Cleaning up After Debtor/Tenants

The Code does not explicitly specify whether the cap applies to non-monetary damages and the language of ' 502(b)(6) is not clear. It provides that it applies to 'damages resulting from the termination of a lease.' Most courts have held that cleanup and repair costs are not damages 'resulting from the termination of a lease' and have concluded only damages related to future rental income are capped.

The Cap Applies Only tTo Future Rent

Three decisions are frequently cited for the proposition that repair and cleanup damages are not capped under ' 502(b)(6). See In re Atlantic Container Corp., 133 B.R. 980 (Bankr. N.D. Ill. 1991) (holding that a landlord's claim for repair and maintenance damages was not capped because the phrase 'damages resulting from the termination of the lease' did not contemplate such damages, and that such damages were unrelated to the termination of the lease); In re Bob's Sea Ray Boats, Inc., 143 B.R. 229 (Bankr. D.N.D. 1992) (holding that claim for damages to leased premises and removal of parking lot lighting fixtures not capped); In re Best Products Co., Inc., 229 B.R. 673 (Bankr. E.D. Va. 1998).

In Best Products, the court disagreed with McSheridan and held that damages for deferred maintenance charges under the lease were not capped. The court found the deferred maintenance 'was a contractual obligation of the debtor on the date it filed bankruptcy' and that the landlord's claim for the cost of the deferred maintenance did not constitute damages resulting from the termination of the lease.

This more narrow interpretation of ' 502(b)(6) seems consistent with the practice under the Bankruptcy Act and the legislative history to the Code. Before the Act amendments in 1934, which provided landlords with a limited claim for future rent, a landlord's claim for future rent was considered contingent, nonprovable and, therefore, not allowable in bankruptcy. See Best Products, 229 B.R. at 675-76. The Act was amended to make claims for future rent 'specifically provable up to a certain statutory cap, thus striking a balance between the interests of the debtor, the landlord, and other creditors.' In re Ames Department Stores, Inc., 209 B.R. 627, 630 (S.D.N.Y. 1997). The legislative history of ' 502(b)(6) reveals that the underlying intent and policy remained to provide limited compensation to landlords for future rent damages. See H.R.Rep. No. 95-595, at 353 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6309. Based on the problem that caused Congress to act ' the loss of future rent ' and the express legislative intent to continue the pre-Code practice, many courts have concluded the legislative intent behind ' 502(b)(6) was to cap only the allowable claim for future rent.

The Entire Claim Is Capped

A handful of decisions conclude that a landlord's entire claim is capped by ' 502(b)(6) regardless of whether the claim relates to future rent. These cases seem to misconstrue the legislative history and policy underlying the ' 502(b)(6) cap. Although the language of the statute makes no distinction between different types of damages, this view seems to adhere to an overly technical interpretation of the Code.

After the Atlantic Container and Bob's Sea Ray Boats decisions, the Ninth Circuit BAP rendered its decision in In re McSheridan, holding that a landlord's entire claim is capped. The McSheridan decision established a three-part test for what constitutes 'rent reserved by such lease' under ' 502(b)(6)(A). The McSheridan test used to determine whether charges constitute 'rent reserved' is as follows: 1) the charge must 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; 2) the charge must be related to the value of the property or the lease thereon; and 3) the charge must be properly classifiable as rent because it is a fixed, regular or periodic charge. It follows from the McSheridan test that one-time charges (e.g., repair and maintenance) that typically occur only upon a default under the lease do not fall within the definition of rent.

The McSheridan decision boldly holds that 'rejection of the lease results in the breach of each and every provision of the lease, including covenants, and ' 502(b)(6) is intended to limit the lessor's damages resulting from that rejection.' McSheridan, 184 B.R. at 102. Moreover, the single lease termination claim afforded to landlords encompasses both prepetition and postpetition breaches of the lease according to McSheridan. Id. at 101.

McSheridan relied on In re Mr. Gatti's, Inc., 162 B.R. 1004 (Bankr. W.D. Tx. 1994), which held rejection is, in effect, the same as termination of the lease, and that the pre-Code practice of capping all damages stemming from rejection of the lease should be continued. See also, In re New Valley Corp., 2000 WL 1251858 (D. N.J. 2000) (holding that covenants to repair, including deferred maintenance payments, fall within the statutory cap of ' 502(b)(6)).

Recently, in In re Foamex Inter- national, Inc., 368 B.R. 383 (Bankr. D. Del. 2007), the court reviewed the legislative history of ' 502(b)(6) and ' 63(a)(9) of the Act and adopted the view that a landlord is entitled to a single claim for all lease termination damages, including pre- and postpetition damages resulting from breaches of the lease. Relying on McSheridan, the court held that because ' 365(g) provides that rejection constitutes a breach of the lease and because ' 502(g) provides that a claim arising from rejection shall be allowed as a prepetition claim, then under ' 502(b)(6) a landlord's entire claim is subject to the statutory cap.

The Foamex decision discussed First Bank National Association v. Federal Deposit Insurance Corporation, 79 F.3d 362 (3d Cir. 1996), which concerned damages for the rejection of a lease under the Financial Institutions Reform, Recovery and Enforcement Act of 1989. The applicable FIRREA provision was modeled after the Code and, therefore, the Third Circuit considered ' 502(b)(6) in its analysis, and relying on McSheridan, held that breaches of covenants are termination damages, and thus concluded FIRREA capped all damages, including asserted damages for failure to make repairs and upgrades.

El Toro Overrules McSheridan ' But to What Extent?

Shortly after the Foamex decision, the Ninth Circuit revisited the question of the application of ' 502(b)(6) to a claim for cleanup under a rejected lease. In El Toro, the Ninth Circuit considered the issue: does ' 502(b)(6) apply to limit a debtor's liability for leaving 1 million tons of clay, mining equipment and other materials on leased real property following rejection of the lease?

The landlord filed a $23 million claim for the estimated cost of the cleanup. The debtor objected and filed an adversary proceeding asserting the landlord breached provisions of the lease. The landlord counterclaimed for breach of the lease, waste, nuisance and trespass and sought injunctive relief requiring the debtor to remove the mining byproducts. All of the counterclaims were based on the debtor's stockpiling of the mining byproducts, and notably, the trespass claim was premised on the debtor's post-petition, post-rejection failure to remove the byproducts.

The bankruptcy court held that: 1) all the claims of the landlord for damages stemming from nonperformance of obligations pursuant to the lease were limited by ' 502(b)(6) because they were damages resulting from termination of the lease; 2) the landlord's claims for damages from 'tortious or illegal acts' (i.e., nuisance and waste) were not subject to the cap of ' 502(b)(6) because they were not damages resulting from the termination of the lease; and 3) the counterclaims for trespass and injunctive relief would be dismissed. Both parties appealed.

The BAP concluded the language of ' 502(b)(6) was not ambiguous and applied as a cap on a landlord's damages without distinction between contract, tort or other claims. Based on the plain meaning of ' 502(b)(6), the BAP observed that Congress
must have intended a difference between all damages and those damages relating to 'rent reserved' and 'unpaid rent' and, had Congress intended to limit the cap of ' 502(b)(6) to claims for future rent it could have so specified.

The BAP concluded the debtor's conduct constituted nuisance and waste, but also constituted a breach of the lease, and that the cleanup damages resulted from the rejection of the lease. The BAP reversed the bankruptcy court and held the nuisance and waster claims were subject to the ' 502(b)(6) cap.

On appeal, the Ninth Circuit observed '[t]he structure of the cap-measured as a fraction of the remaining term-suggests that damages other than those based on a loss of future rental income are not subject to the cap.' The Ninth Circuit noted that '[i]t makes sense to cap damages for lost rental income based on the amount of expected rent: Landlords may have the ability to mitigate their damages by re-leasing or selling the premises, but will suffer injury in proportion to the value of their lost rent in the meantime. In contrast, collateral damages are likely to bear only a weak correlation to the amount of rent ' ' El Toro, 504 F.3d at 980.

The Ninth Circuit concluded that the claims based on theories of waste, nuisance and trespass were separate from the damages resulting from rejection of the lease. 'A simple test reveals whether the damages result from the rejection of the lease: Assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it?' Id. at 980-81. Notably, the landlord asserted the tort claims flowed from obligations independent from the lease under local and state law.

The Ninth Circuit also noted that as a matter of policy that a maximum, fixed amount of damages recoverable by a landlord would have the undesirable effect of giving debtors an incentive to reject an otherwise valuable lease in order to limit liability.

In effect, the court's test is: If the lease was assumed and all curable defaults satisfied, would the landlord still have the same claims being asserted? Unfortunately, limiting collateral damage claims to such a narrow universe could unfairly limit the instances when a landlord would be able to recover collateral damage claims. If the El Toro decision is limited to the holding that only tort claims are not capped, it does not go far enough because there is no justification for denying a landlord recovery for damages entirely unrelated to the rejection and termination of the lease.

Conclusion

Unfortunately, the Ninth Circuit only overruled McSheridan in part because the tort claims in El Toro were 'not based on a failure to perform routine maintenance' and because it was not considering McSheridan's holding that claims for failure to perform routine maintenance are capped. The court has created a dubious distinction between tort-like damages and other non-rent damages that will undoubtedly spawn uncertainty and litigation. As always, landlords should carefully consider how they characterize their claims. For debtors, the risk and uncertainty of potentially uncapped claims will have a significant impact on rejection decisions. On Jan. 30, 2008, the debtor in El Toro filed a petition for a writ of certiorari. Perhaps the Supreme Court will provide practitioners with some clarity regarding
' 502(b)(6) and its application.

Adam L. Rosen, a member of this newsletter's Board of Editors, is a partner and John C. Wright is an associate with the Uniondale, NY, firm of New York firm of Rosen Slome Marder LLP. They may be reached at [email protected] or [email protected].

The scenario is not all that unusual. The debtor files Chapter 11, rejects a commercial real property lease and moves out ' except the debtor leaves behind unwanted equipment, debris, and sometimes, damaged property. The landlord then has to clean up the property and make any necessary repairs, and as a result, has a claim against the debtor for those costs. Courts have reached conflicting conclusions regarding whether clean-up and repair costs are capped under Code
' 502(b)(6). The Ninth Circuit's recent decision in In re El Toro Materials Co., Inc., 504 F.3d 978 (9th Cir. 2007) has cleared up some of the confusion by reversing in part In re McSheridan, 184 B.R. 91 (B.A.P. 9th Cir. 1995), a Ninth Circuit BAP decision which held that a landlord's entire claim was capped. Several other courts have relied on the McSheridan decision, including In re Foamex International, Inc., 368 B.R. 383 (Bankr. D. Del. 2007), a recent Delaware bankruptcy court decision.

Capping Cleanup Costs

Section 502(b)(6) is a legislative compromise ' it limits landlords' claims in order to avoid depletion of estates, which would prevent distributions to other creditors. But, did Congress intend to cap all damages, or only damages from the loss of future rental income?

The Code does not explicitly specify whether the cap applies to non-monetary damages and the language of ' 502(b)(6) is not clear. It provides that it applies to 'damages resulting from the termination of a lease.' Most courts have held that cleanup and repair costs are not damages 'resulting from the termination of a lease' and have concluded only damages related to future rental income are capped.

The Cap Applies Only tTo Future Rent

Three decisions are frequently cited for the proposition that repair and cleanup damages are not capped under ' 502(b)(6). See In re Atlantic Container Corp., 133 B.R. 980 (Bankr. N.D. Ill. 1991) (holding that a landlord's claim for repair and maintenance damages was not capped because the phrase 'damages resulting from the termination of the lease' did not contemplate such damages, and that such damages were unrelated to the termination of the lease); In re Bob's Sea Ray Boats, Inc., 143 B.R. 229 (Bankr. D.N.D. 1992) (holding that claim for damages to leased premises and removal of parking lot lighting fixtures not capped); In re Best Products Co., Inc., 229 B.R. 673 (Bankr. E.D. Va. 1998).

In Best Products, the court disagreed with McSheridan and held that damages for deferred maintenance charges under the lease were not capped. The court found the deferred maintenance 'was a contractual obligation of the debtor on the date it filed bankruptcy' and that the landlord's claim for the cost of the deferred maintenance did not constitute damages resulting from the termination of the lease.

This more narrow interpretation of ' 502(b)(6) seems consistent with the practice under the Bankruptcy Act and the legislative history to the Code. Before the Act amendments in 1934, which provided landlords with a limited claim for future rent, a landlord's claim for future rent was considered contingent, nonprovable and, therefore, not allowable in bankruptcy. See Best Products, 229 B.R. at 675-76. The Act was amended to make claims for future rent 'specifically provable up to a certain statutory cap, thus striking a balance between the interests of the debtor, the landlord, and other creditors.' In re Ames Department Stores, Inc., 209 B.R. 627, 630 (S.D.N.Y. 1997). The legislative history of ' 502(b)(6) reveals that the underlying intent and policy remained to provide limited compensation to landlords for future rent damages. See H.R.Rep. No. 95-595, at 353 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6309. Based on the problem that caused Congress to act ' the loss of future rent ' and the express legislative intent to continue the pre-Code practice, many courts have concluded the legislative intent behind ' 502(b)(6) was to cap only the allowable claim for future rent.

The Entire Claim Is Capped

A handful of decisions conclude that a landlord's entire claim is capped by ' 502(b)(6) regardless of whether the claim relates to future rent. These cases seem to misconstrue the legislative history and policy underlying the ' 502(b)(6) cap. Although the language of the statute makes no distinction between different types of damages, this view seems to adhere to an overly technical interpretation of the Code.

After the Atlantic Container and Bob's Sea Ray Boats decisions, the Ninth Circuit BAP rendered its decision in In re McSheridan, holding that a landlord's entire claim is capped. The McSheridan decision established a three-part test for what constitutes 'rent reserved by such lease' under ' 502(b)(6)(A). The McSheridan test used to determine whether charges constitute 'rent reserved' is as follows: 1) the charge must 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; 2) the charge must be related to the value of the property or the lease thereon; and 3) the charge must be properly classifiable as rent because it is a fixed, regular or periodic charge. It follows from the McSheridan test that one-time charges (e.g., repair and maintenance) that typically occur only upon a default under the lease do not fall within the definition of rent.

The McSheridan decision boldly holds that 'rejection of the lease results in the breach of each and every provision of the lease, including covenants, and ' 502(b)(6) is intended to limit the lessor's damages resulting from that rejection.' McSheridan, 184 B.R. at 102. Moreover, the single lease termination claim afforded to landlords encompasses both prepetition and postpetition breaches of the lease according to McSheridan. Id. at 101.

McSheridan relied on In re Mr. Gatti's, Inc., 162 B.R. 1004 (Bankr. W.D. Tx. 1994), which held rejection is, in effect, the same as termination of the lease, and that the pre-Code practice of capping all damages stemming from rejection of the lease should be continued. See also, In re New Valley Corp., 2000 WL 1251858 (D. N.J. 2000) (holding that covenants to repair, including deferred maintenance payments, fall within the statutory cap of ' 502(b)(6)).

Recently, in In re Foamex Inter- national, Inc., 368 B.R. 383 (Bankr. D. Del. 2007), the court reviewed the legislative history of ' 502(b)(6) and ' 63(a)(9) of the Act and adopted the view that a landlord is entitled to a single claim for all lease termination damages, including pre- and postpetition damages resulting from breaches of the lease. Relying on McSheridan, the court held that because ' 365(g) provides that rejection constitutes a breach of the lease and because ' 502(g) provides that a claim arising from rejection shall be allowed as a prepetition claim, then under ' 502(b)(6) a landlord's entire claim is subject to the statutory cap.

The Foamex decision discussed First Bank National Association v. Federal Deposit Insurance Corporation , 79 F.3d 362 (3d Cir. 1996), which concerned damages for the rejection of a lease under the Financial Institutions Reform, Recovery and Enforcement Act of 1989. The applicable FIRREA provision was modeled after the Code and, therefore, the Third Circuit considered ' 502(b)(6) in its analysis, and relying on McSheridan, held that breaches of covenants are termination damages, and thus concluded FIRREA capped all damages, including asserted damages for failure to make repairs and upgrades.

El Toro Overrules McSheridan ' But to What Extent?

Shortly after the Foamex decision, the Ninth Circuit revisited the question of the application of ' 502(b)(6) to a claim for cleanup under a rejected lease. In El Toro, the Ninth Circuit considered the issue: does ' 502(b)(6) apply to limit a debtor's liability for leaving 1 million tons of clay, mining equipment and other materials on leased real property following rejection of the lease?

The landlord filed a $23 million claim for the estimated cost of the cleanup. The debtor objected and filed an adversary proceeding asserting the landlord breached provisions of the lease. The landlord counterclaimed for breach of the lease, waste, nuisance and trespass and sought injunctive relief requiring the debtor to remove the mining byproducts. All of the counterclaims were based on the debtor's stockpiling of the mining byproducts, and notably, the trespass claim was premised on the debtor's post-petition, post-rejection failure to remove the byproducts.

The bankruptcy court held that: 1) all the claims of the landlord for damages stemming from nonperformance of obligations pursuant to the lease were limited by ' 502(b)(6) because they were damages resulting from termination of the lease; 2) the landlord's claims for damages from 'tortious or illegal acts' (i.e., nuisance and waste) were not subject to the cap of ' 502(b)(6) because they were not damages resulting from the termination of the lease; and 3) the counterclaims for trespass and injunctive relief would be dismissed. Both parties appealed.

The BAP concluded the language of ' 502(b)(6) was not ambiguous and applied as a cap on a landlord's damages without distinction between contract, tort or other claims. Based on the plain meaning of ' 502(b)(6), the BAP observed that Congress
must have intended a difference between all damages and those damages relating to 'rent reserved' and 'unpaid rent' and, had Congress intended to limit the cap of ' 502(b)(6) to claims for future rent it could have so specified.

The BAP concluded the debtor's conduct constituted nuisance and waste, but also constituted a breach of the lease, and that the cleanup damages resulted from the rejection of the lease. The BAP reversed the bankruptcy court and held the nuisance and waster claims were subject to the ' 502(b)(6) cap.

On appeal, the Ninth Circuit observed '[t]he structure of the cap-measured as a fraction of the remaining term-suggests that damages other than those based on a loss of future rental income are not subject to the cap.' The Ninth Circuit noted that '[i]t makes sense to cap damages for lost rental income based on the amount of expected rent: Landlords may have the ability to mitigate their damages by re-leasing or selling the premises, but will suffer injury in proportion to the value of their lost rent in the meantime. In contrast, collateral damages are likely to bear only a weak correlation to the amount of rent ' ' El Toro, 504 F.3d at 980.

The Ninth Circuit concluded that the claims based on theories of waste, nuisance and trespass were separate from the damages resulting from rejection of the lease. 'A simple test reveals whether the damages result from the rejection of the lease: Assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it?' Id. at 980-81. Notably, the landlord asserted the tort claims flowed from obligations independent from the lease under local and state law.

The Ninth Circuit also noted that as a matter of policy that a maximum, fixed amount of damages recoverable by a landlord would have the undesirable effect of giving debtors an incentive to reject an otherwise valuable lease in order to limit liability.

In effect, the court's test is: If the lease was assumed and all curable defaults satisfied, would the landlord still have the same claims being asserted? Unfortunately, limiting collateral damage claims to such a narrow universe could unfairly limit the instances when a landlord would be able to recover collateral damage claims. If the El Toro decision is limited to the holding that only tort claims are not capped, it does not go far enough because there is no justification for denying a landlord recovery for damages entirely unrelated to the rejection and termination of the lease.

Conclusion

Unfortunately, the Ninth Circuit only overruled McSheridan in part because the tort claims in El Toro were 'not based on a failure to perform routine maintenance' and because it was not considering McSheridan's holding that claims for failure to perform routine maintenance are capped. The court has created a dubious distinction between tort-like damages and other non-rent damages that will undoubtedly spawn uncertainty and litigation. As always, landlords should carefully consider how they characterize their claims. For debtors, the risk and uncertainty of potentially uncapped claims will have a significant impact on rejection decisions. On Jan. 30, 2008, the debtor in El Toro filed a petition for a writ of certiorari. Perhaps the Supreme Court will provide practitioners with some clarity regarding
' 502(b)(6) and its application.

Adam L. Rosen, a member of this newsletter's Board of Editors, is a partner and John C. Wright is an associate with the Uniondale, NY, firm of New York firm of Rosen Slome Marder LLP. They may be reached at [email protected] or [email protected].