File for Chapter 11, Get the First Month's Rent Free?

While the language of the Statute appears to be noncontroversial, since its adoption, courts have vacillated between the proration and billing date approaches. Section 365(d)(4) requires that the trustee assume or reject an unexpired lease of nonresidential real property within 120 days after the order for relief. Section 365(d)(3) requires that the trustee “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.” Moreover, courts agree that the purpose of the Statute is to end the unintended consequences of the 1978 Act, which rendered a landlord an involuntary administrative creditor during the period in between the order for relief and rejection or assumption of the lease (the “Gap Period”). Nevertheless, even courts, within the same district, differ regarding proration.

Courts adopting the billing date approach generally conclude that the statute is unambiguous and, as such, rent “arises” prepetition on the first of the month. While this approach should render stub rent a prepetition unsecured debt, most of these courts allow a landlord an administrative expense claim. In contrast, courts adopting the proration approach generally conclude that the Statute is ambiguous and, as such, rent “arises” during the Gap Period, requiring the timely payment of stub rent.

This split plays an important role in bankruptcy cases. A debtor with substantial nonresidential real property leases will consider the consequences of stub rent when selecting a forum. Particularly, a debtor, such as a chain store, that leases property in multiple venues will likely possess a broad selection of forums. Moreover, the billing date approach promotes uneconomic bankruptcy planning, encouraging a debtor to file on the second day of the month and reject leases on the thirtieth day of the month. See Stone Barn, 398 B.R. at 368.

The current split among courts could lead to inconsistent treatment of debtors located in the same property. For example, three chain stores, which lease property in the same shopping center and file in three different forums, may each have a unique stub rent obligation, including: 1) timely payment; 2) a pre petition unsecured claim or 3) an administrative claim.

Historical Background: The Unintended Consequence of The 1978 Act

Under the Bankruptcy Act, a landlord was able to minimize the loss stemming from a tenant's bankruptcy through drafting lease clauses permitting foreclosure in the event of a tenant's bankruptcy. See Rep. No. 98-70, 98th Cong., 1st Sess. 1 (1983), at 5. However, under the Bankruptcy Code, enacted by the 1978 Act, the automatic stay of ' 362(a)(3) rendered these lease clauses unenforceable. Id. The landlord's sole recourse was to seek payment through a hearing for “the actual, necessary costs and expenses of preserving the estate.” 11 U.S.C. ' 503(b)(1).

[T]he landlord was in an awkward spot during the interval between the entry of the tenant into bankruptcy and the tenant's decision to assume or reject the unexpired lease. Matter of Handy Andy Home Improvement Centers, Inc. 144 F.3d 1125, 1128 (7th Cir. 1998).

A landlord was subjected to: 1) the expense and delay of a hearing; 2) risk of waiting to a case's conclusion to receive payment and receiving less than the original bargained for rent (some courts found the benefit to the estate was less than the bargained for rent); and 3) risk of not getting paid in the event of a debtor's administrative insolvency. “Congress passed ' 365(d)(3) to relieve landlords of the uncertainty of collecting rent fixed in the lease in full, promptly, and without legal expense during the awkward postpetition prerejection period.” HA-LO Industries, Inc. v. CenterPoint Properties Trust, 342 F.3d 794, 799 (7th Cir. 2003).

The Statute: More Uncertainty

Courts do not dispute that the purpose of the Statute was to end the unintended consequences of the 1978 Act, which rendered the landlord an involuntary administrative creditor. Likewise, they agree that a trustee must pay the rent or other expenses that are due during the Gap Period for use of the property during that period. Courts differ with respect to stub rent ' where a debtor was billed for the benefit prepetition and received the benefit during the Gap Period. Additionally, courts differ regarding services provided outside the Gap Period but billed during the Gap Period, including post-rejection rent “for rent originally due before the debtor's rejection of a lease but allocable to the period after rejection,” In re Ames Dept. Store, Inc., 306 B.R. 43, 63 (Bankr. S.D.N.Y. 2004); and pre petition expenses that “accrued prepetition but were billed to debtor during the postpetition, prerejection period.” Handy Andy, 144 F.3d at 1126.

The three circuits that have addressed the Statute favor the billing date approach. The Third Circuit, addressing prepetition taxes, decided that: “it is difficult to find a textual basis for a proration approach.” In re Montgomery Ward Holding Corp, 268 F.3d 205 (3d Cir. 2001). The Sixth and Seventh Circuits applied the billing date approach to post rejection rent. See Koenig Sporting Goods, Inc. v. Morse Road Co. (In re Koenig Sporting Goods, Inc.), 203 F.3d 986, 989 (6th Cir. 2000) & HA-LO, 342 F.3d at 798 (finding ' 365(d)(3) unambiguous). The Seventh Circuit, in an opinion authored by Judge Posner, appeared to unequivocally support proration: “When context of the statute is disregarded ' silliness results.” Handy Andy, 144 F.3d at 1128 (addressing the application of the billing date approach). However, the HA-LO panel “with no overlap with the Seventh Circuit panel that had decided Handy Andy” distinguished and severely limited Handy Andy. Ames, 306 B.R. at 77-78.

While there is a split in the Southern District of New York (the “S.D.N.Y.”) regarding proration, the majority of the cases support proration. See, e.g., Ames, 306 B.R. at 64 (citing cases).

Courts that adopt proration generally conclude:

1) proration is simple to apply; 2) the method produces equitable results as it allows both landlords and tenants to get what they bargained for-current service for current payment; 3) proration is consistent with the long-standing, pre-amendment practice of prorating lease obligations pending rejection; 4) neither the statute nor its legislative history indicates proration is precluded; and 5) proration is consistent with other provisions of the Bankruptcy Code, such as ” 365(g) and 502(g).

Stone Barn, 398 B.R. at 364 (citing In re Ames, 306 B.R. at 68-80).

Stone Barn

Stone Barn held the Statute mandates proration and, as such, the timely payment of the stub rent. In addition to the reasons noted by Ames, Stone Barn explained that proration accomplishes the purpose of the Statute. First, [proration] does not eliminate any obligations of tenants to landlords-it merely measures when [the Gap Period] obligations arise and when they end (if the lease is rejected).” Id. at 366. Moreover, Stone Barn noted that courts in circuits that reject proration should treat the stub rent as a pre-petition claim. However, “[t]hese courts find that the only issues to be decided are the amount of the claims and when the ' 503(b)(1)(A) claims of all the landlords should be paid ' [T]he billing date approach thus contradicts the plain purpose of the Statute, a result to be avoided.” Id. at 366-67 (citations omitted).

Stone Barn stayed the decision to provide the parties an opportunity to appeal and offered to certify the question to the Second Circuit because “three Circuit Court opinions have rejected proration, as have several intermediate appellate courts (including the Court that reversed the undersigned).” Id. at 368; see Urban Retail Properties v. Loews Cineplex Entertainment Corp. (In re Loews), 2002 U.S. Dist. LEXIS 6186, 2002 WL 535479 (S.D.N.Y. 2002) (reversing an oral decision of Judge Gropper, the author of Stone Barn, applying proration to prepetition expenses). Ultimately, the parties settled pursuant to a stipulation and order, which provided a choice between stub rent being paid: 1) 75% immediately; or 2) 50% immediately and the remainder to be paid at a later date.

Help from an Unexpected Place

A Delaware District Court, in dicta, strongly supports Stone Barn's approach to stub rent and demonstrates that proration of stub rent can be reconciled with Montgomery Ward. The district court was asked to rule on the “Bankruptcy Court's decisions granting administrative expense priority for unpaid stub rent ' ” Goody's, 401 B.R. at 660. “Tracking the logic of Montgomery Ward, the Bankruptcy Court below held that the rent obligation here arose prepetition, as it was due eight days before the Petition Date.” Id. at 664. Goody's found that the stub rent was payable as an administrative expense and, as such, the court was not required to and did not rule on whether the Statute required timely payment of the stub rent. (Goody's may represent another phenomenon ' Courts within the Third, Sixth and Seventh Circuits, avoiding the stub rent dilemma by rubber stamping stub rent as an administrative expense.)

However, Goody's stated that it may have read Montgomery Ward more narrowly than the bankruptcy court and prorated the stub rent. Goody's provided three possibilities to reconcile proration of stub rent with Montgomery Ward including that rent “arises” each day of a tenant's occupancy. Moreover, Goody's addressed why the billing date approach should not be applied to stub rent.

It is therefore a perverse result that debtor-tenants could use ' 365(d)(3) offensively to avoid timely rent payments ' by strategically filing a bankruptcy petition on the second day of the month and then rejecting the lease ' on the 31st day of the subsequent month.

The application of [the billing date] ' produces confounding consequences. For example, most commercial leases require full payment of the total rent obligation, with amortization in monthly installments' the entire rent obligation “arises” pre-petition, thus depriving ' 365(d)(3) of any practical effect. Conversely, if a lease required that rent be due each day (say, allowing monthly payments for convenience), then ' 365(d)(3) would presumably require payment '

Goody's, 401 B.R. at 664, fn 8.

A Unique Split

The split between the three Circuits and the majority of the lower courts regarding proration may very well be attributed to the lower courts' familiarity with the cases over which they preside. “The context consists not merely of other sentences but also of the real-world situation to which the language pertains.” Handy Andy, 144F3d at 1128. Bankruptcy courts are familiar with and focus on this context and, as such, have adopted the proration approach. In contrast, the three circuit courts focused on the language of the Statute. For example, Montgomery Ward acknowledged “that there are aspects to a proration approach that Congress might have found desirable.” Montgomery Ward, 268 F.3d at 211. Nevertheless, Montgomery Ward found “section 365(d)(3) is unambiguous and allows no consideration of the illogic of literalistically following it.” Ames, 306 B.R. at 75, FN 123; see also HA-LO 342 F.3d at 799 (“The Sixth Circuit [Koenig] acknowledged (but nevertheless rejected) the practical realities of the argument for proration”). Attempting to address the real-world situation, HA-LO and Koenig argued that the billing date approach is not unfair to a debtor because “the debtor had complete control over the obligation” and could avoid an extra month's rent by rejecting the lease before the end of the month. HA-LO 342 F.3d at 799 (addressing post petition rent). However, Stone Barn noted that “this case illustrates why a debtor does not necessarily have effective control over its liability even for the last month's rent.” 398 B.R. at 368.

Return to Proration?

Stone Barn reaffirms that the bankruptcy courts in the S.D.N.Y. will likely require a debtor to timely pay stub rent. Goody's provides a powerful platform for landlords to argue that, even in the Third, Sixth and Seventh Circuits, the Statute requires timely payment of stub rent. While Goody's discussion of limiting Montgomery Ward is dicta and Stone Barn offered to certify the question, these decisions demonstrate that the tide is turning to the proration of stub rent, consistent with the Statute's purpose and legislative history.

Still, a landlord is likely to face an uphill battle in the Circuits following the billing date approach and, as such, Goody's increased the uncertainty regarding stub rent in these Circuits. This uncertainty is likely to continue in the near future without the benefit of a ruling from the Supreme Court. Interestingly, Justice Sotomayor, then a district court judge, held that the Statue requires the billing date approach for prepetition expenses. See In re R.H. Macy & Co., 1994 WL 482948 (S.D.N.Y.1994).

Yitzhak Greenberg is currently associated with the Law Offices of Gabriel Del Virginia in New York. In Stone Barn, Greenberg appeared on behalf of Ravin Greenberg LLC. He can be reached at [email protected]. The author would like to thank Professor John Feerick for all of his support and Tally M. Wiener, Esq. for her review of the article, which is dedicated to the memory of his teacher, mentor and dear friend, Anthony H. N. Schnelling, Esq. The views expressed in this article are solely the academic views of the author and may not be attributed to any other party.

Two recent court opinions, In re Stone Barn Manhattan LLC, 398 B.R. 359 (Bankr. S.D.N.Y. 2008) and In re Goody's Family Clothing, Inc., 401 B.R. 656 (D. Del. 2009), challenge the growing consensus that 11 U.S.C. ' 365(d)(3) (the “Statute,” or “Section 365(d)(3)”) does not require the timely payment of stub rent. Stub rent is “the rent for the interim period between the day the order for relief was entered in the bankruptcy case and the end of that month.” Stone Barn, 398 B.R. at 360-361. In a commercial lease, prepayment of rent is generally due on the first of the month. A debtor usually files after the first of the month. Therefore, stub rent is present in almost every case that involves nonresidential real property leases.

“Courts have differed on whether an obligation to pay rent 'arises' on the day that rent is due (the 'billing-date approach'), or on each day the tenant occupies the leased premises (the 'proration approach') [requiring the timely payment of stub rent].” Goody's, 401 B.R. at 663. While circuit courts generally favor the billing date approach, bankruptcy courts generally favor the proration approach. As will be discussed, this split may well be a result of bankruptcy courts' familiarity with the real world context of the Statute.

Mind the Gap

While the language of the Statute appears to be noncontroversial, since its adoption, courts have vacillated between the proration and billing date approaches. Section 365(d)(4) requires that the trustee assume or reject an unexpired lease of nonresidential real property within 120 days after the order for relief. Section 365(d)(3) requires that the trustee “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.” Moreover, courts agree that the purpose of the Statute is to end the unintended consequences of the 1978 Act, which rendered a landlord an involuntary administrative creditor during the period in between the order for relief and rejection or assumption of the lease (the “Gap Period”). Nevertheless, even courts, within the same district, differ regarding proration.

Courts adopting the billing date approach generally conclude that the statute is unambiguous and, as such, rent “arises” prepetition on the first of the month. While this approach should render stub rent a prepetition unsecured debt, most of these courts allow a landlord an administrative expense claim. In contrast, courts adopting the proration approach generally conclude that the Statute is ambiguous and, as such, rent “arises” during the Gap Period, requiring the timely payment of stub rent.

This split plays an important role in bankruptcy cases. A debtor with substantial nonresidential real property leases will consider the consequences of stub rent when selecting a forum. Particularly, a debtor, such as a chain store, that leases property in multiple venues will likely possess a broad selection of forums. Moreover, the billing date approach promotes uneconomic bankruptcy planning, encouraging a debtor to file on the second day of the month and reject leases on the thirtieth day of the month. See Stone Barn, 398 B.R. at 368.

The current split among courts could lead to inconsistent treatment of debtors located in the same property. For example, three chain stores, which lease property in the same shopping center and file in three different forums, may each have a unique stub rent obligation, including: 1) timely payment; 2) a pre petition unsecured claim or 3) an administrative claim.

Historical Background: The Unintended Consequence of The 1978 Act

Under the Bankruptcy Act, a landlord was able to minimize the loss stemming from a tenant's bankruptcy through drafting lease clauses permitting foreclosure in the event of a tenant's bankruptcy. See Rep. No. 98-70, 98th Cong., 1st Sess. 1 (1983), at 5. However, under the Bankruptcy Code, enacted by the 1978 Act, the automatic stay of ' 362(a)(3) rendered these lease clauses unenforceable. Id. The landlord's sole recourse was to seek payment through a hearing for “the actual, necessary costs and expenses of preserving the estate.” 11 U.S.C. ' 503(b)(1).

[T]he landlord was in an awkward spot during the interval between the entry of the tenant into bankruptcy and the tenant's decision to assume or reject the unexpired lease. Matter of Handy Andy Home Improvement Centers, Inc. 144 F.3d 1125, 1128 (7th Cir. 1998).

A landlord was subjected to: 1) the expense and delay of a hearing; 2) risk of waiting to a case's conclusion to receive payment and receiving less than the original bargained for rent (some courts found the benefit to the estate was less than the bargained for rent); and 3) risk of not getting paid in the event of a debtor's administrative insolvency. “Congress passed ' 365(d)(3) to relieve landlords of the uncertainty of collecting rent fixed in the lease in full, promptly, and without legal expense during the awkward postpetition prerejection period.” HA-LO Industries, Inc. v. CenterPoint Properties Trust , 342 F.3d 794, 799 (7th Cir. 2003).

The Statute: More Uncertainty

Courts do not dispute that the purpose of the Statute was to end the unintended consequences of the 1978 Act, which rendered the landlord an involuntary administrative creditor. Likewise, they agree that a trustee must pay the rent or other expenses that are due during the Gap Period for use of the property during that period. Courts differ with respect to stub rent ' where a debtor was billed for the benefit prepetition and received the benefit during the Gap Period. Additionally, courts differ regarding services provided outside the Gap Period but billed during the Gap Period, including post-rejection rent “for rent originally due before the debtor's rejection of a lease but allocable to the period after rejection,” In re Ames Dept. Store, Inc., 306 B.R. 43, 63 (Bankr. S.D.N.Y. 2004); and pre petition expenses that “accrued prepetition but were billed to debtor during the postpetition, prerejection period.” Handy Andy, 144 F.3d at 1126.

The three circuits that have addressed the Statute favor the billing date approach. The Third Circuit, addressing prepetition taxes, decided that: “it is difficult to find a textual basis for a proration approach.” In re Montgomery Ward Holding Corp, 268 F.3d 205 (3d Cir. 2001). The Sixth and Seventh Circuits applied the billing date approach to post rejection rent. See Koenig Sporting Goods, Inc. v. Morse Road Co. (In re Koenig Sporting Goods, Inc.), 203 F.3d 986, 989 (6th Cir. 2000) & HA-LO, 342 F.3d at 798 (finding ' 365(d)(3) unambiguous). The Seventh Circuit, in an opinion authored by Judge Posner, appeared to unequivocally support proration: “When context of the statute is disregarded ' silliness results.” Handy Andy, 144 F.3d at 1128 (addressing the application of the billing date approach). However, the HA-LO panel “with no overlap with the Seventh Circuit panel that had decided Handy Andy” distinguished and severely limited Handy Andy. Ames, 306 B.R. at 77-78.

While there is a split in the Southern District of New York (the “S.D.N.Y.”) regarding proration, the majority of the cases support proration. See, e.g., Ames, 306 B.R. at 64 (citing cases).

Courts that adopt proration generally conclude:

1) proration is simple to apply; 2) the method produces equitable results as it allows both landlords and tenants to get what they bargained for-current service for current payment; 3) proration is consistent with the long-standing, pre-amendment practice of prorating lease obligations pending rejection; 4) neither the statute nor its legislative history indicates proration is precluded; and 5) proration is consistent with other provisions of the Bankruptcy Code, such as ” 365(g) and 502(g).

Stone Barn, 398 B.R. at 364 (citing In re Ames, 306 B.R. at 68-80).

Stone Barn

Stone Barn held the Statute mandates proration and, as such, the timely payment of the stub rent. In addition to the reasons noted by Ames, Stone Barn explained that proration accomplishes the purpose of the Statute. First, [proration] does not eliminate any obligations of tenants to landlords-it merely measures when [the Gap Period] obligations arise and when they end (if the lease is rejected).” Id. at 366. Moreover, Stone Barn noted that courts in circuits that reject proration should treat the stub rent as a pre-petition claim. However, “[t]hese courts find that the only issues to be decided are the amount of the claims and when the ' 503(b)(1)(A) claims of all the landlords should be paid ' [T]he billing date approach thus contradicts the plain purpose of the Statute, a result to be avoided.” Id. at 366-67 (citations omitted).

Stone Barn stayed the decision to provide the parties an opportunity to appeal and offered to certify the question to the Second Circuit because “three Circuit Court opinions have rejected proration, as have several intermediate appellate courts (including the Court that reversed the undersigned).” Id. at 368; see Urban Retail Properties v. Loews Cineplex Entertainment Corp. (In re Loews), 2002 U.S. Dist. LEXIS 6186, 2002 WL 535479 (S.D.N.Y. 2002) (reversing an oral decision of Judge Gropper, the author of Stone Barn, applying proration to prepetition expenses). Ultimately, the parties settled pursuant to a stipulation and order, which provided a choice between stub rent being paid: 1) 75% immediately; or 2) 50% immediately and the remainder to be paid at a later date.

Help from an Unexpected Place

A Delaware District Court, in dicta, strongly supports Stone Barn's approach to stub rent and demonstrates that proration of stub rent can be reconciled with Montgomery Ward. The district court was asked to rule on the “Bankruptcy Court's decisions granting administrative expense priority for unpaid stub rent ' ” Goody's, 401 B.R. at 660. “Tracking the logic of Montgomery Ward, the Bankruptcy Court below held that the rent obligation here arose prepetition, as it was due eight days before the Petition Date.” Id. at 664. Goody's found that the stub rent was payable as an administrative expense and, as such, the court was not required to and did not rule on whether the Statute required timely payment of the stub rent. (Goody's may represent another phenomenon ' Courts within the Third, Sixth and Seventh Circuits, avoiding the stub rent dilemma by rubber stamping stub rent as an administrative expense.)

However, Goody's stated that it may have read Montgomery Ward more narrowly than the bankruptcy court and prorated the stub rent. Goody's provided three possibilities to reconcile proration of stub rent with Montgomery Ward including that rent “arises” each day of a tenant's occupancy. Moreover, Goody's addressed why the billing date approach should not be applied to stub rent.

It is therefore a perverse result that debtor-tenants could use ' 365(d)(3) offensively to avoid timely rent payments ' by strategically filing a bankruptcy petition on the second day of the month and then rejecting the lease ' on the 31st day of the subsequent month.

The application of [the billing date] ' produces confounding consequences. For example, most commercial leases require full payment of the total rent obligation, with amortization in monthly installments' the entire rent obligation “arises” pre-petition, thus depriving ' 365(d)(3) of any practical effect. Conversely, if a lease required that rent be due each day (say, allowing monthly payments for convenience), then ' 365(d)(3) would presumably require payment '

Goody's, 401 B.R. at 664, fn 8.

A Unique Split

The split between the three Circuits and the majority of the lower courts regarding proration may very well be attributed to the lower courts' familiarity with the cases over which they preside. “The context consists not merely of other sentences but also of the real-world situation to which the language pertains.” Handy Andy, 144F3d at 1128. Bankruptcy courts are familiar with and focus on this context and, as such, have adopted the proration approach. In contrast, the three circuit courts focused on the language of the Statute. For example, Montgomery Ward acknowledged “that there are aspects to a proration approach that Congress might have found desirable.” Montgomery Ward, 268 F.3d at 211. Nevertheless, Montgomery Ward found “section 365(d)(3) is unambiguous and allows no consideration of the illogic of literalistically following it.” Ames, 306 B.R. at 75, FN 123; see also HA-LO 342 F.3d at 799 (“The Sixth Circuit [Koenig] acknowledged (but nevertheless rejected) the practical realities of the argument for proration”). Attempting to address the real-world situation, HA-LO and Koenig argued that the billing date approach is not unfair to a debtor because “the debtor had complete control over the obligation” and could avoid an extra month's rent by rejecting the lease before the end of the month. HA-LO 342 F.3d at 799 (addressing post petition rent). However, Stone Barn noted that “this case illustrates why a debtor does not necessarily have effective control over its liability even for the last month's rent.” 398 B.R. at 368.

Return to Proration?

Stone Barn reaffirms that the bankruptcy courts in the S.D.N.Y. will likely require a debtor to timely pay stub rent. Goody's provides a powerful platform for landlords to argue that, even in the Third, Sixth and Seventh Circuits, the Statute requires timely payment of stub rent. While Goody's discussion of limiting Montgomery Ward is dicta and Stone Barn offered to certify the question, these decisions demonstrate that the tide is turning to the proration of stub rent, consistent with the Statute's purpose and legislative history.

Still, a landlord is likely to face an uphill battle in the Circuits following the billing date approach and, as such, Goody's increased the uncertainty regarding stub rent in these Circuits. This uncertainty is likely to continue in the near future without the benefit of a ruling from the Supreme Court. Interestingly, Justice Sotomayor, then a district court judge, held that the Statue requires the billing date approach for prepetition expenses. See In re R.H. Macy & Co., 1994 WL 482948 (S.D.N.Y.1994).

Yitzhak Greenberg is currently associated with the Law Offices of Gabriel Del Virginia in New York. In Stone Barn, Greenberg appeared on behalf of Ravin Greenberg LLC. He can be reached at [email protected]. The author would like to thank Professor John Feerick for all of his support and Tally M. Wiener, Esq. for her review of the article, which is dedicated to the memory of his teacher, mentor and dear friend, Anthony H. N. Schnelling, Esq. The views expressed in this article are solely the academic views of the author and may not be attributed to any other party.