Fools And Bankruptcy And Broken Leases

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What is an herbaceous plant that has jagged leaves covered with stinging hairs? Some may think it is a “nettle.” We’re thinking it is “bankruptcy law.” That’s a reason why we’ve steered away from doing any Ruminating about nettles. Today, we’re shunning the 300 year old advice from Alexander Pope in his An Essay on Criticism when he warned: “Fools rush in where angels fear to tread.” Ruminations is fairly characterized as “criticism” and we have been duly warned.

For some reason, explicable, but slightly off-base, leasing professionals are asked: “What can a landlord recover when its bankrupt tenant rejects its lease?”

Our starting point is the bankruptcy law itself. Its most relevant provision reads thusly:

A claim or interest … is deemed allowed … if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds—

(A) the 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, following the earlier of—

(i) the date of the filing of the petition; and

(ii) the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus

(B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates;

That [heavily edited] text is called the “cap.” After many Congressional iterations, it is the current (and reasonably long-standing) legislative compromise that allows landlords to recover “something” but not receive a windfall. We’ll explain.

Under state law there are two different basic approaches to what a landlord can recover if a lease is prematurely terminated by reason of a tenant default. One approach, rooted in feudal history, is that a landlord is entitled to get paid the rest of what would have been the rent had the lease not been terminated. Basically, add up all of what would have been the remaining rent, perhaps adjust that amount based on the time value of money (think: reduce it to present value), and voilà – you’ve got your answer. The second (and more modern) approach is to calculate the difference between what the landlord would have received under the lease and what the leased space is then (at the time the lease was terminated) worth in the leasing market. This second approach, in effect, calls for a landlord to mitigate its loss by encouraging a landlord to find a replacement tenant. Much more about this approach to a landlord’s damages can be found in an earlier Ruminations posting and can be found by clicking: HERE.

Until 1933, landlords could not recover what would have been the rent after a lease was rejected in bankruptcy. Ouch! The Great Depression inspired a lot of complaints (from landlords) about this “imbalance.” So, the Bankruptcy Act was amended to permit claims for such “injury” or “damages” resulting from a lease rejection. Those damages were limited to one year’s rent. With that law, “Congress intended to strike a balance between compensating the landlord for [its] loss together with a limited sacrifice to protect other creditors and the debtor’s rehabilitation….” Basically, the limitation (and later legislative adjustments to this “cap”) was to recognize that landlords would eventually replace the bankrupt tenant and should not receive damages as if the space would never be re-leased. Currently, landlords can recover “damages resulting from the termination of a lease,” so long as those particular damages are subject to the “cap” we described above.

Another compromise implied by the Bankruptcy Code’s lease rejection damages provision is that, unlike what a landlord would need to do in those states that recognize a landlord’s duty to mitigate its damages, a landlord does not need to prove what the “now” market rent might be or to actually use efforts to find a replacement tenant.

Now, reading the part of the Bankruptcy Code we’ve set forth above might seem like a pretty easy task. Many bankruptcy courts have read those very words, but it turns out that reasonable judges have differed as to how they interpret the same words. Basically, in some parts of the country, courts have read those words to say that a landlord can list all of the various reasons why a bankrupt tenant owes it money, but those courts will tally up the total of all of the legitimate claims and then apply the cap to that “grand total.” Basically, at “one end of the spectrum, some courts have interpreted the provision expansively, as a kind of subject matter cap on all lease-related damages.” An example of this would be that one particular court held, “as a matter of law, the actual damage claim … for termination of a lease, whether for non-payment of rent, taxes, costs, attorney’s fees, or other financial covenants such as [a guaranty], are limited by the damage cap.”

“On the other end of the spectrum, the provision has been interpreted narrowly to cap claims for future rent, but to exclude all other damages, thereby permitting collateral claims to be asserted in full.”

There is a middle approach and it was a United States Court of Appeals decision filed on December 29, 2016 that induced us to raise this topic today. That decision can be seen by clicking: HERE.

Here’s a caution. Bankruptcy law is above our pay grade. That, however, hasn’t stopped us in the past from speaking out. And, today will be little different. As we have always seen it, bankruptcy judges look at the law differently than do other judges. They appear to be less constrained by the words of the Bankruptcy Code and more guided by a sense of what outcome would be equitable. We know that what we’ve just written may not make sense and doesn’t give any actionable guidance, but it helps us get comfortable with court decisions that seem to be based on a twisted understanding of the Code. How else could a court decide that every kind of a claim a landlord may have is subject to the “cap.”

So, here’s what encouraged us about the court decision we saw. Here’s the test it endorsed for leases that are rejected in bankruptcy:

A 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?

And, the court adapted that test for leases that were terminated before the bankruptcy petition was filed. Here is that test:

Assuming that all other conditions remain constant, would the landlord have the same claim against the tenant had the lease not been terminated?

So, what is the practical application of that test? Well, this court was faced with a lease that had been terminated and where the landlord and tenant fought over monies in a subsequent arbitration proceeding. The arbitrator awarded about $1.3 million to the landlord and added another $200,000 in attorney’s fees to the tenant’s bill. In bankruptcy court, the landlord argued that only the rents were subject to the “cap,” and that the attorney’s fee award was entirely exempt from the “cap.” The bankruptcy court agreed with the landlord and, upon appeal by the tenant to the United States District Court, that court upheld the landlord’s entire claim for attorney’s fees.

This is how the appellate court saw it. The dispute involved both past-due rent and future rent. The tenant brought a variety of counterclaims, alleging torts and breaches of contract committed by the landlord. Even though the tenant did not prevail on those claims, they were litigated, and the fees and costs reflected that litigation. The tenant’s obligation to reimburse its landlord for fees and costs arose from covenants in the lease. The Bankruptcy Code’s “cap” in not supposed to apply to damages resulting from every breach of contract—only those claims for “damages resulting from the termination of a lease.” Fees attributable to litigating a landlord’s claims for future rent are capped, because such claims would not arise were the leases not terminated. But, here, the arbitration award also included damages for past rent, which a landlord could claim independent of termination. So, the fees attributable to that portion of the litigation would not be subject to the “cap.” The parties also litigated the tenant’s numerous counterclaims. To the extent that the counterclaims concerned ordinary alleged breaches, independent of a lease termination, the associated fees and costs would not be capped, either.

Therefore, the appellate court sent the case back to the district court, telling it to categorize all claims as either directly resulting from termination of the leases, or not. The former would be capped; the latter would not. Then, the lower court would need to apportion the associated fees and costs accordingly.

Now, here’s a caution. The approach taken by this particular appellate court is not yet the approach that all appellate courts are taking, though it looks as if that’s where the laggard courts are moving. Our uninformed view is that the Bankruptcy Code, though federal law, seems to have many local variations as to how it is interpreted and implemented. For that reason alone (as if there weren’t many other good reasons), if any reader really needs to know how bankruptcy law will deal with a particular situation, ask a competent bankruptcy practitioner. Don’t rely on Ruminations for any more than Ruminating. Our object today was to introduce some readers to the “cap” and to explain that figuring out what claims fall under the “cap” is “complicated” but seems to be getting less so.

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