February 3, 2016
Setting the Clock on the Section 502(b)(6) Time vs. Rent Debate
By Justin R. Alberto
The Bankruptcy Code offers a debtor myriad tools to facilitate an effective reorganization. Two of the most fundamental devices include the permissive revaluation of executory contracts and unexpired leases under § 365 and the reconciliation of claims against the estate under § 502. While factually distinct, the intersection of the two sections has sparked a great deal of litigation and academic debate. One particular point of contention centers on the application of § 502(b)(6)’s cap of a landlord’s claim for a bankrupt tenant’s rejection of a nonresidential lease. On April 16, Judge Kevin J. Carey of the U.S. Bankruptcy Court for the District of Delaware issued an opinion in In re Filene’s Basement that should curtail at least a portion of the dispute.
Filene’s Basement historically owned and operated off-price retail stores throughout the country. In November 2011, the company filed a petition under Chapter 11 of the Bankruptcy Code to finalize its affairs and to maximize the value of its real estate for the benefit of creditors.
Prior to the petition date, Filene’s leased retail space in Washington, D.C., pursuant to a lease agreement with Connecticut/ DeSales LLC as landlord.1 In December 2011, Filene’s rejected the lease pursuant to Bankruptcy Code § 365.2 Absent rejection, the lease would have expired on Jan. 31, 2019.3
Following rejection of the lease, the landlord timely filed a proof of claim against Filene’s for, among other things, rejection damages, subject to the Bankruptcy Code § 502(b)(6) cap.4 The landlord calculated the statutorily capped rejection damages as the total rent due for the remaining term multiplied by 15 percent.5 Filene’s objected to the claim on the basis that § 502(b)(6) caps rejection damages at 15 percent of the remaining term of the lease rather than at 15 percent of the remaining rent due under the lease. The difference in the parties’ respective positions represented approximately $105,000.
Pursuant to Bankruptcy Code § 365, a debtor in a bankruptcy proceeding may reject any unexpired lease of nonresidential real property.6 Although the Bankruptcy Code does not specify the standard by which to assess a debtor’s decision to reject a lease, courts typically use a business judgment test and refrain from second guessing the debtor if rejection will benefit the estate.7 If a debtor carries its burden on rejection, the lease is deemed to have been breached, and the debtor is relieved from future performance.8
Under the current Bankruptcy Code, rejection of a lease gives rise to a claim for damages in favor of the landlord. However, much of the debate in this area historically focused on what, if any, aspects of a landlord’s claim should be allowed. For instance, prior to 1934, a landlord’s claim for premature lease termination damages was not recognized as a viable claim, because it was considered purely contingent and incapable of proof.9 As a result, landlords could not recoup any damages for post-termination rent. The 1934 and 1938 amendments rectified that inequity. Pursuant to the amendments, landlords received distributions for future rents, subject to certain limitations that were designed to prevent large unearned rent claims from diluting a debtor’s dividend to unsecured creditors.10 Specifically, landlord claims for future rent in liquidation cases were capped at “the year next succeeding” surrender or reentry.11 Similarly, claims by landlords in rehabilitation cases were capped at “the three years next succeeding” surrender or reentry.12
The reasoning behind the lease rejection da
The Bankruptcy Code offers a debtor myriad tools to facilitate an effective reorganization. Two of the most fundamental devices include the permissive revaluation of executory contracts and unexpired leases under § 365 and the reconciliation of claims against the estate under § 502. While factually distinct, the intersection of the two sections has sparked a great deal of litigation and academic debate. One particular point of contention centers on the application of § 502(b)(6)’s cap of a landlord’s claim for a bankrupt tenant’s rejection of a nonresidential lease. On April 16, Judge Kevin J. Carey of the U.S. Bankruptcy Court for the District of Delaware issued an opinion in In re Filene’s Basement that should curtail at least a portion of the dispute.
Background
Filene’s Basement historically owned and operated off-price retail stores throughout the country. In November 2011, the company filed a petition under Chapter 11 of the Bankruptcy Code to finalize its affairs and to maximize the value of its real estate for the benefit of creditors.
Prior to the petition date, Filene’s leased retail space in Washington, D.C., pursuant to a lease agreement with Connecticut/ DeSales LLC as landlord.1 In December 2011, Filene’s rejected the lease pursuant to Bankruptcy Code § 365.2 Absent rejection, the lease would have expired on Jan. 31, 2019.3
Following rejection of the lease, the landlord timely filed a proof of claim against Filene’s for, among other things, rejection damages, subject to the Bankruptcy Code § 502(b)(6) cap.4 The landlord calculated the statutorily capped rejection damages as the total rent due for the remaining term multiplied by 15 percent.5 Filene’s objected to the claim on the basis that § 502(b)(6) caps rejection damages at 15 percent of the remaining term of the lease rather than at 15 percent of the remaining rent due under the lease. The difference in the parties’ respective positions represented approximately $105,000.
Bankruptcy Code § 502
Pursuant to Bankruptcy Code § 365, a debtor in a bankruptcy proceeding may reject any unexpired lease of nonresidential real property.6 Although the Bankruptcy Code does not specify the standard by which to assess a debtor’s decision to reject a lease, courts typically use a business judgment test and refrain from second guessing the debtor if rejection will benefit the estate.7 If a debtor carries its burden on rejection, the lease is deemed to have been breached, and the debtor is relieved from future performance.8
Under the current Bankruptcy Code, rejection of a lease gives rise to a claim for damages in favor of the landlord. However, much of the debate in this area historically focused on what, if any, aspects of a landlord’s claim should be allowed. For instance, prior to 1934, a landlord’s claim for premature lease termination damages was not recognized as a viable claim, because it was considered purely contingent and incapable of proof.9 As a result, landlords could not recoup any damages for post-termination rent. The 1934 and 1938 amendments rectified that inequity. Pursuant to the amendments, landlords received distributions for future rents, subject to certain limitations that were designed to prevent large unearned rent claims from diluting a debtor’s dividend to unsecured creditors.10 Specifically, landlord claims for future rent in liquidation cases were capped at “the year next succeeding” surrender or reentry.11 Similarly, claims by landlords in rehabilitation cases were capped at “the three years next succeeding” surrender or reentry.12
The reasoning behind the lease rejection da