El Toro: A Red Flag on Lease Rejection Damages

The U.S. Court of Appeals for the Ninth Circuit recently issued the first circuit-level decision regarding what sort of damages are subject to the cap imposed by Bankruptcy Code '502(b)(6) on landlords' claims arising from a debtor's rejection of a nonresidential real property lease.

The decision in Saddleback Valley Community Church v. El Toro Materials Co., No. 05-56154, 2007 U.S. App. LEXIS 22991 (9th Cir. Oct. 1, 2007), unsettled existing law, holding that damages corresponding to 'tort-like' conduct by the debtor-tenant related to the lease are not capped by '502(b)(6). If the result is followed by other courts, debtors may face a new uncertainty as they decide how to deal with their leases in bankruptcy.

Limitation on Lease Rejection Damages

Bankruptcy Code '365 provides debtors with the right to assume or reject executory contracts and unexpired leases. Pursuant to '365(g), a debtor's rejection of a nonresidential real property lease effects a breach of the lease as of the instant before the debtor filed bankruptcy.

Section 502(b)(6) caps a landlord's claim arising from the rejection of a lease to the amount of the rent reserved by such lease, without acceleration, for the greater of: a) one year, or b) 15%, not to exceed three years, of the remaining term of the lease, following the earlier of: 1) the filing of the bankruptcy petition and 2) the date on which the landlord repossessed, or the debtor surrendered, the leased property. This cap has its roots in the Bankruptcy Act of 1898 and was designed to promote equality among unsecured creditors by preventing landlords with long-term leases from dominating the unsecured creditor class.

Bankruptcy courts, district courts, and bankruptcy appellate panels have wrestled with numerous aspects of '502(b)(6). One particular area of debate has been whether the cap applies to all damages flowing from the landlord-tenant relationship or only those damages tied to the payment of rent and other routine lease obligations.

In 1995, the Bankruptcy Appellate Panel ('BAP') for the Ninth Circuit, in a case called In re McSheridan, 184 B.R. 91 (B.A.P. 9th Cir. 1995), held that '502(b)(6) operates to limit all claims arising from a rejected lease. (In addition, McSheridan crafted a test for determining which obligations under a lease constitute part of the 'rent reserved,' which is one of the key elements in calculating the cap. The validity of three-part 'rent-reserved' test was not before the El Toro court.) In McSheridan, the guarantors of a lease filed a claim for $74,000, which included damages related to repair and maintenance. The debtors contended that all of the guarantors' damages, not just the amounts corresponding to rent, should be limited by '502(b)(6). The McSheridan court analyzed the legislative history of '502(b)(6) and interpreted it against the backdrop of several Bankruptcy Code provisions governing lease rejection and the allowance of claims. McSheridan premised its conclusion about the scope of the cap on Bankruptcy Code '502(g), which provides that rejection affects the breach of every provision of a contract or lease. The BAP held that because rejection results in a comprehensive breach of a lease, '502(b)(6) limits all damages arising from a rejected lease.

McSheridan has been widely followed by other courts, including, for example, the U.S. Bankruptcy Court for the District of Delaware as recently as May 2007 in In re Foamex International, Inc., 368 B.R. 383 (Bankr. D. Del. 2007). The Foamex court applied '502(b)(6) to all portions of the landlord's claim of $793,872, reducing it to $24,472. Foamex sided with McSheridan on the basis of McSheridan's thorough analysis of '502(b)(6). The court was also persuaded by First Bank Nat'l Assoc. v. FDIC, 79 F.3d 362 (3d Cir. 1996), in which the U.S. Court of Appeals for the Third Circuit upheld a lease termination damages cap under the Financial Institutions Reform Recovery and Enforcement Act of 1989 ('FIRREA'). The Third Circuit approved of McSheridan's analysis of the scope of '502(b)(6), which the court noted was Congress' model for the analogous provision under FIRREA at issue in First Bank.

In addition to being the only court of appeals decision to give an opinion directly on the scope of '502(b)(6), El Toro overrules McSheridan, holding that 'tort claims other than those based on rent' are not subject to the limitation imposed by '502(b)(6).

The El Toro Decision

El Toro Materials Co. ('El Toro') was in the business of processing and selling sand and gravel in Orange County, CA. El Toro conducted its operations from a parcel of land it leased for $28,000 per month from Saddleback Valley Community Church ('the church').

The lease permitted El Toro to conduct mining operations and store debris on the land, but also required El Toro to re-grade and rehabilitate the property before vacating. The church sought to terminate the lease and demanded that El Toro, in accordance with the lease's repair and maintenance provision, remove 650,000 cubic yards of saturated clay, which the church characterized as 'goo.'

El Toro filed a Chapter 11 bankruptcy petition in response to the
liability imposed by the church's demand. After El Toro rejected the lease, the church filed a proof of claim for $23 million. El Toro objected to the claim and commenced an adversary proceeding, alleging that the church breached the lease and interfered with El Toro's operations. The church asserted counterclaims for breach of the lease, waste, nuisance, and trespass. El Toro argued that '502(b)(6) operated to cap the church's damages. Under '502(b)(6), the church's claim would be limited to approximately $336,000, compared with the $23 million asserted by the church.

The bankruptcy court held that the '502(b)(6) capped all damages stemming from El Toro's nonperformance of the lease, but not damages from tortious or illegal activity, such as nuisance and waste. Ch. 11 Case No. SA 02-18913 RA, Adv. No. SA 03-1486 (Bankr. C.D. Cal. March 12, 2004) (docket no. 42).

The parties appealed the bankruptcy court's decision to the Ninth Circuit BAP. The BAP held that McSheridan controlled. (BAP No. CC-04-1287-PaBK (B.A.P. 9th Cir. July 8, 2005) available at www.ce9.uscourts.gov/ bap.) The BAP found significant the substantial factual overlap between the church's $23 million claim and its tort claims. The BAP reasoned that any uncapped recovery based on the tort label applied by the church to El Toro's conduct would enable it to 'succeed in a classic end-run around the will of Congress.' The BAP noted that this result appeared at odds with the rule against recovering in tort for conduct otherwise falling within the scope of a contract except if such conduct violates a duty independent of the contract. E.g., Clark-Fitzgerald, Inc. v. Long Island R.R. Co., 70 N.Y.2d 382, 389 (1987). However, the BAP declined to base its decision on this rule because the bankruptcy court failed to address it.

The parties then appealed the BAP decision to the Ninth Circuit. The court of appeals reversed the BAP, expressly overruling McSheridan 'to the extent that [it] holds '502(b)(6) to be a limit on tort claims other than those based on rent, rent-like payments or other damages directly arising from a tenant's failure to complete a lease term.' 2007 U.S. App. LEXIS 22991 at *9. The Ninth Circuit cited numerous grounds for its decision. First, the court reasoned that non-rent or 'collateral' damages should not be capped because such damages correlate weakly to the amount of rent remaining on a lease, which is the measure by which the '502(b)(6) cap is computed. According to the court, a total cap calculated from rent remaining would place landlords who suffered non-routine damage to their property in a worse position than other creditors.

Second, the court viewed the words 'resulting from the termination of the lease' in '502(b)(6) to limit the cap to only those damages proximately caused by the act of rejection, as opposed to damages caused by the conduct that actually violated a lease covenant. Following this line of reasoning, the court contrasted El Toro's breach of its obligation to pay rent, which was triggered directly by its act of rejecting the lease, with El Toro's breach of the repair covenant, which was caused by its failure to remove the 'goo' from the church's land, an omission independent of El Toro's decision to reject the lease. The court declined to link the 'goo'-related damage to rejection on the theory that such damage would have persisted had the debtor assumed the lease.

Third, the Ninth Circuit was concerned that the cap would present a classic moral hazard by tempting debtors with lease liabilities already exceeding the cap to damage the leased property with impunity, knowing that they would incur no additional liability.

And fourth, the court noted that the cap does not aid in preserving the operating value of a business because it may motivate debtors to shed otherwise favorable leases and reap the benefit of limited claim exposure instead of keeping a lease and enhancing the value of a business.

Analysis

The Ninth Circuit in El Toro appeared to reach its conclusion based on policy concerns it had regarding the cap. However, El Toro's bifurcation of potential lease rejection damages into 'rent-like' damages and 'collateral,' 'tort-like' damages injects an element of uncertainty into a debtor's lease assumption/rejection decision and may adversely affect the feasibility of a debtor's plan of reorganization. Both debtors and creditors may find it difficult to determine accurately which damages are subject to the cap. Catastrophically expensive consequences could result if a court disagrees with a debtor's characterization of certain damages as being 'rent-like' and thus capped, and re-classifies the damages as 'collateral' to a lease and thus not subject to the cap.

El Toro also blunts the potency of lease rejection as a vital reorganizational tool. A cautious debtor, fearing an uncapped collateral damage claim, may be inclined to dedicate valuable estate resources to avoid violating a lease covenant that raises the specter of potentially tortious conduct, effectively incurring cure costs to perform its cleanup obligation that would otherwise be payable only if it assumed the lease.

Another notable aspect of the Ninth Circuit's decision is its characterization of the church's claims as sounding in tort rather than arising from the breach of the cleanup provision of the lease. Indeed, its holding overruling McSheridan is limited specifically to excluding tort claims from the '502(b)(6) cap. However, the court did not address how a landlord could recover damages for repair and maintenance under a tort theory in light of the common-law rule prohibiting tort recovery for conduct otherwise governed by a contract that does not breach an independent duty. The common-law rule suggests that a landlord could only recover damages provided under the four corners of a lease. Thus, a court might hold that El Toro does not apply because the claim under the lease cannot sound in tort and must, therefore, be subject to the limitation of '502(b)(6).

Conclusion

The El Toro decision supplies landlords with greater incentive to litigate claims relating to rejected leases of nonresidential real property aggressively by asserting that their damages are not subject to the Bankruptcy Code's limitation because they are more akin to tort damages than rent. Later courts may limit the decision, however, by holding that a landlord is precluded from recovering damages in tort for conduct governed by a lease and that the limitation of '502(b)(6) operates to cap these contract damages.

John J. Rapisardi is a partner in the financial restructuring department of Cadwalader, Wickersham & Taft LLP and is an adjunct professor of law at Pace University School of Law. Christopher R. Mirick, special counsel of the firm, and Michael J. Cohen, associate of the firm, assisted in the preparation of this article. This article originally appeared in the New York Law Journal, a sister publication of this newsletter.

The U.S. Court of Appeals for the Ninth Circuit recently issued the first circuit-level decision regarding what sort of damages are subject to the cap imposed by Bankruptcy Code '502(b)(6) on landlords' claims arising from a debtor's rejection of a nonresidential real property lease.

The decision in Saddleback Valley Community Church v. El Toro Materials Co., No. 05-56154, 2007 U.S. App. LEXIS 22991 (9th Cir. Oct. 1, 2007), unsettled existing law, holding that damages corresponding to 'tort-like' conduct by the debtor-tenant related to the lease are not capped by '502(b)(6). If the result is followed by other courts, debtors may face a new uncertainty as they decide how to deal with their leases in bankruptcy.

Limitation on Lease Rejection Damages

Bankruptcy Code '365 provides debtors with the right to assume or reject executory contracts and unexpired leases. Pursuant to '365(g), a debtor's rejection of a nonresidential real property lease effects a breach of the lease as of the instant before the debtor filed bankruptcy.

Section 502(b)(6) caps a landlord's claim arising from the rejection of a lease to the amount of the rent reserved by such lease, without acceleration, for the greater of: a) one year, or b) 15%, not to exceed three years, of the remaining term of the lease, following the earlier of: 1) the filing of the bankruptcy petition and 2) the date on which the landlord repossessed, or the debtor surrendered, the leased property. This cap has its roots in the Bankruptcy Act of 1898 and was designed to promote equality among unsecured creditors by preventing landlords with long-term leases from dominating the unsecured creditor class.

Bankruptcy courts, district courts, and bankruptcy appellate panels have wrestled with numerous aspects of '502(b)(6). One particular area of debate has been whether the cap applies to all damages flowing from the landlord-tenant relationship or only those damages tied to the payment of rent and other routine lease obligations.

In 1995, the Bankruptcy Appellate Panel ('BAP') for the Ninth Circuit, in a case called In re McSheridan, 184 B.R. 91 (B.A.P. 9th Cir. 1995), held that '502(b)(6) operates to limit all claims arising from a rejected lease. (In addition, McSheridan crafted a test for determining which obligations under a lease constitute part of the 'rent reserved,' which is one of the key elements in calculating the cap. The validity of three-part 'rent-reserved' test was not before the El Toro court.) In McSheridan, the guarantors of a lease filed a claim for $74,000, which included damages related to repair and maintenance. The debtors contended that all of the guarantors' damages, not just the amounts corresponding to rent, should be limited by '502(b)(6). The McSheridan court analyzed the legislative history of '502(b)(6) and interpreted it against the backdrop of several Bankruptcy Code provisions governing lease rejection and the allowance of claims. McSheridan premised its conclusion about the scope of the cap on Bankruptcy Code '502(g), which provides that rejection affects the breach of every provision of a contract or lease. The BAP held that because rejection results in a comprehensive breach of a lease, '502(b)(6) limits all damages arising from a rejected lease.

McSheridan has been widely followed by other courts, including, for example, the U.S. Bankruptcy Court for the District of Delaware as recently as May 2007 in In re Foamex International, Inc., 368 B.R. 383 (Bankr. D. Del. 2007). The Foamex court applied '502(b)(6) to all portions of the landlord's claim of $793,872, reducing it to $24,472. Foamex sided with McSheridan on the basis of McSheridan's thorough analysis of '502(b)(6). The court was also persuaded by First Bank Nat'l Assoc. v. FDIC, 79 F.3d 362 (3d Cir. 1996), in which the U.S. Court of Appeals for the Third Circuit upheld a lease termination damages cap under the Financial Institutions Reform Recovery and Enforcement Act of 1989 ('FIRREA'). The Third Circuit approved of McSheridan's analysis of the scope of '502(b)(6), which the court noted was Congress' model for the analogous provision under FIRREA at issue in First Bank.

In addition to being the only court of appeals decision to give an opinion directly on the scope of '502(b)(6), El Toro overrules McSheridan, holding that 'tort claims other than those based on rent' are not subject to the limitation imposed by '502(b)(6).

The El Toro Decision

El Toro Materials Co. ('El Toro') was in the business of processing and selling sand and gravel in Orange County, CA. El Toro conducted its operations from a parcel of land it leased for $28,000 per month from Saddleback Valley Community Church ('the church').

The lease permitted El Toro to conduct mining operations and store debris on the land, but also required El Toro to re-grade and rehabilitate the property before vacating. The church sought to terminate the lease and demanded that El Toro, in accordance with the lease's repair and maintenance provision, remove 650,000 cubic yards of saturated clay, which the church characterized as 'goo.'

El Toro filed a Chapter 11 bankruptcy petition in response to the
liability imposed by the church's demand. After El Toro rejected the lease, the church filed a proof of claim for $23 million. El Toro objected to the claim and commenced an adversary proceeding, alleging that the church breached the lease and interfered with El Toro's operations. The church asserted counterclaims for breach of the lease, waste, nuisance, and trespass. El Toro argued that '502(b)(6) operated to cap the church's damages. Under '502(b)(6), the church's claim would be limited to approximately $336,000, compared with the $23 million asserted by the church.

The bankruptcy court held that the '502(b)(6) capped all damages stemming from El Toro's nonperformance of the lease, but not damages from tortious or illegal activity, such as nuisance and waste. Ch. 11 Case No. SA 02-18913 RA, Adv. No. SA 03-1486 (Bankr. C.D. Cal. March 12, 2004) (docket no. 42).

The parties appealed the bankruptcy court's decision to the Ninth Circuit BAP. The BAP held that McSheridan controlled. (BAP No. CC-04-1287-PaBK (B.A.P. 9th Cir. July 8, 2005) available at www.ce9.uscourts.gov/ bap.) The BAP found significant the substantial factual overlap between the church's $23 million claim and its tort claims. The BAP reasoned that any uncapped recovery based on the tort label applied by the church to El Toro's conduct would enable it to 'succeed in a classic end-run around the will of Congress.' The BAP noted that this result appeared at odds with the rule against recovering in tort for conduct otherwise falling within the scope of a contract except if such conduct violates a duty independent of the contract. E.g., Clark-Fitzgerald, Inc. v. Long Island R.R. Co., 70 N.Y.2d 382, 389 (1987). However, the BAP declined to base its decision on this rule because the bankruptcy court failed to address it.

The parties then appealed the BAP decision to the Ninth Circuit. The court of appeals reversed the BAP, expressly overruling McSheridan 'to the extent that [it] holds '502(b)(6) to be a limit on tort claims other than those based on rent, rent-like payments or other damages directly arising from a tenant's failure to complete a lease term.' 2007 U.S. App. LEXIS 22991 at *9. The Ninth Circuit cited numerous grounds for its decision. First, the court reasoned that non-rent or 'collateral' damages should not be capped because such damages correlate weakly to the amount of rent remaining on a lease, which is the measure by which the '502(b)(6) cap is computed. According to the court, a total cap calculated from rent remaining would place landlords who suffered non-routine damage to their property in a worse position than other creditors.

Second, the court viewed the words 'resulting from the termination of the lease' in '502(b)(6) to limit the cap to only those damages proximately caused by the act of rejection, as opposed to damages caused by the conduct that actually violated a lease covenant. Following this line of reasoning, the court contrasted El Toro's breach of its obligation to pay rent, which was triggered directly by its act of rejecting the lease, with El Toro's breach of the repair covenant, which was caused by its failure to remove the 'goo' from the church's land, an omission independent of El Toro's decision to reject the lease. The court declined to link the 'goo'-related damage to rejection on the theory that such damage would have persisted had the debtor assumed the lease.

Third, the Ninth Circuit was concerned that the cap would present a classic moral hazard by tempting debtors with lease liabilities already exceeding the cap to damage the leased property with impunity, knowing that they would incur no additional liability.

And fourth, the court noted that the cap does not aid in preserving the operating value of a business because it may motivate debtors to shed otherwise favorable leases and reap the benefit of limited claim exposure instead of keeping a lease and enhancing the value of a business.

Analysis

The Ninth Circuit in El Toro appeared to reach its conclusion based on policy concerns it had regarding the cap. However, El Toro's bifurcation of potential lease rejection damages into 'rent-like' damages and 'collateral,' 'tort-like' damages injects an element of uncertainty into a debtor's lease assumption/rejection decision and may adversely affect the feasibility of a debtor's plan of reorganization. Both debtors and creditors may find it difficult to determine accurately which damages are subject to the cap. Catastrophically expensive consequences could result if a court disagrees with a debtor's characterization of certain damages as being 'rent-like' and thus capped, and re-classifies the damages as 'collateral' to a lease and thus not subject to the cap.

El Toro also blunts the potency of lease rejection as a vital reorganizational tool. A cautious debtor, fearing an uncapped collateral damage claim, may be inclined to dedicate valuable estate resources to avoid violating a lease covenant that raises the specter of potentially tortious conduct, effectively incurring cure costs to perform its cleanup obligation that would otherwise be payable only if it assumed the lease.

Another notable aspect of the Ninth Circuit's decision is its characterization of the church's claims as sounding in tort rather than arising from the breach of the cleanup provision of the lease. Indeed, its holding overruling McSheridan is limited specifically to excluding tort claims from the '502(b)(6) cap. However, the court did not address how a landlord could recover damages for repair and maintenance under a tort theory in light of the common-law rule prohibiting tort recovery for conduct otherwise governed by a contract that does not breach an independent duty. The common-law rule suggests that a landlord could only recover damages provided under the four corners of a lease. Thus, a court might hold that El Toro does not apply because the claim under the lease cannot sound in tort and must, therefore, be subject to the limitation of '502(b)(6).

Conclusion

The El Toro decision supplies landlords with greater incentive to litigate claims relating to rejected leases of nonresidential real property aggressively by asserting that their damages are not subject to the Bankruptcy Code's limitation because they are more akin to tort damages than rent. Later courts may limit the decision, however, by holding that a landlord is precluded from recovering damages in tort for conduct governed by a lease and that the limitation of '502(b)(6) operates to cap these contract damages.

John J. Rapisardi is a partner in the financial restructuring department of Cadwalader, Wickersham & Taft LLP and is an adjunct professor of law at Pace University School of Law. Christopher R. Mirick, special counsel of the firm, and Michael J. Cohen, associate of the firm, assisted in the preparation of this article. This article originally appeared in the New York Law Journal, a sister publication of this newsletter.