Lease Damage Claim: Federal or State Law – Flip A Coin?

Broadfoot v. Jamestown Mgmt. Corp. (In re Int’l BioChemical Indus., Inc.), 521 B.R. 395 (Bankr. N.D. Ga. 2014) –

A chapter 7 trustee objected to the claim of a creditor/lessor on the basis that it should be disallowed because the lessor failed to turn over property recoverable using the trustee’s voiding powers, or alternatively, that it constituted a claim for lease termination damages that was subject to a cap.

In December 2000 the debtor stopped paying rent and vacated the leased premises.  In January 2001 the landlord obtained a default judgment awarding it a writ of possession and delinquent rent for December and January.

When the landlord was unable to re-let the premises, it went back into court in December 2001 to recover unpaid rent, late fees and attorney fees.  The debtor objected that the lease had been terminated and appealed the judgment in the landlord’s favor.  On appeal a state court confirmed that the lease had not been terminated, and thus the landlord was entitled to the judgment.

In October 2003 the landlord obtained a judgment awarding ~$3.1 million consisting of ~$2.8 million for unpaid rent from February 2001 to October 2003 and ~$300,000 for attorney fees.  The landlord recorded its judgment in the U.S. Patent and Trademark Office against certain patents that had been owned by the debtor.  However, by the time the landlord recorded its judgment the debtor had transferred its interest to another party.

The debtor filed bankruptcy in 2004.  In 2006 the chapter 7 trustee successfully took action to recover the debtor’s interests in the patents.  The landlord filed first an unsecured claim, and then a secured claim for around $3.3 million.

The trustee’s first objection was that the entire claim should be disallowed.  Although the landlord asserted a secured claim based on the judgments recorded against the patents, that lien could be avoided because the debtor did not have any interest in the patents at the time that the judgments were recorded.  Under Section 502(d) of the Bankruptcy Code, a court is directed to disallow a claim of an entity if property can be recovered from that entity using the trustee’s avoidance powers unless the entity “has paid the amount or turned over any such property.”

The landlord conceded that to the extent the debtor transferred its interest in the patents before the judgment was recorded, it did not acquire a lien.  Consequently, at a hearing on the matter, the landlord agreed to give up its lien.  The trustee contended that this was too little too late.  However, the court noted that there was no deadline for action, and since the landlord in effect had turned over the property at issue, its claim should not be disallowed under Section 502(d).

The trustee next argued that the claim should be reduced under Section 502(b)(6), which provides that a claim should be limited to the extent it exceeds a cap (emphasis added):

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,  acceleration, on the earlier of such dates;

Since the cap applies only to damages from termination and state courts had determined that the lease had not been terminated by the landlord’s repossession, the trustee argued that the deemed rejection of the lease under Section 365(d) of the Bankruptcy Code that occurred when the trustee failed to assume the lease was the equivalent of termination.

The Bankruptcy Code provides that rejection constitutes a breach of the lease.  The court acknowledged that there are differing views on whether breach and termination are equivalent.  However, the court did not need to reach this issue.  Since the landlord’s claim was for rent due from 2001 to 2003, its claim could not be for damages resulting from termination in 2004.

However, the court raised the question of whether “termination” should be determined solely under state law (as is typically the case for defining property rights in bankruptcy) or whether the term could be slightly broader for purposes of Section 502(b)(6).  The court was persuaded by an argument that relying solely on state law would allow a landlord to avoid the cap by simply not terminating the lease.  This could lead to a result where an accelerated rent claim could “swallow the assets” available for distribution.

Congress included the cap to provide a balance between the policy of equality of distribution and the adverse consequences of allowing prospective damage claims from a long term lease to swamp the claims of general unsecured creditors.  In fact, in this case the landlord’s claim was for ~five years of base rent, which was 77% of the total claims filed.

The court decided that the proper test for termination would be termination under state law or when “there is an uncured breach of a lease coupled with an intentional abandonment of the premises to the landlord, similar to rejection under §365 of the Bankruptcy Code when the tenant itself is in bankruptcy.”  This allows Section 502(b)(6) to be implemented “in the way it was intended – to limit large claims for rent or related damages that arise after the beneficial interest in the premises has shifted in its entirety from the lessee to the landlord – while also serving the fundamental bankruptcy purpose of equality of distribution.”  So, the court concluded that the lease was de facto terminated when the landlord obtained a writ of possession after the debtor vacated the premises.

The next question was the date “the lessor repossessed or the lessee surrendered the property.”  A landlord’s claim includes unpaid rents through that date, and prospective rents after that date subject to the cap.  Once again, the question was whether “surrender” and “repossession” should be interpreted under state law.

Under applicable state law (as in many states) surrender by a tenant required acceptance by the landlord.  While noting the majority view that these terms should be construed under state law, and the counter view that there can be a different result in bankruptcy, the court did not reach the issue in this case.

Apparently when the debtor vacated the premises it left some property behind.  So the date of repossession by the landlord, which was not in dispute, was the relevant date.  This meant that the cap was calculated based on a January 2001 date, which resulted in a substantial reduction of the landlord’s claim.

Section 502(b)(6) (originally Section 502(b)(7)) has been around for more than 35 years.  It is mildly surprising that there is still so much left to argue about.

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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