Memo to Tenants If Youre Going to Trash Leased Estate Property Be Sure to Reject the Lease

In <i>In re TreeSource Industries Inc.,</i> ___
F.3d ___ (9th Cir. Case No. 03-35018, April 12, 2004), the Ninth Circuit
Court of Appeals decided an interesting decision that saved a chapter
11 estate from a very large potential administrative claim. TreeSource (or,
more precisely, a subsidiary of TreeSource) leased a large parcel of
nonresidential real property. That lease required TreeSource to remove all
fixtures and equipment on the premises upon termination or expiration of
the lease. This was important because TreeSource wanted to erect certain
buildings on the leased site. It made clear in the lease these additions
did not belong to the lessor at the end of the lease.

</p><p>Subsequent to the execution of the lease, TreeSource
filed for chapter 11. Prior to the expiration of its deadline to assume or
reject the lease, it removed the building it had constructed but did not
remove the concrete slab that it had laid down. In addition, it
didn't restore the premises to their pre-lease condition as required
by the lease. Subsequently, the debtor rejected the lease by order of the
bankruptcy court and a few months later confirmed a reorganization plan. So
far, so good.

</p><p>The lessor was not amused and filed an administrative
claim by the bar date set in the confirmed plan for nearly $300,000 based
on the debtor's failure to remove the concrete building slab and
restore the premises, and otherwise failing to repair and maintain the
leased premises under the terms of the lease. The reorganized debtor
objected to the administrative claim.

</p><p>The bankruptcy court denied the lessor's
administrative claim request on the basis that the debtor's
obligations to restore the leased premises in the lease arose only upon
"termination or expiration" of the lease. The bankruptcy court
reasoned that termination or expiration occurred upon rejection of the
lease. As such, all damages for leaving the premises a pigsty were
rejection claims, not administrative expenses. The district court affirmed,
and the matter went to the Ninth Circuit Court of Appeals.

</p><blockquote><blockquote>
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<big><i><center>
When a lease is rejected, the Bankruptcy Code provides that the breach of the lease is deemed to occur immediately before the petition date, thereby creating the fiction that rejection damages are general unsecured claims.
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</blockquote></blockquote>

<p>The lessor argued that a lessee of commercial
property is required to timely perform all of its obligations that arise
between the start of the bankruptcy case and the assumption or rejection of
the lease. It argued that since every claim under a nonresidential real
property lease that arises during the post-petition, pre-rejection period
is an administrative expense, and the debtor's removal obligation
arose during that time period, the lessor was entitled to an administrative
expense claim. The Ninth Circuit agreed that the debtor must perform on a
timely basis its obligations under a nonresidential lease post-petition and
until rejection.<small><a href="#1" name="1a">1</a></small> In fact, the Ninth Circuit held that prompt
performance of lease obligations prior to rejection was a
"bright-line rule" and encompassed "all obligations
contained in a bargained-for agreement." The Ninth Circuit went on to
state that, of course, if a lease is ultimately assumed, all pre- and
post-petition defaults are required to be cured under Bankruptcy Code
§365(b)(1).

</p><p>The Ninth Circuit didn't stop there. When a
lease is rejected, explained the court, the Code provides that the breach
of the lease is deemed to occur immediately before the petition date,
thereby creating the fiction that rejection damages are general unsecured
claims. <i>See</i> Code
§365(g)(1).

</p><p>The Ninth Circuit then reasoned that resolution of
this issue hinged on whether the lessor's claim that the debtor
breached the lease by not restoring the premises as required under the
lease arose pre-rejection (in which case it would be given an
administrative expense priority) or upon rejection (in which case it would
be treated as a general unsecured claim).

</p><p>This is where things took a turn for the worse for
the lessor. The Ninth Circuit reasoned that under the terms of the lease,
the obligations to remove fixtures and the like arose "upon
termination or expiration of the lease." The termination or
expiration of the lease occurred when the debtor rejected the lease. As a
result, the debtor's obligation to remove fixtures and the concrete
slab did not arise post-petition/pre-rejection. Instead, the lessor's
claim for breach of this provision arose upon rejection, in which case it
was only entitled to be treated as a pre-petition general unsecured claim
for rejection damages under Code §365(g)(1).

</p><p>The Ninth Circuit distinguished the obligation to
remove the concrete slab from, for example, tax or rent obligations for
which the relevant time to determine whether the obligation is pre- or
post-petition is when the obligations accrue and not necessarily when
performance must take place. In this case, the obligation to remove the
concrete slab did not accrue over time; rather, it was a one-time
obligation that became ripe only upon the termination or expiration of the
lease.

</p><p>The lessor argued that the obligation to maintain
the leased premises partially arose during the post-petition pre-rejection
period, and as such certainly any ongoing maintenance obligations should be
given administrative expense perhaps on a <i>pro
rata</i> basis. The debtor's removal of
the building occurred post-petition but pre-rejection. The Ninth Circuit
dispensed with this argument by saying that ultimately the obligation to
maintain was breached only when the lessee rejected the lease, because the
maintenance obligations really became choate only if the property was not
returned in the same condition as it was at the commencement of the lease.
Accordingly, it's okay for the lessee to be a complete slob during
the entire tenancy, as long as the lessee cleans up after itself before
returning the property.

</p><p>So the message is clear. If you're going to
trash leased property, be sure to reject the lease. "Do it and
run" would seem to be the motto of the day.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} <i>See In re Cukierman,</i> 265 F.3d 846, 849 (9th Cir. 2001). <a href="#1a">Return to article</a>