When a retail company enters bankruptcy, its most valuable asset routinely includes its interest as a tenant in unexpired commercial-space leases. Subject to certain limitations, the Bankruptcy Code permits the debtor-tenant to continue its operations in the profitable locations and “reject” the unprofitable stores, which are effectively abandoned back to the landlords. The debtor is generally able to sell its lease interest to an assignee, even if the lease prohibits the assignment, and conduct “going out of business” or “store closing” sales from a location, despite lease provisions that otherwise prohibit liquidation activities on site.
Despite these debtor-friendly provisions, the Code also creates rights that are unique to landlords under commercial leases. One such protection is set forth in §365(d)(3), which requires a debtor-tenant to “timely perform all the obligations of the debtor…arising from and after the [petition date] under any unexpired lease of nonresidential real property, until such lease is assumed or rejected.” Courts in the Third Circuit have interpreted this to mean that, if rent becomes due under a lease during the period between the time a debtor files a bankruptcy petition and the date such debtor rejects the lease, the rental obligation must be satisfied with administrative expense priority—even if the rent is attributable to a period of time before bankruptcy or after a rejection. This protection in the Code represents a significant advantage because the Code requires that administrative claims in a chapter 11 proceeding be satisfied in full in order to confirm a plan, while unsecured claims without administrative priority might receive pennies on the dollar, or nothing at all.
In Goody’s Family Clothing Inc. v. Mountaineer Property Co. II LLC (In re Goody’s Family Clothing Inc.), 401 B.R. 656 (D. Del. 2009), the U.S. District Court for the District of Delaware was presented with an appeal of a bankruptcy court order that awarded administrative priority for rent claims involving payment due dates, which fell prior to the debtor’s bankruptcy filing. The court held that §365 is not the exclusive avenue by which landlords can obtain administrative priority for claims based on rental obligations. Rather, pursuant to §503(b)(1) of the Code, the landlords were entitled to an administrative claim for the debtor’s postpetition “occupancy and use” of the leased spaces, irrespective of the lease payment due date.
In Goody’s, the debtors sold apparel in 350 retail locations throughout the United States and the debtors were party to nonresidential real property leases at many of these locations. The leases required that the rent be paid monthly, and in advance. The debtors failed to pay rent under certain leases for June 2008 that were due June 1, and filed their bankruptcy petitions on June 8. Notwithstanding that the debtors had missed these payments, the debtors continued operating from the leased premises, even conducting store-closing sales at the properties. Since the rent was due prior to the petition date, the June 1 rental obligation was not a “postpetition, pre-rejection” lease obligation that could be enforced automatically under §365(d)(3).
Nevertheless, each landlord requested allowance and payment of an administrative expense claim under §503(b)(1). Specifically, they sought allowance and payment of the June 2008 rent, but in a reduced amount to include only those dates that the debtors had occupied “postpetition,” i.e., after June 8. The debtors objected to these requests, arguing that the landlords had to satisfy the requirements of §365 in order to achieve administrative treatment for their claims, as §365(d)(3) was the exclusive remedy. In other words, the debtors maintained that because §365(d)(3) did not provide landlords with an administrative claim, the landlords could not rely on §503(b)(1), the traditional provision of the Code that sets the standard for administrative priority. The court held that §365 is not an exclusive remedy for landlords seeking administrative priority for postpetition rent claims. The court held that “[j]ust because §365(d)(3) now makes postpetition rent automatically payable, does not mean that, when a debtor-tenant’s postpetition occupancy and use of property is outside the ambit of §365(d)(3), landlords may not recover under the traditional administrative expense procedure.”
The court reasoned that the plain language of the statute, as well as the “longstanding and widespread application of §503(b)(1) to the payment of rent,” supported this result. In addition, the court consulted the legislative history of §365(d)(3) and noted that this Code provision was intended to alleviate formalities and evidentiary burdens attendant to a landlord’s proving an administrative claim under §503(b)(1), but that nothing in the history indicated that §365(d)(3) operated to the exclusion of pursuing an administrative claim under §503.
Holding that §503 still provides a mechanism for landlords to obtain administrative priority claims for a debtor’s postpetition occupancy of a leased property, the court turned to whether the landlords had satisfied their burden under the particular facts of Goody’s. To demonstrate entitlement to an administrative priority claim, §503(b)(1) requires: (1) a postpetition transaction; (2) it resulting in an actual expense; and (3) that it was necessary to the preservation of the bankruptcy estate. In Goody’s, the court held that landlords’ claims satisfied all three elements and reasoned that the postpetition transaction requirement was satisfied by the debtors’ decision to use the leased premises postpetition, as well as debtors’ acceptance of the landlords’ continued performance under the leases. The postpetition rent also represented an actual expense because it was a legitimate cost for the leased properties, and because the landlords had effectively demanded payment by filing their administrative claims. Finally, the court determined that the debtors’ postpetition occupancy was “necessary to the preservation of the estate” because they had conducted their ordinary operations from the properties and had permitted store-closing sales to take place postpetition. “When a debtor uses a landlord’s premises for its postpetition business, this will ordinarily satisfy the requirement that the use be ‘necessary.’” (Goody’s, 401 B.R. at 668)
Debtors, especially those involved in retail operations, will often plan chapter 11 proceedings to minimize its ongoing expenses under commercial leases. In some cases, this will mean that the filing will be timed to cut off the “automatic enforcement” of the lease terms under §365(d)(3). However, as explained in Goody’s, a landlord should not abandon all efforts to obtain full payment even if §365(d)(3) is unavailable, and the debtors should not assume that they will escape such liability.