Lease Rejection Damages: How to Avoid the Cap (Maybe)

In re Energy Conversion Devices, Inc., 483 B.R. 119 (Bankr. E.D. Mich. 2012) –

Damages arising from the rejection of a lease by a tenant in bankruptcy are subject to a cap under Section 502(b)(6) of the Bankruptcy Code.  In this case the landlord managed to find a way to characterize part of its claim so that it was not subject to the cap.

Section 502(b)(6) provides that a claim will be disallowed to the extent that:

(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds –

(A)       the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease, following the earlier of –

    (i)         the date of the filing of the petition; and

    (ii)        the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus

  (B)       any unpaid rent due under such lease, without acceleration, on the earlier of such dates.

In addition to asserting a claim for prepetition rent and a Section 502(b) claim equal to one year’s rent, the landlord asserted an “Additional Damages Claim” for the costs of removing equipment and other personal property of the tenant, and for various other items, including damage to the roof, parking lot and HVAC system, environmental damage and liabilities, and other costs for restoring the property to the condition required by the lease.

The court noted a split in case law regarding the scope of claims subject to the cap:

  • The bankruptcy trustee relied on cases holding that a debtor’s rejection of a lease constitutes a breach of all of the covenants, so that all damage claims are subject to the cap.
  • In contrast, the landlord argued for a narrower reading that the cap applies only to those claims arising as a result of lease termination.  Under the narrower view, the cap would not apply to claims that the landlord would have even if the tenant assumed rather than rejected the lease.

In analyzing the issues, the ECD court quoted extensively from a Ninth Circuit case, In re El Toro Materials Co., Inc., 504 F.3d 978 (9th Cir. 2007).  That case provided an interesting history of this section.  Prior to 1934, landlords were not able to recover for future lease payments because they were considered contingent and not provable in bankruptcy.  However, the Great Depression created pressure for change after it led to a number of bankruptcies that left landlords with broken leases and empty buildings, and no way to recover from the former tenants.  The Bankruptcy Act of 1934 balanced (i) the interest in allowing a landlord to claim lost rent in order to reduce the harm done by a breach against (ii) “extravagant” claims that could deplete the estate to the detriment of other creditors by allowing a claim for back rent to the date of abandonment plus damages no greater than one year of future rent.  When the Bankruptcy Act was overhauled in 1978, existing law was carried forward.

The Ninth Circuit analyzed the scope of the cap as follows:  The structure of the cap, which is measured as a fraction of the remaining term and refers to damages “resulting from” lease termination, suggests that damages other than those based on the loss of future income are not subject to the cap.

Further, extending the cap to cover collateral damage to the premises would allow a post-petition but pre-rejection tenant to cause any amount of damage to the premises – either negligently or intentionally – without fear of liability beyond the cap.  If the tenant’s debt to the landlord already exceeded the cap then there would be no deterrence against even the most flagrant acts in violation of the lease, possibly even to the point of the tenant burning down the property in a fit of pique.  Absent clear statutory language supporting such an absurd result, we cannot suppose that Congress intended such an absurd result.

Based on this and other similar analyses, the ECD court adopted the narrower view and allowed the landlord to proceed with its “Additional Damages Claim” without regard to the cap.

There are merits to both sides of the argument.  However, the test offered for distinguishing between those claims subject to the cap and claims for collateral damage that are not is far from a bright line.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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