Landlord Lease Claims: Avoiding the Statutory Cap – Round 1

In re Denali Family Services, 506 B.R. 783 (Bankr. D. Alaska 2014) –

The debtor objected to an amended proof of claim filed by its landlord after the debtor, arguing that the claim exceeded the statutory limit under Section 502(b)(6) of the Bankruptcy Code. In response, the landlord amended its claim to include additional items.

The debtor leased a building to operate a day care center that was previously used as a retail/wholesale warehouse (and a bingo parlor). The lease provided for monthly rent payments. It also required the debtor to pay tenant improvement costs in excess of $400,000 over five years at 6% interest as additional monthly rent.

Section 502(b)(6) provides (emphasis added) that a claim is allowed except to the extent that:

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%, 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.

After the debtor rejected the lease, the landlord filed an amended proof of claim for ~$1.5 million, including claims for (1) future rent allowed under Section 502(b)(6), (2) the unpaid excess tenant improvement costs, (3) real property tax obligations, (4) anticipated real estate commission for securing a new tenant, and (5) the costs of making the property suitable for a new tenant.

According to the debtor, the claim should have been $480,000. The debtor accepted the claim for 15 months future rent under Section 502(b)(6), the real property taxes, and unpaid prepetition rent, but objected to the rest of the claim.

In response, the landlord argued that, in addition to the rent allowed subject to the statutory cap, it should be allowed to recover the entire amount of unpaid excess tenant improvement costs, future real estate commission, remodeling costs, attorney fees, and utilities because these items fell outside the cap. Alternatively, if the tenant improvement allowance and utilities were within the cap, it should be entitled to those amounts for 15 months. After adding projected utility expenses, the landlord increased its claim to ~$1.74 million.

The first issue was whether the claim was for damages resulting from termination of the lease. (Cases typically analyze rejection of a lease as the equivalent of termination.) Under 9th Circuit precedent, this question is framed as: “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?”

The landlord argued that this should be read narrowly to cover only future rental income, which would be appropriate since the landlord has an ability to mitigate damages by re-leasing the premises. However, the bankruptcy court disagreed, concluding that the damages subject to the cap included not only rent but also damages directly arising from the failure to complete the lease.

In particular, if the debtor had assumed the lease, the landlord would have no claims for rent, the excess tenant improvement expenses, or utilities, since those claims would have been paid during performance under the lease. Similarly, the debtor would not have been liable for a real estate commission for locating a future tenant if it had performed under the lease. Thus, all of these claims were subject to the cap.

The bulk of the claim – $800,000 – related to the anticipated costs of remodeling the property. The landlord presented expert testimony that the unique configuration as a day care center with numerous classrooms and accommodations for children limited the market for the space. The expert estimated that it would cost $100,000 – $120,000 to remove the existing improvements, and an additional $500,000 – $600,000 to restore the premises to a large retail/warehouse space (with the work estimated to take four to eight months.)

Turning to the lease, the court acknowledged that it gave the landlord a right to require the tenant to either leave or remove tenant improvements at the end of the lease. However, there was nothing in the lease that would require the tenant to restore the property to a condition suitable for a retail/warehouse use. Consequently, the court allowed $110,000 for removing and repairing tenant improvements, but did not allow any claim for remodeling the premises.

The next question was the meaning of “rent reserved” for purposes of calculating the cap. The court applied a three-part test for this determination: (1) the charge must be designated as rent as the tenant’s obligation in the lease, (2) the charge must be related to the value of the property or lease, and (3) the charge must be properly classified as rent because it is a “fixed, regular or periodic charge.”

In this case, the obligation to repay the excess tenant improvement expenses met all three requirements. Consequently those payments were rent reserved and recoverable by the landlord subject to the cap. However, the future utility payments, although classified as additional rent, related to occupancy and use of the property rather than its value and did not constitute a fixed, regular or periodic charge. Consequently the utility claim was not rent reserved, and disallowed.

In summary, the landlord was allowed a claim of ~$650,000 consisting of past due pre-petition rent, 15 months of future rent, property taxes, 15 months of excess tenant improvement expense payments, and the cost to remove tenant improvements. (A claim relating to attorney’s fees was reserved for later consideration.)

It can be difficult to predict whether a particular obligation related to leased premises will be allowed subject to the cap, allowed without regard to the cap, or disallowed. As illustrated by this case, the terms of the lease can be critical. If this lease had required the tenant to restore the premises to a particular configuration at the end of the lease term, the landlord’s claim could have been significantly higher. This is worth keeping in mind when negotiating leases and considering whether it is worth fighting over a particular provision.

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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