Components of a Non-residential Real Property Lease Rejection Claim

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Oct 2003

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One of the advantages of filing a chapter 11 bankruptcy is to rid an entity of its
obligations under a lease of non-residential real property. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re PPI Enterprises, 228 B.R. 339 (Bankr. D.
Del. 1998)</a>. Considering the various economic changes in the past
several years, a lease of non-residential real property may have had a higher
market value when executed than it does now. In other words, it may be much
cheaper for the leasee to move across the street and take advantage of current,
lower-lease market conditions than it is currently obligated to pay. The
Bankruptcy Code provides for a cap on lease-rejection damages that a lessor may
claim for non-residential real property. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §502(b)(6)</a>. Therefore, in order to reduce overhead,
rejection of a now-overvalued lease may very well constitute an exercise of the
debtor's best business judgment.

The reduction of rent
may also result in the reduction of other expenses related to that lease. For
example, many leases of non-residential real property require the lessee to
satisfy obligations over and above base rent such as taxes, insurance, utility
charges and common area maintenance (CAM) charges. These charges can aggregate
to a significant amount over the lease's base rent. The rejection of a
lease, therefore, not only reduces the debtor/lessee's base rent, but
ancillary expenses as well.

Despite §502(b)(6)'s lease-rejection damages cap, the Bankruptcy Code does
not specifically address such ancillary expenses or whether such ancillary
expenses are (1) allowable in addition to the rent as calculated by
§502(b)(6), (2) included in and thereby limited by §502(b)(6) or (3)
simply disallowed. Fortunately, numerous courts have provided guidance as to
the components of a lease-rejection claim under §502(b)(6) and how to
treat expenses that are not addressed by §502(b)(6).

<h3>The Lease-rejection Damage Model</h3>

Pursuant to §502(b)(6):
<blockquote>
(b) [T]he court shall...allow such claim in such amount, except to the extent
that—
<blockquote>
(6) if
such claim is the claim of a lessor for damages resulting from the termination
of a lease of real property, such claim exceeds—
<blockquote>
(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—
<blockquote>
(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...
</blockquote>
</blockquote>
</blockquote>
</blockquote>

"The purpose of
[§502 (b)(6)'s] statutory cap is to fairly compensate the landlord
for its loss due to the breach without allowing such large damages as to
deprive other creditors of a reasonable recovery." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Farley, 146 B.R. 739, 744-45 (Bankr. N.D.
Ill. 1992)</a>. Thus, a lessor of a rejected non-residential real
property lease has a lease-rejection damages claim for its "rent
reserved," as calculated and limited by §502(b)(6). Section
502(b)(6) does not, however, define "rent reserved." Nor, does
§502(b)(6) address ancillary expenses.

Courts addressing these issues have developed certain tests, which differ slightly but
are conceptually similar. For example, the Ninth Circuit BAP created a
three-prong test to determine the applicability of §502(b)(6) to the
various components of a lease-rejection damages claim. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
v. McSheridan (In re McSheridan), 184 B.R. 91
(BAP 9th Cir. 1995)</a>. Specifically, the court held that to
constitute "rent reserved," the expense at issue must:

<ol>
<li>(a) be designated as "rent" or "additional rent" in the
lease or (b) be provided as the tenant's/lessee's obligation in the
lease,
</li><li>be related to the value of the property or the lease thereon, and
</li><li>be properly classifiable as rent because it is a fixed, regular or periodic charge.
</li></ol>

See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; 184 B.R. at 99-00</a>; see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Crown Books Corp., 291 B.R. 623, 627 (Bankr.
D. Del. 2003)</a> (holding that "rent reserved" included
CAM charges, taxes and insurance premiums, but did not include brokerage
commissions).

While most courts examining what constitutes "rent reserved" cite McSheridan for authority, certain courts adopted a slightly
different test. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Rose's Stores Inc., 179 B.R. 789, 791
(Bankr. E.D.N.C. 1995)</a>. In Rose's Stores, the court adopted a two-prong test to determine what
constitutes "rent reserved:" (1) The charge must be provided for in
the lease as the tenant's obligation, though it need not be denominated
as rent, and (2) the charge must be related to the value of the property and
the value of the lease thereon. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
Stores, 179 B.R. at 791</a>; citing

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Heck's Inc., 123 B.R. 544, 546 (Bankr.
S.D. W.Va. 1991)</a>.

In applying its test, the Rose's Stores
court held that taxes and insurance were not only the lessee's
obligation, but also related to the value of the property and the lease. See
<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; The court distinguished general maintenance and
utility charges as being generally related to the lessee's use of the
property, rather than the value of the property, thereby excluding such
expenses from the "rent reserved" under §502(b)(6). See
<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;

Courts
applying the McSheridan and Rose's
Stores factors have almost universally held
that "rent reserved" includes real estate taxes, insurance costs
and CAM charges. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Avenue Jewelers Inc. v. Great East Mall Inc. (In re Fifth Avenue Jewelers
Inc.), 203 B.R. 372, 381 (Bankr. W.D. Pa. 1996)</a>;
<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Andover Togs Inc., 231 B.R. 521, 540-41
(Bankr. S.D.N.Y. 1999)</a>. Despite the widespread use of the McSheridan and Rose's Stores factors, various courts differ on what constitutes a
CAM charge. For example, at least one court has specified that CAM charges may
include costs for services such as window-washing, elevator maintenance,
cleaning services and replacements and improvements in the building's infrastructure.

See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Togs, 231 B.R. at 540-41</a>.

Other
courts have focused the "rent reserved" inquiry on whether said
expenses are prospective damages. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Best Products Co. Inc., 229 B.R. 673, 677-79
(Bankr. E.D. Va. 1998)</a>; citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Atlantic Container Corp., 133 B.R. 980,
987-88 (Bankr. N.D. Ill. 1991)</a>. In Best Products, the court held that §502(b)(6) applied only to
those lease damages that occurred after rejection, not those that occurred
prior to rejection. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; Also, all other damages were in addition to
§502(b)(6)'s lease-rejection damages model, not limited thereby. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…;;

see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Farley, 146 B.R. 739, 746 (Bankr. N.D. Ill.
1992)</a> (holding that such prospective damages include future
rent, future CAM charges, future insurance, future taxes and future capital
improvement fees).

Just
as courts have differed on the appropriate factors to apply and the appropriate
items included in CAM charges, courts have also differed on the appropriate
treatment of non-"rent reserved" components of a lessor's
claim, which are not included in §502(b)(6)'s lease-rejection
damages model.

<h3>Damages Outside of §502(b)(6)'s Purview</h3>

Although
§502(b)(6) applies to "rent reserved" only, lessors suffer
other damages as well. For example, many debtors strategically default on their
rent obligations just prior to a bankruptcy filing in order to build available
cash. Pre-petition rent, however, is not "rent reserved" and is not
a prospective damage. Nonetheless, pre-petition rent is specifically addressed
by §502(b), which provides that a lessor's claim includes "any
unpaid rent due under such lease...," which is in addition to the
"rent reserved." Indeed, "a landlord [should be able to]
claim any and all unpaid amounts due it under the lease as of the petition
date." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Togs, 231 B.R. at 544</a>.

In
fact, "§502(b)(6) is not a formula for determining the total
allowable damages incurred by a lessor...[but r]ather...casts a limitation on
the amount a lessor may claim for unpaid rent." See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Avenue Jewelers, 203 B.R. at 376</a>;

citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Steven Windsor Inc., 201 B.R. 133, 135
(Bankr. D. Md. 1996)</a>. "Congress only placed said
limitations on a landlord's claim for post-petition damages, while
ensuring that said landlord recovers on those damages incurred up to the
earlier of lease termination or the petition filing." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Avenue Jewelers, 203 B.R. at 379</a>.

Certain
courts have expanded on this concept and held that non-prospective damages are
allowable in addition to the lease-rejection damages allowable under
§502(b)(6). See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Products, 229 B.R. at 677-79</a>; citing

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Atlantic Container Corp., 133 B.R. 980,
987-88 (Bankr. N.D. Ill. 1991)</a>. Best Products held that §502(b)(6) applied only to those
lease damages that occurred after rejection, not those that occurred prior to
rejection. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; Therefore, pre-petition damages are allowable and
not subject to §502(b)(6)'s cap.

Conversely,
courts more often hold that post-petition, non "rent reserved"
damages are not allowable. For example, liquidated damages, attorneys'
fees caused by a lease rejection, general maintenance fees and utility fees are
not "rent reserved" and accordingly are not only excluded from a
lessor's §502(b)(6) lease rejection damages claim, but are not
allowable at all. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Books, 291 B.R. at 627</a> (where
the court held that brokerage commissions were not properly included in the
§502(b)(6) lease rejection damage calculation, thereby requiring the
reduction of the allowed amount of the lessor's claim); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Enterprises, 228 B.R. at 348-49</a>

(holding that §502(b)(6) represents that maximum amount recoverable as a
result of the termination of the lease, thereby disallowing attorneys'
fees); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Gantos Inc., 181 B.R. 903, 907 (Bankr. W.D.
Mich. 1995)</a> (disallowing the construction allowance portion of a
lessor's claim because it was not rent, as it was not a regular, fixed
payment classifiable as rent).

As
Congress intended to limit the amount of a lessor's rejection damages
claim, the disallowance of ancillary expenses, which accrue because of the
rejection of the lease but do not meet the definition of rent reserved, appears
to be the more logical approach. Nonetheless, contradicting authority exists,
which lessors will certainly cite to increase the amount of their claim.

<h3>Conclusion</h3>

In
calculating a lease-rejection claim, practitioners must do more than calculate
the limitation under §502(b)(6). Careful and perhaps creative thought must
be given to various components of the claim. After all, the differing
components are treated differently, some of which are limited while others are
not. Therefore, the classification of a lease expense determines how such
expense is treated upon rejection. And, as in so many other circumstances, how
such an expense is classified is determined by the operative legal documents.
Stated otherwise, the determination of a lease rejection claim begins with the
formulation of the lease itself.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Wednesday, October 1, 2003 - 12:00

Bankruptcy Rule

2003