The treatment of commercial lease liabilities in chapter 11 cases is a frequent point of contention in commercial bankruptcy proceedings. Landlords and tenants often clash over when (and how much) rent is due when filing for bankruptcy, what the tenant’s cure obligations are upon assignment of an unexpired lease, and a myriad of other issues dependent on the nature of the lease, the debtor, and the property being leased.

Subchapter V chapter 11 cases add another layer of consideration for landlords and tenants faced with a bankruptcy filing: how should the outstanding liabilities under an unexpired lease be treated when determining a debtor’s eligibility to elect Subchapter V treatment?

Before answering that question, it is critical to understand why the answer is important to landlords and tenants alike. Since its inception, Subchapter V of Chapter 11 has been lauded for the benefits it offers to smaller chapter 11 debtors—providing a streamlined path through chapter 11 without many of the costs associated with “traditional” chapter 11 cases[1] . But before a debtor can elect Subchapter V treatment and take advantage of these benefits, the debtor must have less than $7.5 million in total noncontingent, liquidated debts (both secured and unsecured). Debtors in Subchapter V can take advantage of the fact that the absolute priority rule does not apply to their cases, disadvantaging a landlord who may be left holding a mere unsecured claim against a chapter 11 debtor if its lease is rejected during the bankruptcy case.

Thus, for unexpired leases, understanding what does—and doesn’t—count toward this $7.5 million threshold can be outcome determinative, particularly if the debtor’s eligibility for Subchapter V hangs in the balance because it has a long-term lease obligation at the time it files for bankruptcy protection. Specifically, if past due rent is $1,000,000 and remaining rent due under the lease for the balance of the lease term is $8 million, which amount is counted towards the $7.5 million debt limit?

Two courts recently addressed this issue and came to opposite conclusions as to how to treat a debtor-tenant’s outstanding unpaid lease obligations at the time of filing.

Future Lease Liabilities Included as Qualifying Debts: Macedon Consulting

In In re Macedon Consulting, Inc.,[1] the Bankruptcy Court for the Eastern District of Virginia held that all a debtor’s future liability under an unexpired lease is considered noncontingent, liquidated debts subject to the Subchapter V eligibility requirements of section 1182 of the Bankruptcy Code. The Macedon debtor was a tenant under a long-term lease that had nearly $14.4 million in future lease payment liabilities when the debtor filed for bankruptcy protection and elected Subchapter V treatment. Simultaneously, it filed a motion seeking to reject the lease, arguing that the rejection (effective as of the debtor’s bankruptcy filing date) extinguished the debtor’s future liability under the lease and therefore future rent amounts could not be counted as qualifying debts when calculating its Subchapter V eligibility.

The court concluded that the Macedon debtor’s full future liability under its lease controlled the analysis, rather than the Bankruptcy Code’s formula for determining “rejection damages” for a lease that is rejected prior to the conclusion of its term, which in many cases acts as a cap on the total liability a debtor has to its landlord.

Future Lease Liabilities Not Included as Qualifying Debts: Zhang Medical

In In re Zhang Medical P.C.,[2] the Bankruptcy Court for the Southern District of New York responded directly to the Macedon decision, reaching the opposite conclusion on this issue (despite finding that the Debtor did not qualify for Subchapter V on other grounds), holding that a debtor’s future payment obligations under an unexpired lease should rarely, if ever, be counted toward the Subchapter V debt threshold “because of the enormous—and in the Court’s view detrimental—impact that ruling, if followed, would have in limiting eligibility for subchapter V relief.”

Practice Pointers: Know Your Lease, Know Your Rights

The developing case law in this area creates uncertainty as to whether a debtor-tenant will qualify for Subchapter V treatment. While we believe that the Zhang case is better reasoned and more likely to be followed by other courts, the issue is likely to spawn additional future decisions on either side of these analyses.

For landlords: when faced with a chapter 11 filing, due diligence should be performed regarding its tenants’ remaining lease obligations, coupled with an analysis (aided by counsel) regarding the benefits and drawbacks of challenging a debtor-tenant’s Subchapter V election.

For tenants: understanding the particular terms of an unexpired lease, remaining payment obligations, and the potential impact it will have on a Subchapter V election will also be a key piece of due diligence when preparing for a chapter 11 filing, particularly when weighing the likelihood of a dispute over a Subchapter V election against the benefits of Subchapter V.

[1] Case No. 23-10300-KHK (Bankr. E.D. Va., June 14, 2023).

[2] Case No. 23-10678(PB) (Bankr. S.D.N.Y., November 30, 2023).

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