Landlord Debtor: The Cost of Rejection

In re Lake Dearborn, LLC, 534 B. R. 747 (Bankr. N.D. Ill. 2015) –

A landlord debtor sought to reject unexpired food court leases, giving rise to tenant claims for rejection damages. The court was asked to determine the amount of damages for a number of the tenants.

In a Chapter 11 bankruptcy the debtor may choose to assume or reject a lease. Under Section 365(h) of the Bankruptcy Code, if a debtor landlord rejects a lease, the tenant has an option to either (1) retain possession subject to certain conditions, or (2) treat the lease as terminated, vacate without liability for future rent and assert a claim for damages resulting from the landlord’s deemed breach.

In this case about 7 or 8 months after the landlord filed bankruptcy, it committed to sell the property that contained the food court space. The purchaser was a developer that planned to tear down the building and replace it with a high rise with hotel and apartment units.

In connection with the proposed sale, the debtor filed a motion to reject 18 unexpired food court leases, with the purchaser obligated to pay for any rejection damages or termination fees. The court approved the rejection motion. Several tenants remained in possession of their premises after the effective date of the lease rejections, some without paying rent.

A few months later the court closed the Chapter 11 cases of the landlord and its affiliates. Six months after that the court reopened the landlord’s case for the limited purpose of determining damage claims from the rejection of the food court leases. The tenants were given an opportunity to either file a proof of claim for damages or give notice that they intended to retain possessory rights. Nine of the 18 tenants filed timely proofs of claim that there were not resolved.

As background, the court noted that, while a debtor can reject a lease to mitigate the unfavorable economic lease consequences, this does not mean that the lease is canceled. The court further noted that there is no Bankruptcy Code provision authorizing a debtor landlord to avoid or strip off an unwanted lease. If the landlord rejects a lease and the tenant does not elect to continue in possession, the landlord is treated as breaching the lease prepetition. In that case, the tenant can generally recover:

such damages as may be fairly and reasonably be considered as naturally arising from the breach thereof, in light of the facts known or which should have been known, or such as may reasonably be supposed to have been within the contemplation of the parties as a probable result of a breach thereof.

However: “Speculative damages or damages not the proximate result of the breach of contract will not be allowed.”

The tenants generally argued that their damages should include relocation costs includng:

(1) full build-out costs of and equipment relocation to a new location;

(2) replacement rent for the balance of the original lease term; and

(3) advertising and promotion for a new location.

Some tenants also sought return of their security deposit and attorneys’ fees.

In response the purchaser argued that the tenants could not recover any damages because their failure to pay rent resulted in termination of the lease on account of their defaults.

Alternatively it claimed that the tenants were seeking a windfall and their claims must be limited to actual damages as determined based on the leases and applicable state law. For leases with a 2 year early termination option, the purchaser argued that any damages should be limited to 2 years.

Additional limitations the purchaser advanced included: (1) in most cases market rent was lower than rent under the lease, so tenants were not entitled to any replacement rent, (2) new build-out costs should be prorated over their useful life, (3) tenants should not be able to recover build-out costs at both the food court and new locations, (4) security deposits should be applied to unpaid rent and rejection damages reduced by unpaid rent, (5) tenants were not entitled to attorneys’ fees since neither the leases nor applicable law authorized the fees, and (6) the tenants made little or no profit, undermining the claim for lost profits.

The purchaser provided an expert witness from CBRE to establish fair market rent and buildout costs. Unfortunately for the plaintiff, the court did not find the expert persuasive. It characterized the expert’s inspection of the properties as cursory, commented that he appeared confused as to the location of some of the comparable food court properties, incorrectly identified one of the comparable food courts as located on the street level as opposed to a lower concourse level, and did not cite any learned treatises.

The expert also failed to realize that he had what was probably a disqualifying conflict of interest since CBRE was involved with management of the property until it came to his attention during his deposition. Consequently, the court discounted the proffered testimony on market rental rates and build-out costs.

Another major factor in the court’s decision was its finding that the purchaser and debtor violated the implied covenant of good faith and fair dealing. Under applicable state law all contracts include such an implied duty, which among other things “requires a party vested with contractual discretion to exercise it reasonably, and further he may not do so arbitrarily, capriciously, or in a manner inconsistent with reasonable expectations of parties.” The implied covenant of good faith further has been interpreted as a “promise to do nothing which will destroy or injure the other party’s right to receive the fruits of the contract.”

This was an issue raised sua sponte by the court based on the timing of the bankruptcy filing vs. execution of the leases:

  • 6 of the 9 claimants entered into at least 5 year leases after the landlord filed for bankruptcy.
  • All of them entered into leases less than 2 years before the landlord sought rejection so that some had between 8 and 18 years remaining on their leases.

In the most egregious example, the landlord executed a new 5 year lease on March 25 (the day before it entered into a commitment with the purchaser) for a term beginning May 1. At that time it knew that the purchaser’s plan from the beginning was to tear down and redevelop the property. In fact, this tenant received a notice of termination of his lease around May 30, less than a month after the term began.

Neither the debtor landlord nor the purchaser exercised the two-year termination option under any of the leases. Instead, the purchaser offered new two-year leases with a 30 day cancellation clause. The purchaser’s goal was to be able to terminate a lease on short notice as soon as it obtained the required zoning approvals.

It appears that the court included this discussion to set the stage for its determination of what was reasonably foreseeable at the time the leases were executed.

Turning to the specifics of the claims, the court rejected the purchaser’s argument that damages should be limited to 2 years based on the early termination clauses on the basis that those clauses were never triggered. Citing the Restatement (Second) of Property, the court noted that damages could include pre-rejection tenant expenditures that the landlord could reasonably have foreseen at the time a lease was executed, reasonable relocation costs, and loss of anticipated profits.

The court found that the tenants provided sufficient evidence to support their estimates of necessary buildout costs and moving costs (including equipment relocation and marketing and advertising for the new space), as well as replacement rent differential for the remainder of their leases. The court also approved claims based on a prorated portion of the leasehold improvements made to the food court space as reasonable given that they were able to occupy the space less than 2 years before rejection, and said the landlord and purchaser would be liable for any proven lost profits.

On the other hand the court did not approve “losses due to ‘down-time’, ‘ramp-up’, ‘time expended’ and retraining of employees” since the court did not view these losses as reasonably arising from the rejection or contemplated by the parties as a probable result of rejection. The tenants were also held responsible for payment of rent during the time that they continued to occupy the leased premises after rejection.

In approving a fairly expansive scope of damages the court was probably influenced by its view that the landlord and purchaser did not act in good faith. In discussing the types of damages that might be available as outlined in the Restatement, the court made a comment that this was “absent a valid agreement as to the measure of damages.” Although it is not unusual to see a lease that does not address damages for a landlord breach, a landlord might benefit from a carefully crafted provision in order to limit its exposure in circumstances such as this.

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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