing the premises to another tenant or other mitigation measures.7 The landlord also may recover additional amounts necessary to compensate it for the tenant's failure to perform other duties under the lease, such as the obligation to maintain or restore the property to a specified condition or payment of property taxes.8 Accordingly, when faced with a tenant's rejection of its lease in bankruptcy, an owner of California property must first apply nonbankruptcy law and determine the amount of its unpaid rent and lost rent due to the breach and thereafter determine in what way, if any, Section 502(b)(6) limits those damages by imposing a cap.9
Time versus Rent
Bankruptcy Code Section 502(b)(6) expressly limits a landlord's claim to the greater of "one year, or 15 percent, not to exceed three years, of the remaining term of such lease." This language is subject to two interpretations. If the remaining term at the time of the breach exceeds one year, does the "or 15 percent" limitation require measurement of the time remaining on the lease or the amount of rent "reserved by such lease"? Courts have had trouble agreeing on how to answer this question, and the varying results can be meaningful if the rent increases over the remainder of the term of the lease, or the lease contains significant free rent periods that affect the timing of rental payments.10
The fact that courts are split on the question of whether the 15 percent cap applies to the remaining rent "reserved" under the lease or the time remaining under the lease (to which the rental rate is then applied) suggests that the language of the statute is unclear on this issue. The language of Section 502(b)(6) implies, however, that the time remaining on the lease--not the remaining rent--should be measured.
A reading of the statute that involves removing the "not to exceed three years" clause--which establishes the maximum period of rent to be awarded--results in an unambiguous reference to time. The statute limits a landlord's claim against the breaching tenant to the extent the claim exceeds the rent reserved under the lease for "the greater of one year, or 15 percent...of the remaining term of [the] lease." Indeed, courts that have looked to the plain meaning of the statute to answer the "time versus rent" question have determined that the clause refers to the time remaining on the lease.11 Under this interpretation, after calculating the length of 15 percent of the remaining term, the rent in effect during that period is applied. Although the Ninth Circuit has not squarely addressed the issue of time versus rent, in applying Section 502(b)(6) the court has measured the time remaining on the lease to determine the maximum recovery available to a landlord when the cap is applied.12
An additional indication that the cap imposed by Section 502(b)(6) is intended to measure the time remaining on the lease and not the total rent reserved is the frequently used method for determining whether the cap is governed by the one-year limitation or, alternatively, the limitation of 15 percent, not to exceed three years, of the remaining term. The court in In re Iron-Oak Supply Corporation noted that the statute enables the bankruptcy court to determine the number of months of rent that can be claimed as damages by looking to the remaining term of the lease following the earlier of the filing of the bankruptcy petition and the surrender of the leased premises. If less than 80 months remain on the term of the lease, then the one-year cap will apply (15 percent of 80 months is one year). If more than 80 months and less than 240 months remain, then the 15 percent limitation will apply (15 percent of 240 months is three years).13 If the lease has more than 240 months remaining, then the statute limits the landlord's claim to three years of rent. According to the Iron-Oak Supply court, the reference in the statute to the remaining number of months in the lease indicates that "Congress intended...the phrase 'remaining term' be a measure of time, not rent."14
Further support of this reading of the statute is Section 502(b)(6)(A)'s reference to the rent reserved by the lease "without acceleration." That phrase only has meaning if it is referring to the next succeeding periods under the lease--whether one year or 15 percent of the remaining term, whichever is greater--so long as the total claim is capped at three years. If Congress had intended for the rent to be calculated based on the remaining rent due, and not the length of the term remaining, then it would not have added the "without acceleration" language to the statute. Calculating the remaining rent due has the same economic effect as an acceleration of the lease.15
Thus, the statute is best interpreted to cap the amount of time that remains on the lease. Once 15 percent of the number of months remaining on the lease is determined, Section 502(b)(6)(A) caps the landlord's claim for future rent at the amount of rent that would have become due during that period.16 If any free or reduced rent is applicable to that period, then those aspects of the lease will serve to limit the landlord's allowable claim.
Nonetheless, despite the arguments for why the cap on damages imposed by Section 502(b)(6) is best interpreted as referring to the time remaining under the lease, the majority of cases that have considered the issue have reached the opposite conclusion. These courts have interpreted "15 percent of the remaining term [of the lease]" to mean "15 percent of the net amount of rent, after subtracting amounts received in mitigation, due for the remaining term."17 Thus, the majority view is that the "or 15 percent" limitation quantifies the aggregate rent remaining under the lease and not the time remaining.18
Courts applying a "total rent remaining" theory have identified compelling reasons for focusing less on the words of the statute in reaching the desired result. After all, a strong argument can be made that the landlord is not unjustly benefited by receiving the higher amount, because the landlord is collecting a portion of the increasing rent that it bargained for in the lease. Courts have also noted that in a lease the landlord retains the risk of fluctuations in the value of the property. At the conclusion of the lease, the tenant has no risk associated with a decline in value.19 One factor that can affect that fluctuation in value is the bankruptcy of one or more tenants. Since landlords assume the risk of value and bankruptcy, they should not be deprived of any bargained-for increases in rent during the term of the lease.
Limits on Non-Rent Obligations
Once a commercial landlord calculates its damages in the form of lost rent, and any limitation on those damages imposed by the Bankruptcy Code, the landlord must next consider whether the Section 502(b)(6) cap applies to any other damages that may have resulted from the breach. Since the Bankruptcy Code limits the landlord's recovery following the rejection of the lease to the "rent reserved" by the lease for the time periods specified in Section 502(b)(6), an initial question is whether expenses that are contractually the tenant's obligations--but may not be considered rent--are subject to the Section 502(b)(6) cap. Examples of these type of expenses are property taxes, insurance, maintenance, and repair costs.
A landlord seeking to avoid the limitations imposed by the cap might contend that expenses allocated to the tenant under the lease are obligations independent of the covenant to pay rent and therefore are outside the scope of Section 502(b)(6). A second, and related, argument is that these kinds of expenses--which are contractually the tenant's responsibility--are, to the extent they are delinquent at the time of the bankruptcy filing, outside the scope of Section 502(b)(6) because they do not arise "from the termination" of the tenant's lease.20 If the tenant's obligations, such as its share of property taxes or maintenance expenses, are delinquent at the time of bankruptcy, those obligations do not arise from the termination of the lease and arguably should not be limited by the statutory cap.
While there is some division among bankruptcy courts on the issue of whether non-rent expenses are subject to the cap imposed by Section 502(b)(6), the majority of courts, including the Ninth Circuit Bankruptcy Appellate Panel, have held that a tenant's breach of its non-rent obligations should be treated no differently from damages resulting directly from the tenant's rejection of the lease.21 The Bankruptcy Code suggests that there is no distinction between past obligations, such as failure to pay property taxes, and damages caused by the termination of the lease, because all damages due to the tenant's nonperformance are encompassed by the Section 502(b)(6) cap.22 This would also include covenants that may have been violated before the date of rejection.
However, the analysis should be different when the tenant commits a tort against the property, such as waste, nuisance, or trespass. When the landlord suffers damages that are collateral to the purpose of the lease, and are not based on lost rent or damages directly arising from a tenant's failure to perform an obligation specified in the lease, these damages do not "result from" the rejection of the lease and are not subject to the cap.23
The Ninth Circuit's test for determining whether the landlord's damages were the result of the lease rejection and therefore limited by Section 502(b)(6) is whether the landlord would have the same claim against the tenant if the tenant were to assume the lease rather than reject it.24 If the landlord would have the claim against the tenant even after the tenant has cured the defaults and performed the covenants necessary to assume the lease, then the cap does not apply--but if the landlord's claim arises only upon lease rejection, then the damages are subject to the statutory cap.
This rule properly aligns the tenant's incentives. If Section 502(b)(6) were held to limit a landlord's claim when the tenant has done collateral damage to the property, the tenant may have an incentive to reject the lease to avoid paying the full amount of damages it has caused. This is so even when performing under the terms of the lease would otherwise be desirable to preserve the value of the tenant's business.25
If the landlord is unable to convince the court that Section 502(b)(6) should not apply because its damages are collateral to the terms of the lease, the landlord should then try to expand the universe of items that entail "rent reserved" by the lease.26 In this way, the landlord increases its potential recovery because the limitation to one year's rent, or 15 percent of the remaining term of the lease, whichever is applicable, would be based on a larger pool of funds to which the cap is then applied. It would include not only traditional rent but also other tenant obligations--such as taxes, insurance, and maintenance costs--that are generally considered necessary to maintain the value of the property.
The Ninth Circuit has adopted a three-prong test to determine whether a charge under a lease is rent reserved and thus included within the one or three years' rent to which the landlord is entitled.27 First, the charge under the lease must be designated as "rent" or "additional rent" in the lease or deemed the tenant's obligation under the lease. Second, the charge must be related to the value of the property or the lease on the property. Third, the charge must be properly classifiable as rent because it is fixed, regular, or periodic. Thus property taxes and insurance premiums are likely to qualify as rent if they are the tenant's obligation. By contrast, a one-time maintenance fee would not satisfy the third prong of the test and would not be considered rent reserved when calculating the landlord's damages. A landlord should expect its recovery to be limited to one year's rent, or 15 percent of the remaining term, as applicable, and should base the 15 percent test on all "rent" as established by the Ninth Circuit's three-prong test.
The delivery of a security deposit under the lease is a separate but related issue that also arises following the rejection of a tenant's lease in bankruptcy.28 The bankruptcy court must decide if the security deposit should be used to offset the landlord's total damages before the application of Section 502(b)(6) or should be taken into account after the cap has been applied to further limit the landlord's claim. A landlord holding a claim against the debtor's estate would prefer a method in which the first step is calculating the gross damages under the lease, and next the amount of the security deposit held by the landlord is subtracted from the gross damages. That sum would be compared to the cap imposed by Section 502(b)(6)--and the landlord's claim would be the lesser of the two.29 This calculation makes intuitive sense if the purpose of the Section 502(b)(6) cap is to limit the landlord's damages.
However, the debtor--or the debtor's creditors other than the landlord--would prefer to subtract the security deposit after the court determines the landlord's damages under the Section 502(b)(6) cap. The landlord's damages under nonbankruptcy law would be compared to the capped amount under Section 502(b)(6), and then the security deposit would be subtracted from the lesser of the two.30 Determining whether this preference by debtors should prevail cannot be discerned by referring to the plain language of the statute.31
Courts that have considered the application of a security deposit held by the landlord have largely relied on legislative history and a Second Circuit decision, Oldden v. Tonto Realty Corporation, that predates the Bankruptcy Reform Act of 1978 by more than 30 years.32 The Oldden court considered whether a landlord who held a cash security deposit was required to deduct the amount of that deposit from the total damages provided by the lease or from the total allowable claim under the then-existing Bankruptcy Code.33 The court concluded that the security deposit should be deducted from the allowable claim rather than the total damages.
Congress endorsed this holding when it enacted the 1978 act and indicated that the new Bankruptcy Code Section 502(b)(6) was not intended to overrule Oldden.34 Noting that the purpose of the cap on a landlord's damages is to "compensate the landlord for [its] loss while not permitting a claim so large...as to prevent other general unsecured creditors from recovering a dividend from the estate," Congress expressly stated that a landlord's security deposit "will be applied in satisfaction of the claim that is allowed under [Section 502(b)(6)]"--the same determination under Oldden.35 Much to the dismay of a landlord who takes comfort in having had the foresight to secure a large deposit from its now bankrupt tenant, courts have almost unanimously determined that the full amount of a security deposit should reduce the landlord's allowable claim in bankruptcy and not be subtracted from its gross damages.36
Nevertheless, the possession of a security deposit is not without benefit to a landlord. Even though the security deposit does not expand the universe of damages that the landlord might otherwise receive after application of the statutory cap, a security deposit ensures that the landlord will receive 100 percent recovery on that portion of its claim that is held in the form of a security deposit. Without a security deposit, the landlord is subject to the potential limitation on recovery that all creditors face due to the inability of the debtor's estate to compensate the creditors to the extent of their claims.
A landlord faced with a bankrupt tenant or a tenant threatening to file for bankruptcy protection faces a long and challenging road to recover its bargained-for benefits under its lease. In today's climate of large bankruptcies filed by national tenants with leases across the country, landlords cannot be sure whether their leases will be rejected, whether their location is one that benefits the tenant, or if the most advantageous result is to sell their unsecured claim--an option that has become commonplace in large bankruptcy cases. In order to best evaluate their course of action, landlords must first predict the amount of their allowable claim, which must then be discounted by the likelihood of recovery.
To calculate the amount of the claim, a landlord must determine its gross damages under nonbankruptcy law and determine how much, if any, the cap on damages imposed by Bankruptcy Code Section 502(b)(6) will limit that claim. Further consideration should be given to whether the landlord has any non-rent damages, and if so, whether they are also likely to be limited by the statutory cap. Finally, if the landlord holds a security deposit, it must be subtracted from the capped damages to determine the likely amount of its claim. Although numerous unknown events in the bankruptcy case may still emerge and bring their own complications, this analysis will enable landlords to be in the best position to further their interests.