Chris Candon and Jacki Fisher | July 21, 2021
For businesses of all sizes, the cost associated with its office or retail space is a significant expense. This reality may be even more accentuated for small businesses that are tied to long-term lease obligations, resulting in the landlord being one of the largest and/or most influential creditors of the business. For the past 16 months, the COVID-19 pandemic has challenged businesses and landlords in navigating never-before experienced economic pressures. Many businesses were forced to shut their doors, unable to meet ongoing rent and other obligations, while others managed to get by and, with respect to rent obligations, negotiated lease modifications to provide some temporary relief. But now as stimulus funds are no longer as readily available, businesses may be faced with mounting pressure to pay postponed rent obligations while staying current on existing monthly rent and all other business obligations. If this burden is too much, businesses may be forced to consider bankruptcy in order to restructure debt and/or reject burdensome leases.
To properly evaluate a bankruptcy filing (or the threat of a tenant bankruptcy filing), both the business tenant and landlord need to understand how the Bankruptcy Code will treat a landlord’s claim resulting from the termination of a lease of real property. Absent such understanding, any pre-bankruptcy negotiations may not be productive.
Under Section 502(b)(6) of the Bankruptcy Code, claims for damages resulting from the termination of a lease (i.e., lease rejection claims) may not exceed the amount of “rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease….” Not surprisingly, the courts have struggled in applying this formula, largely settling on two approaches – the rent and time approaches.
The Rent and Time Approaches
Courts that have adopted the rent approach permit the landlord to compute the total amount of rent due for the remainder of the lease term and multiply that amount by 15 percent. This results in a capped claim for damages at a maximum of 15 percent of the total rent due for the remainder of the lease term. Although not universally applied, some courts hold that if the 15 percent amount exceeds the total amount of rent due under the lease for the next three years, the three-year amount would be the capped claim.
In the alternative time approach, courts view the 15 percent marker as a measure of time remaining under the lease term. In other words, the damages claim would be capped at the amount of rent due for the first 15 percent of the time remaining under the lease, such time period not to exceed three years.
In practical application, the mechanism for calculating the landlord’s capped claim for damages can be summarized as follows:
- Establish the “start date,” which is the earlier of (i) the date the bankruptcy case commenced, or (ii) the date on which the premises were repossessed by the landlord or surrendered by the tenant (herein, the “Cap Commencement Date”).
- Determine the projected amount of all rent charges that will come due for the year commencing on the Cap Commencement Date.
- Using the rent approach, determine all projected rent charges that will come due for the remaining term of the lease, and multiply by 15 percent. Then, determine all projected rent charges that will come due for the three-year period commencing on the Cap Commencement Date. Whichever amount (the 15 percent computation or the three-year computation) is greater will be the governing amount of the cap.
- Using the time approach, determine the number of months remaining on the term of the lease, and multiply by 15 percent. The number of months is limited to 36 months (“not to exceed three years”). Then, determine the amount of rent for those months.
- Whichever of the two “caps” (the oneyear cap vs. the 15 percent/three-year cap), calculated as provided above, results in a greater claim is the cap that will be utilized in computing the capped rejection damage claim.
Not All Damages Are Subject to the Cap
However, while much attention is given to the calculation of the capped claim, a landlord’s claim may involve more than just damages resulting from the termination of the lease and subject to the Section 502(b)(6) cap. Clearly, a landlord is entitled to an unsecured claim for all amounts due and owing under the lease through the earlier to occur of its termination or the filing of the bankruptcy petition. This component of a landlord’s claim is not subject to the “cap.”
More controversially, courts have been divided on the issue of whether or in what instances less obvious claims result from the termination of the lease and, thus, are limited by the cap. For example, would a landlord’s claim for maintenance and repair costs associated with its rejected property lease be subject to the cap? What about the costs associated with the removal of a mechanic’s lien?
A landmark bankruptcy case provided guidance to the interpretation and application of the Section 502(b)(6) cap. In Saddleback Valley Community Church v. El Toro Materials Co. (In re El Toro Materials Co, Inc.), 504 F.3d 978 (9th Cir. 2007), the Ninth Circuit ruled that tort claims against the debtor tenant for collateral damages (i.e. damages unrelated to the loss of rental income) to the property were not subject to the cap under the Bankruptcy Code. In so ruling, the Ninth Circuit buttressed the courts that held the cap to be inapplicable to claims for a tenant’s breach of repair and maintenance obligations and cast doubt on the viability of the line of cases that held otherwise.
Since the El Toro case, many courts moved away from the once-held precedent that the Bankruptcy Code creates a broad cap on rejection damages in favor of what is now referred to as the “El Toro” test. More recently, the Ninth Circuit ruled again that the Bankruptcy Code does not create a cap on damages a landlord can receive for every breach of lease and rejected the “all or nothing approach,” adopting the “El Toro” test for determining when rejection damages should be capped in bankruptcy cases. See In re Kupfer, 63 Banker. Ct. Dec. 136 (9th Cir. 2016). The “El Toro” test is considered a “simple” test that asks: 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?
Courts in the Third Circuit have followed the lead of the Ninth Circuit and similarly adopted the El Toro test. For now, the First Circuit has yet to adopt the El Toro test for determining what claims of a landlord are subject to the Section 502(b)(6) cap. As the challenges of the COVID-19 pandemic continue to unfold, the burden of lease obligations may rise to the forefront. As tenants consider options, landlords must understand how claims may be treated if the tenant’s possibilities include a potential bankruptcy filing and rejection of a lease. With that understanding, the landlord can consider lease modification requests or evaluate the risks of a bankruptcy filing.
This article was originally published in the Bar News and can be found here.