For businesses of all sizes, the cost associated with its office or retail space is a significant expense. This reality may be further accentuated for small businesses that are tied to long-term lease obligations, making the owner one of the largest and / or most influential creditors in the business. Over the past 16 months, the COVID-19 pandemic has challenged businesses and homeowners to deal with unprecedented economic pressures. Many businesses have been forced to close their doors, unable to meet rents and other outstanding obligations, while others have managed to get by and, when it comes to rent obligations, have negotiated changes to the rent. lease to provide temporary relief. But now that stimulus funds are no longer so readily available, businesses may face increasing pressure to pay deferred rent obligations while staying current on existing monthly rent and all other business obligations. If this burden is too heavy, companies may be forced to consider bankruptcy in order to restructure their debt and / or refuse heavy leases.
To properly assess a bankruptcy filing (or the threat of a tenant filing for bankruptcy), the business tenant and landlord must understand how the Bankruptcy Code will deal with a landlord’s claim resulting from the bankruptcy. termination of a real estate lease. Without such an understanding, any pre-bankruptcy negotiation might not be productive.
Under Article 502 (b) (6) of the Bankruptcy Code, claims for damages resulting from the termination of a lease (i.e. claims for refusal of a lease) cannot exceed the amount of “rent reserved by this lease, without acceleration, for the greater of one year, or 15 percent, not exceeding three years, of the remaining term of such lease ….” It is not not surprisingly, courts have struggled to apply this formula, relying largely on two approaches – the rent and time approaches.
Rent and time approaches
Courts that have adopted the rent approach allow the landlord to calculate the total amount of rent owed for the remainder of the lease term and multiply that amount by 15%. This results in a claim for damages capped at a maximum of 15% of the total rent due for the remainder of the lease term. While not universally applied, some courts have held that if the 15 percent amount exceeds the total amount of rent owed under the lease for the next three years, the three-year amount would be the claim capped.
In the alternative approach to time, courts view the 15 percent marker as a measure of the time remaining under the lease term. In other words, the claim for damages would be capped at the amount of rent due for the first 15 percent of the time remaining under the lease, this period not to exceed three years.
In practice, the mechanism for calculating the lessor’s capped claim can be summarized as follows:
- Establish the ‘start date’, which is the earliest of (i) the date the bankruptcy case began, or (ii) the date the premises were taken over by the owner or transferred to the tenant ( hereinafter, the “Ceiling start date”).
- Determine the projected amount of all rental charges that will be due for the year beginning on the start date of the cap.
- Using the rent approach, determine any projected rent charges that will expire for the remaining term of the lease and multiply them by 15 percent. Next, determine all of the expected rents that will be due for the three-year period starting on the cap start date. The higher amount (the 15% calculation or the three-year calculation) will be the determining amount of the cap.
- Using the temporal approach, determine the number of months remaining over the lease term and multiply by 15 percent. The number of months is limited to 36 months (“not to exceed three years”). Next, determine the amount of rent for those months.
- The one of the two “ceilings” (the one-year ceiling against the 15% / three-year ceiling), calculated as indicated above, gives rise to a higher claim is the ceiling which will be used in the calculation of the claim. capped rejection damage claim.
Not all damage is subject to the ceiling
However, although great attention is paid to the calculation of the capped claim, a landlord’s claim may involve more than damages resulting from the termination of the lease and subject to the limit of Article 502 (b) (6). . Obviously, a landlord is entitled to an unsecured claim for all amounts due and owed under the lease until the earliest of its termination or the filing of the bankruptcy petition occurs. This component of a landlord’s claim is not subject to the “cap”.
More controversially, the courts have been divided on whether or in what cases the less obvious claims result from the termination of the lease and, therefore, are limited by the cap. For example, would a landlord’s claim for maintenance and repair costs associated with his rejected real estate lease be subject to the cap? What about the costs associated with removing a mechanic’s lien?
A landmark bankruptcy case provided guidance for the interpretation and application of the Section 502 (b) (6) limit. 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 held that the tort actions against the debtor tenant for collateral damages (v. Bankruptcy Code. In so ruling, the Ninth Circuit supported the claims courts that have ruled that the cap is inapplicable to claims for a tenant’s breach of repair and maintenance obligations and questioned the viability of the series of cases that said otherwise.
Since El Toro In this case, many courts moved away from the precedent that the Bankruptcy Code creates a broad cap on damages for dismissal in favor of what is now called the “El Toro” test. More recently, the Ninth Circuit ruled again that the Bankruptcy Code does not create a cap on the damages a landlord can receive for each breach of a lease and rejected the “all or nothing” approach, adopting the “El Toro “to determine when the rejection of damages should be capped in bankruptcy. See In re Kupfer, 63 Banker. Ct. Dec. 136 (9th Cir. 2016). The “El Toro” test is considered a “simple” test which asks the following question: 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 to reject it?
The courts of the Third Circuit followed the example of the Ninth Circuit and also adopted the El Toro test. As of yet, Circuit 1 has yet to pass the El Toro test to determine which owner’s claims are subject to the Section 502 (b) (6) cap. As the challenges of the COVID-19 pandemic continue to unfold, the burden of rental obligations could come to the fore. When tenants are considering options, landlords should understand how claims can be handled if the tenant’s options include a potential bankruptcy filing and rejection of a lease. With this understanding, the landlord can consider lease modification requests or assess the risks of filing for bankruptcy.
This article was originally published in the Bar Newsand can be found here, July 21, 2021.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.