When the Tenant Files for Bankruptcy

In recognition of the fact that the non-residential real estate landlord is forced to continue to perform under its contract when the tenant files a bankruptcy case, section 365(d)(3) of the Bankruptcy Code requires the tenant debtor to timely perform its lease obligations pending the assumption or rejection of the lease. In re Garden Ridge Corp., et al, 321 B.R. 669 (Bankr. D.Del. 2005) (citing Center Point Props. v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 268 F.3d 205, 211 (3d Cir. 2001)). Indeed, as Congress recognized, “the landlord is forced to provide current services ' the use of its property, utilities, security, and other services ' without current payment. No other creditor is put in this position.” See H.R. Rep. No. 882, 95th Cong., 2d Sess., reprinted in 1984 U.S.C.C.A.N. 576.

Different Judicial Approaches

Despite the mandate of ' 365(d)(3), however, landlords should affirmatively seek payment of the “stub rent” for the period of the tenant's occupancy and use of the leased premises between the petition date and the first full-month's post-petition rent payment. In many instances, because the stub rent is part of the rent for the month that was due on a date prior to the filing of the bankruptcy petition, tenant debtors will assert that they have no obligation to pay it, despite their continued tenancy during the stub rent period, because the entire month's rent is a pre-petition claim. Courts have not treated this issue uniformly. In some cases, courts have applied the “billing date” approach, where the obligation to pay rent arises on the date rent is due. See In re Goody's Family Clothing, Inc., 401 B.R. 656 (D. Del. 2009). In others, they have applied the “proration” approach, where the obligation to pay rent is treated as if arising on each day the tenant occupies the premises. In re Stone Barn Manhattan, LLC, 398 B.R. 359 (Bankr. S.D.N.Y. 2008). Under the billing date approach, stub rent is a pre-petition claim that need not be paid immediately pursuant to ' 365(d)(3); under the proration approach, stub rent is treated as a post-petition claim that is immediately payable.

The Third Circuit, one of the more influential federal circuits in the United States in bankruptcy law due to the large number of mega cases filed in debtor-friendly Delaware, follows the billing date approach. See In re Goody's Family Clothing, Inc., 610 F.3d 812 (3d Cir. 2010) (reaffirming the applicability of the billing date approach). The Third Circuit, however, disagreed with the debtors' position that, not only does ' 365(d)(3) make stub rent a pre-petition claim, it also effectively precludes the landlord from seeking priority payment of the stub rent as a post-petition claim under ' 503(b)(1). Id., 610 F.3d at 816-818. As the Third Circuit explained, ' 365(d)(3) permits the landlord to obtain payment of post-petition rent (other than stub rent) as an administrative priority claim, without having to go through the burdensome process under ' 503(b)(1) to demonstrate that the tenant's use and occupancy of the leased premises constituted actual, necessary costs and expenses of' preserving the debtor's estate. Id., 601 F.3d at 817.

For landlords dealing with tenant debtor bankruptcies in circuits applying the billing date approach, the Third Circuit affirmed that the landlord is nevertheless entitled to seek payment of stub rent under ' 503(b). As the court explained:

Relieving a landlord under ' 365(d)(3) of burdensome administrative procedures, however, does not foreclose that landlord's ability to use the more burdensome procedures to recover in situations outside the scope of ' 365(d)(3). Put simply, ' 365(d)(3) does not supplant or preempt ' 503(b)(1). The last sentence of ' 365(d)(3) makes this plain: “Acceptance of any such performance [under ' 365(d)(3)] does not constitute waiver or relinquishment of the lessor's rights under such lease or under [the Bankruptcy Code].”

In re Goody's Family Clothing, Inc., 610 F.3d at 817.

Thus, while the landlord may not obtain immediate payment for stub rent in circuits applying the billing date approach, the landlord should not sleep on its rights and let pass the opportunity to obtain payment of stub rent as an administrative expense under ' 503(b). In doing so, the landlord will usually be able to obtain payment of the stub rent as an administrative expense where the tenant occupies and uses the leased premises. Id., 610 F.3d at 819 (citations omitted).

A Different Approach

More recently, a California bankruptcy court offered a revitalized approach to the proration approach to stub rent, and criticized the Third Circuit's requirement of forcing the landlord to undertake the burden of seeking stub rent under ' 503. In In re Leather Factory Inc., 475 B.R. 710 (Bankr. C.D. Cal. 2012), the court opined:

Congress intended to shift the burden from the landlords for the debtor's use of their property. To allow “stub rent” to be considered as a pre-petition unsecured claim gives a windfall to the debtor and its administrative creditors at the expense of the landlord, who has no ability at that time to evict because of the automatic stay.

Id. at 714.

Not only does the court reject the billing date method, it also rejects the requirement that the landlord demonstrate that the amount of stub rent to be recovered is equal to the actual fair value that the debtor received, and rather, concludes that the landlord is entitled to be paid stub rent as an administrative expense without the necessity of meeting the burden of proof under ' 503. Id.

In keeping with the prorated approach, the court in Leather Factory also held that the debtor's security deposit was not to be used as the source of funds to pay the stub rent. Id., at 718-19. Rather, under the proration approach, the debtor must pay stub rent as an administrative expense out of its post-petition operating budget, as part of its duty to timely pay its obligations under ' 365. Id. Thus, not only does the difference in application of billing approach and proration approach affect the landlord's ability to obtain timely payment of stub rent, it also affects the source of funds from which the landlord may receive payment.'

Conclusion

In both situations, it is important for the landlord to be aware of its right to obtain payment of stub rent, whether under ' 365(d)(3) or under the more burdensome process of seeking payment under ' 503(b). In either event, the landlord should not delay in seeking a court order approving payment of stub rent and, in the case of circuits applying the proration approach, should be alert to ensure that the debtor does not seek to require the landlord to satisfy its stub rent payment out of its security deposit, thus avoiding a reduction of the source of funds that would be available to satisfy any claims for unpaid pre-petition rent.”

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Susan Jaffe Roberts is a partner in Whiteford, Taylor & Preston, LLP's bankruptcy section in Baltimore. She has represented landlords, real estate developers, creditors' committees, trustees and debtors in bankruptcy cases and in non-bankruptcy restructurings and workouts.

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The timing of the filing of a shopping center tenant's bankruptcy filing may be affected by many factors, including, among others, the tenant's liquidity, down turns in sales and secured creditor issues. In order to preserve cash on hand and to limit the payments the landlord will receive in distributions in bankruptcy, the tenant debtor often times its filing to occur after the first of the month, when rent and other lease payment obligations are commonly due, thus making the rent for the month prior to the filing date a pre-petition claim.

What Happens to the Landlord?

Unless the tenant has already shut its doors and surrendered possession to the landlord, the tenant will remain in possession of the leased premises, and the landlord's immediate remedies will be restricted by the application of the automatic stay, imposed upon all creditors upon the filing of a bankruptcy by 11 U.S.C. ' 362(a) of the United States Bankruptcy Code (Bankruptcy Code) (see “In the Spotlight,” infra, p. 1).

In recognition of the fact that the non-residential real estate landlord is forced to continue to perform under its contract when the tenant files a bankruptcy case, section 365(d)(3) of the Bankruptcy Code requires the tenant debtor to timely perform its lease obligations pending the assumption or rejection of the lease. In re Garden Ridge Corp., et al, 321 B.R. 669 (Bankr. D.Del. 2005) (citing Center Point Props. v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 268 F.3d 205, 211 (3d Cir. 2001)). Indeed, as Congress recognized, “the landlord is forced to provide current services ' the use of its property, utilities, security, and other services ' without current payment. No other creditor is put in this position.” See H.R. Rep. No. 882, 95th Cong., 2d Sess., reprinted in 1984 U.S.C.C.A.N. 576.

Different Judicial Approaches

Despite the mandate of ' 365(d)(3), however, landlords should affirmatively seek payment of the “stub rent” for the period of the tenant's occupancy and use of the leased premises between the petition date and the first full-month's post-petition rent payment. In many instances, because the stub rent is part of the rent for the month that was due on a date prior to the filing of the bankruptcy petition, tenant debtors will assert that they have no obligation to pay it, despite their continued tenancy during the stub rent period, because the entire month's rent is a pre-petition claim. Courts have not treated this issue uniformly. In some cases, courts have applied the “billing date” approach, where the obligation to pay rent arises on the date rent is due. See In re Goody's Family Clothing, Inc., 401 B.R. 656 (D. Del. 2009). In others, they have applied the “proration” approach, where the obligation to pay rent is treated as if arising on each day the tenant occupies the premises. In re Stone Barn Manhattan, LLC, 398 B.R. 359 (Bankr. S.D.N.Y. 2008). Under the billing date approach, stub rent is a pre-petition claim that need not be paid immediately pursuant to ' 365(d)(3); under the proration approach, stub rent is treated as a post-petition claim that is immediately payable.

The Third Circuit, one of the more influential federal circuits in the United States in bankruptcy law due to the large number of mega cases filed in debtor-friendly Delaware, follows the billing date approach. See In re Goody's Family Clothing, Inc., 610 F.3d 812 (3d Cir. 2010) (reaffirming the applicability of the billing date approach). The Third Circuit, however, disagreed with the debtors' position that, not only does ' 365(d)(3) make stub rent a pre-petition claim, it also effectively precludes the landlord from seeking priority payment of the stub rent as a post-petition claim under ' 503(b)(1). Id., 610 F.3d at 816-818. As the Third Circuit explained, ' 365(d)(3) permits the landlord to obtain payment of post-petition rent (other than stub rent) as an administrative priority claim, without having to go through the burdensome process under ' 503(b)(1) to demonstrate that the tenant's use and occupancy of the leased premises constituted actual, necessary costs and expenses of' preserving the debtor's estate. Id., 601 F.3d at 817.

For landlords dealing with tenant debtor bankruptcies in circuits applying the billing date approach, the Third Circuit affirmed that the landlord is nevertheless entitled to seek payment of stub rent under ' 503(b). As the court explained:

Relieving a landlord under ' 365(d)(3) of burdensome administrative procedures, however, does not foreclose that landlord's ability to use the more burdensome procedures to recover in situations outside the scope of ' 365(d)(3). Put simply, ' 365(d)(3) does not supplant or preempt ' 503(b)(1). The last sentence of ' 365(d)(3) makes this plain: “Acceptance of any such performance [under ' 365(d)(3)] does not constitute waiver or relinquishment of the lessor's rights under such lease or under [the Bankruptcy Code].”

In re Goody's Family Clothing, Inc., 610 F.3d at 817.

Thus, while the landlord may not obtain immediate payment for stub rent in circuits applying the billing date approach, the landlord should not sleep on its rights and let pass the opportunity to obtain payment of stub rent as an administrative expense under ' 503(b). In doing so, the landlord will usually be able to obtain payment of the stub rent as an administrative expense where the tenant occupies and uses the leased premises. Id., 610 F.3d at 819 (citations omitted).

A Different Approach

More recently, a California bankruptcy court offered a revitalized approach to the proration approach to stub rent, and criticized the Third Circuit's requirement of forcing the landlord to undertake the burden of seeking stub rent under ' 503. In In re Leather Factory Inc., 475 B.R. 710 (Bankr. C.D. Cal. 2012), the court opined:

Congress intended to shift the burden from the landlords for the debtor's use of their property. To allow “stub rent” to be considered as a pre-petition unsecured claim gives a windfall to the debtor and its administrative creditors at the expense of the landlord, who has no ability at that time to evict because of the automatic stay.

Id. at 714.

Not only does the court reject the billing date method, it also rejects the requirement that the landlord demonstrate that the amount of stub rent to be recovered is equal to the actual fair value that the debtor received, and rather, concludes that the landlord is entitled to be paid stub rent as an administrative expense without the necessity of meeting the burden of proof under ' 503. Id.

In keeping with the prorated approach, the court in Leather Factory also held that the debtor's security deposit was not to be used as the source of funds to pay the stub rent. Id., at 718-19. Rather, under the proration approach, the debtor must pay stub rent as an administrative expense out of its post-petition operating budget, as part of its duty to timely pay its obligations under ' 365. Id. Thus, not only does the difference in application of billing approach and proration approach affect the landlord's ability to obtain timely payment of stub rent, it also affects the source of funds from which the landlord may receive payment.'

Conclusion

In both situations, it is important for the landlord to be aware of its right to obtain payment of stub rent, whether under ' 365(d)(3) or under the more burdensome process of seeking payment under ' 503(b). In either event, the landlord should not delay in seeking a court order approving payment of stub rent and, in the case of circuits applying the proration approach, should be alert to ensure that the debtor does not seek to require the landlord to satisfy its stub rent payment out of its security deposit, thus avoiding a reduction of the source of funds that would be available to satisfy any claims for unpaid pre-petition rent.”

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Susan Jaffe Roberts is a partner in Whiteford, Taylor & Preston, LLP's bankruptcy section in Baltimore. She has represented landlords, real estate developers, creditors' committees, trustees and debtors in bankruptcy cases and in non-bankruptcy restructurings and workouts.

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