A Sign of the Times: Retail Store Debtors Stubbornly Refuse to Pay Stub Rent

Examples of how the current economic meltdown impacts the chapter 11 landscape are many. The unavailability of debtor-in-possession financing in most cases makes maintaining cash levels that much more important during the reorganization process. The continuous decline of asset values across the board means that debtors, unsecured creditors' committees and, in some instances, subordinated secured lenders are leaving no stone unturned in the search of untapped value. Thus, it should not be surprising that retail store debtors, sometimes at the behest of their nonlandlord creditors, are fighting to keep cash in their coffers that would otherwise have been used to pay "stub rent" to landlords.

The Bankruptcy Code requires the debtor "to timely perform all the obligations of the debtor...arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected." 11 U.S.C. §365(d)(3). "Stub rent" is a commonly-used shorthand for rentals payable pursuant to an unexpired lease of nonresidential real property for the period from the bankruptcy petition date/order for relief until the end of that month.[1] Is stub rent under a commercial lease an "obligation" of the debtor that "arises from and after" the filing of a voluntary bankruptcy petition? Before the recent deterioration of the global economy and attendant collapse of retail sales, the answer to the question depended on little more than the jurisdiction in which the bankruptcy case was filed.

Pre-meltdown Stub Rent Landscape
Some bankruptcy courts find the language of §365(d)(3) to be ambiguous and therefore look to Congress' intent in enacting the statute. After doing so, these courts will typically conclude that prorating the filing month's rent between prepetition and postpetition days best implements the underlying purpose of §365(d)(3); it is generally accepted that §365(d)(3) was enacted "to nullify the requirement of §503(b) that a creditor prove benefit to the estate before it can obtain administrative expense status for a postpetition rent claim." In re Stone Barn Manhattan LLC, 398 B.R. 359 (Bankr. S.D.N.Y. 2008). Proration courts generally require debtors to timely pay the postpetition prorated portion of the filing month's rent. Thus, the practice that developed in these proration courts was for debtors to pay landlords the postpetition prorated portion of the filing month's rent promptly.

Other courts, including at least three circuit courts, have criticized the legal underpinnings of the "proration theory" in similar contexts. These courts, including the Third Circuit Court of Appeals- whose holdings bind the most popular corporate restructuring venue in the land, the District of Delaware- generally subscribe to what is referred to as the "billing date" theory. Billing date courts generally determine that §365(d)(3) is clear and unambiguous. They hold that the statute clearly requires debtors to pay each lease obligation when it first "arises." Because a typical commercial lease requires the debtor to pay monthly rent in full on the first of the month, they reason that the entire monthly rent obligation arose before, not "from and after," the petition date. Thus, in billing date jurisdictions, stub rent is not payable under §365(d)(3). Nevertheless, the law and the practice in billing-date jurisdictions was to grant landlords administrative rent claims for stub rent under §503(b), that were payable on or before the effective date of a confirmed plan. Before the recent economic downturn, the main practical difference between a court that applied proration theory and one that followed billing date precedent in the context of stub rent was the timing of the debtor's stub rent payment to the landlord.

Post-meltdown Stub Rent Landscape
Retail debtors' necessity to now preserve cash has led debtors and nonlandlord creditors to try to change the stub rent question from "when" to "if."  In the Goody's I case, the debtors appealed a Delaware bankruptcy court's allowance of stub rent as administrative claims under §503(b). In re Goody's Family Clothing Inc., 392 B.R. 604 (Bankr. D. Del. 2008). Goody's, which emerged from chapter 11 in October 2008 only to file for chapter 11 relief again in January 2009, is still prosecuting its stub rent appeal from the first bankruptcy case. Goody's is asking the appellate court to reinterpret Third Circuit precedent and practice by having postpetition stub rent deemed to be a prepetition general unsecured debt.

To support this position, Goody's relies heavy on a recent bankruptcy court decision from Ohio holding that stub rent does not satisfy the test for allowance of an administrative claim. In re Johnson Rubber Co., 391 B.R. 779, 782 (Bankr. N.D. Ohio 2008) ("[H]ere was no postpetition transaction or inducement from the debtor-in-possession that would satisfy the two-prong test in this Circuit with respect to the stub rent."). It also attempts to distinguish Zagata Fabricators Inc. v. Superior Air Products, 893 F.2d 624, 627 (3d Cir. 1990) (although the lease in question was expired, because the debtor used and occupied the premises after the petition date, the Third Circuit stated, "When the creditor involved is a landlord seeking rent for the use and occupancy of real estate, the Bankruptcy Code provides two basic avenues of relief. First, the landlord may seek payment as a first priority creditor. There is no question, of course, that the payment of rent for the use and occupancy of real estate ordinarily counts as an "actual, necessary' cost to which a landlord, as a creditor, is entitled").[2]  Now many other retail debtors in Delaware are following Goody's lead and are refusing to agree to allow stub rent administrative claims unless the landlord agrees to some form of "Goody's appeal" discount.

Similarly, in the Southern District of New York, where the majority of reported decisions and, to a greater extent, the practice favors application of the proration theory,[3] debtors are also trying to fight against jurisdictional stub rent precedent. After Judge Allan L. Gropper stayed his memorandum decision applying proration to stub rent in Stone Barn,[4] Bally Total Fitness filed its second recent chapter 11 and asked the court to establish a several-month-long briefing schedule on the issue of stub rent and to consider setting the stub rent issue aside pending the outcome of the Stone Barn appeal. Though now it is almost certain that there will not be a Stone Barn stub rent appeal and notwithstanding the absence of any hint of administrative insolvency, the Bally court has yet to adjudicate the landlords' request for timely payment of stub rent.

Conclusion
Regardless of whether the answer to the stub rent question is billing date or proration, the worst-case scenario should be administrative claim allowance.[5] To minimize uncertainty and legal fees for all parties in interest, bankruptcy courts should apply one stub rent theory or the other and then adjudicate any remaining issue of timing of the stub rent payment expeditiously. If a bankruptcy court chooses the billing date, then the landlord possesses an administrative claim under §503(b)(1) in the amount of the stub rent. Bankruptcy courts routinely approve payments to all types of administrative claimants that are, at best, on par with landlords' stub rent claims (e.g., professional fees) while stub rent claims go unpaid. Even lower-ranking prepetition priority claims (e.g., wages and taxes) and general unsecured prepetition claims (e.g., claims of "critical" vendors) often get paid before postpetition administrative-level stub rent claims.

This blurring of the Bankruptcy Code's priority of distribution scheme is encouraging, and, in some instances, enabling debtors to negotiate a discount off their postpetition stub rent obligations. The current "uncertainty" regarding stub rent in proration and billing date jurisdictions alike is benefiting other creditors at landlords' expense.