In the Spotlight: Dealing with Stub Rent After <i>In re Oreck</i>

A bankruptcy judge recently held that lessors of a debtor's corporate headquarters were not entitled to administrative expense priority under 11 U.S.C. ' 365(d)(3) for 25 days of unpaid “stub rent” for the period between the Chapter 11 petition and the first post-petition rent payment. In re Oreck (Bankr. D. Tenn., Mar. 10, 2014). The court held that the lessors' stub rent claim was a prepetition debt that was not within the scope of ' 365(d)(3) and was not entitled to administrative expense priority under section 503(b)(1).

Does the Billing Date Method or Proration Approach Apply?

“Stub Rent” has been defined as the amount due a commercial landlord for a period of occupancy and use between the petition date and the first post-petition rent payment. In re Goody's Family Clothing Inc., 610 F.3d 812, 815 (3d Cir. 2010). In Goody's, the court said that while the Bankruptcy Code does not address the landlord's remedy if a debtor-tenant fails to pay post-petition rent as ' 365(d)(3) requires, most courts have held that the landlord may recover rent by filing an automatic administrative expense claim.

Bankruptcy attorneys and commentators have noted that courts have reached different conclusions about whether stub rent should be characterized as an administrative expense or a pre-petition, unsecured debt for bankruptcy priority purposes.

The stub rent issue arose in Oreck's reorganization because Oreck's lease contained a typical provision that all rent was due and payable in advance on the first of each month. After Oreck filed a Chapter 11 petition on May 6, 2013, it continued to use its headquarters post-petition. Lessors asserted that the prorated stub rent of approximately $30,000 for the 25 post-petition days in May was an administrative expense under 11 U.S.C. ' 365(d)(3).

Application of Billing Date Method

Quoting the applicable language from that provision, the court focused on the requirement 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, notwithstanding section 503(b)(1) of this title. '” 11 U.S.C. ' 365(d)(3). The court said that in view of that section's use of the terms “obligations” and “arising,” the clear and express intent of ' 365(d)(3) required consideration of the terms of the lease to determine both the nature of the obligation and when it arises.

The court in In re Circuit City Stores Inc., 447 B.R. 475 (Bankr. E.D. Va. 2009) explained the difference between the billing method and pro rata (or “accrual”) approach: “Under the billing method, the obligation to pay arises at the time that payment is due under the terms of the lease contract. When the petition date falls in the middle of a month, the obligation to pay rent will be treated entirely as a pre-petition obligation if the Lease is an Advance Lease, and the obligation to pay rent will be treated entirely as a post-petition obligation if the Lease is an Arrears Lease. Alternatively, under the accrual method, the obligation to pay rent is deemed to accrue on a daily basis following the Petition Date. The Petition Date separates the pre-petition obligations (general unsecured claims for the portion of the month prior to the petition date) from post-petition obligations (administrative expense claims for the portion of the month after the petition date).”

Some courts have called for the uniform application of a pro rata approach to determining the priority status of stub rent. See, e.g., In re Circuit City Stores Inc., 447 B.R. 475 (Bankr. E.D. Va. 2009) (noting that a minority of courts have adopted the billing method approach). Application of that approach would benefit landlords by giving administrative expense status to stub rent. Arguing that a proration (or accrual) approach would discourage litigation and time-consuming word games involving the interpretation of lease terms, some courts support the uniform and simple application of pro rata division of obligations for stub rent and related tax debts that arise prepetition.

Some commentators have also disagreed with a focus on the lease payment date and have taken an accrual approach, arguing that bankruptcy courts should simply apply a pro-rata formula to stub rent obligations. Those commentators have noted that the characterization of stub rent can have significant financial consequences for landlords because denial of administrative expense priority makes the stub rent an unsecured creditor claim. See Aaron H. Stulman, Stub Rent Under Section 365(d)(3): A Call for a Unified Approach, 36 Del. J. Corp. L. 655 (2011).

Rejecting the views of this commentator and those courts, looking to the explicit terms of the lease, and noting that Oreck's lease required payment of monthly rent in advance, due and payable on the first of each month, the Oreck court rejected the proration approach and held that Oreck's obligation to pay stub rent arose on the first of the month for bankruptcy priority purposes. In particular, the court found that Oreck's obligation for May 2013 stub rent arose on May 1, 2013.

No Administrative Expense Priority

The court also rejected the lessors' claim that the stub rent met the key prepetition requirement for administrative expense status under ' 503(b)(1). Relying on an unpublished Sixth Circuit holding, the court focused on the prepetition lease payment due date. Rejecting an accrual approach, the Sixth Circuit said that the landlord's requirement that rent is due on the first of the month means that the debtor's obligation to pay rent for any given month arises on the first of the month. In re Baby N' Kids Bedrooms, Inc., 2008 U.S. App. LEXIS 27720 (6th Cir. 2008).

In light of this holding, the court concluded that since the stub rent expense and the lessor's right to payment took place before the petition was filed, and since administrative expense status is available only for post-petition obligations, the lessor was not entitled to administrative expense priority under section 503(b)(1).

Drafting to Maximize Recovery of Stub Rent

Because stub rent in large bankruptcy cases has amounted to hundreds of thousands of dollars, and because unsecured creditors typically receive pennies on the dollar, landlords should draft leases to ensure that they receive administrative expense priority status and thereby recover all the stub rent to which their leases entitle them. In view of the importance of stub rent in some bankruptcies and the holding in Oreck' a bankruptcy strategist could counsel a landlord to include the following provision in its leases:

Tenant' s obligation to pay rent shall arise, accrue, and be due and payable, at Landlord's option, (1) in advance on the first day of the month for which rent is due under this Lease, or (2) in arrears on the last day of the month for which rent is due under this Lease, or (3) daily on a pro rata basis during the term of the Lease. Landlord shall retain sole discretion to determine, at any time, the payment method with which Tenant must comply. Landlord shall, from month to month, impose upon Tenant whichever option, (1), (2), or (3) above, will maximize Landlord's recovery of all rent due under the Lease during the term of the Lease.

Conclusion

The court's conclusion contains a clear lesson for landlords. They should assume that some courts may apply a bright line rule that makes stub rent an unsecured debt unless the lease specifies that the monthly rent obligation arises ' or could arise ' after the day in the month when the debtor files the bankruptcy petition. Including the type of provision described in the preceding paragraph could help landlords collect rent that was due during the month in which the bankruptcy petition was filed. Carefully crafted provisions could help landlords recover rent due after the petition was filed and before the debtor assumes or rejects the lease.

John B. Spitzer practices law in Pennsylvania, edited several editions of The Fundamentals of Bankruptcy Law, serves on the board of a condominium association, and has worked with bankruptcy attorneys in several states.

A bankruptcy judge recently held that lessors of a debtor's corporate headquarters were not entitled to administrative expense priority under 11 U.S.C. ' 365(d)(3) for 25 days of unpaid “stub rent” for the period between the Chapter 11 petition and the first post-petition rent payment. In re Oreck (Bankr. D. Tenn., Mar. 10, 2014). The court held that the lessors' stub rent claim was a prepetition debt that was not within the scope of ' 365(d)(3) and was not entitled to administrative expense priority under section 503(b)(1).

Does the Billing Date Method or Proration Approach Apply?

“Stub Rent” has been defined as the amount due a commercial landlord for a period of occupancy and use between the petition date and the first post-petition rent payment. In re Goody's Family Clothing Inc., 610 F.3d 812, 815 (3d Cir. 2010). In Goody's, the court said that while the Bankruptcy Code does not address the landlord's remedy if a debtor-tenant fails to pay post-petition rent as ' 365(d)(3) requires, most courts have held that the landlord may recover rent by filing an automatic administrative expense claim.

Bankruptcy attorneys and commentators have noted that courts have reached different conclusions about whether stub rent should be characterized as an administrative expense or a pre-petition, unsecured debt for bankruptcy priority purposes.

The stub rent issue arose in Oreck's reorganization because Oreck's lease contained a typical provision that all rent was due and payable in advance on the first of each month. After Oreck filed a Chapter 11 petition on May 6, 2013, it continued to use its headquarters post-petition. Lessors asserted that the prorated stub rent of approximately $30,000 for the 25 post-petition days in May was an administrative expense under 11 U.S.C. ' 365(d)(3).

Application of Billing Date Method

Quoting the applicable language from that provision, the court focused on the requirement 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, notwithstanding section 503(b)(1) of this title. '” 11 U.S.C. ' 365(d)(3). The court said that in view of that section's use of the terms “obligations” and “arising,” the clear and express intent of ' 365(d)(3) required consideration of the terms of the lease to determine both the nature of the obligation and when it arises.

The court in In re Circuit City Stores Inc., 447 B.R. 475 (Bankr. E.D. Va. 2009) explained the difference between the billing method and pro rata (or “accrual”) approach: “Under the billing method, the obligation to pay arises at the time that payment is due under the terms of the lease contract. When the petition date falls in the middle of a month, the obligation to pay rent will be treated entirely as a pre-petition obligation if the Lease is an Advance Lease, and the obligation to pay rent will be treated entirely as a post-petition obligation if the Lease is an Arrears Lease. Alternatively, under the accrual method, the obligation to pay rent is deemed to accrue on a daily basis following the Petition Date. The Petition Date separates the pre-petition obligations (general unsecured claims for the portion of the month prior to the petition date) from post-petition obligations (administrative expense claims for the portion of the month after the petition date).”

Some courts have called for the uniform application of a pro rata approach to determining the priority status of stub rent. See, e.g., In re Circuit City Stores Inc., 447 B.R. 475 (Bankr. E.D. Va. 2009) (noting that a minority of courts have adopted the billing method approach). Application of that approach would benefit landlords by giving administrative expense status to stub rent. Arguing that a proration (or accrual) approach would discourage litigation and time-consuming word games involving the interpretation of lease terms, some courts support the uniform and simple application of pro rata division of obligations for stub rent and related tax debts that arise prepetition.

Some commentators have also disagreed with a focus on the lease payment date and have taken an accrual approach, arguing that bankruptcy courts should simply apply a pro-rata formula to stub rent obligations. Those commentators have noted that the characterization of stub rent can have significant financial consequences for landlords because denial of administrative expense priority makes the stub rent an unsecured creditor claim. See Aaron H. Stulman, Stub Rent Under Section 365(d)(3): A Call for a Unified Approach, 36 Del. J. Corp. L. 655 (2011).

Rejecting the views of this commentator and those courts, looking to the explicit terms of the lease, and noting that Oreck's lease required payment of monthly rent in advance, due and payable on the first of each month, the Oreck court rejected the proration approach and held that Oreck's obligation to pay stub rent arose on the first of the month for bankruptcy priority purposes. In particular, the court found that Oreck's obligation for May 2013 stub rent arose on May 1, 2013.

No Administrative Expense Priority

The court also rejected the lessors' claim that the stub rent met the key prepetition requirement for administrative expense status under ' 503(b)(1). Relying on an unpublished Sixth Circuit holding, the court focused on the prepetition lease payment due date. Rejecting an accrual approach, the Sixth Circuit said that the landlord's requirement that rent is due on the first of the month means that the debtor's obligation to pay rent for any given month arises on the first of the month. In re Baby N' Kids Bedrooms, Inc., 2008 U.S. App. LEXIS 27720 (6th Cir. 2008).

In light of this holding, the court concluded that since the stub rent expense and the lessor's right to payment took place before the petition was filed, and since administrative expense status is available only for post-petition obligations, the lessor was not entitled to administrative expense priority under section 503(b)(1).

Drafting to Maximize Recovery of Stub Rent

Because stub rent in large bankruptcy cases has amounted to hundreds of thousands of dollars, and because unsecured creditors typically receive pennies on the dollar, landlords should draft leases to ensure that they receive administrative expense priority status and thereby recover all the stub rent to which their leases entitle them. In view of the importance of stub rent in some bankruptcies and the holding in Oreck' a bankruptcy strategist could counsel a landlord to include the following provision in its leases:

Tenant' s obligation to pay rent shall arise, accrue, and be due and payable, at Landlord's option, (1) in advance on the first day of the month for which rent is due under this Lease, or (2) in arrears on the last day of the month for which rent is due under this Lease, or (3) daily on a pro rata basis during the term of the Lease. Landlord shall retain sole discretion to determine, at any time, the payment method with which Tenant must comply. Landlord shall, from month to month, impose upon Tenant whichever option, (1), (2), or (3) above, will maximize Landlord's recovery of all rent due under the Lease during the term of the Lease.

Conclusion

The court's conclusion contains a clear lesson for landlords. They should assume that some courts may apply a bright line rule that makes stub rent an unsecured debt unless the lease specifies that the monthly rent obligation arises ' or could arise ' after the day in the month when the debtor files the bankruptcy petition. Including the type of provision described in the preceding paragraph could help landlords collect rent that was due during the month in which the bankruptcy petition was filed. Carefully crafted provisions could help landlords recover rent due after the petition was filed and before the debtor assumes or rejects the lease.

John B. Spitzer practices law in Pennsylvania, edited several editions of The Fundamentals of Bankruptcy Law, serves on the board of a condominium association, and has worked with bankruptcy attorneys in several states.