New York bankruptcy court breaks with precedent and endorses time approach for calculating lease termination damages over rent amount approach, resulting in smaller claims for landlords.
- Time approach limits, and often eliminates, landlord bargained-for rights to rent escalations over the lease term when calculating termination damage claims.
- A lease is “functionally dead” and terminated for damage calculation purposes when a debtor-tenant vacates the premises.
- The cap on “rent reserved” does not include costs for store cleanup, mechanic’s liens, and window repairs because they are not fixed, regular or periodic charges under a lease.
When a lease is rejected in bankruptcy, the lease is breached, thereby enabling the non-debtor landlord to terminate the lease and file a proof of claim for damages largely as an unsecured claim. The same is true when a lease with a non-debtor, that is guaranteed by a debtor, is terminated outside of bankruptcy. Under state law, that damage claim is largely for future rent for the remaining lease term. Huge landlord lease termination claims, however, would dilute recoveries for other unsecured creditors. To balance the interests of landlords and other unsecured creditors, section 502(b)(6) of the Bankruptcy Code caps a landlord’s lease termination damages claim at the rent “reserved by” the lease, without acceleration, “for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease ....”
The meaning of the above italicized language on the cap for future rent has been debated for years, with courts applying two different approaches:
- The “time approach” caps the claim at the rent reserved under the lease for a specified time period, the next 15 percent of the remaining lease term, so long as that time period is at least one year and no more than three years.
- The “rent approach” caps the claim at 15 percent of the total dollar amount of the rent that would be payable for the entire remaining lease term, so long as that amount is at least equal to the rent reserved for one year and does not exceed the rent reserved for the next three years of the lease term.
By way of example, assume a lease with a remaining term of 10 years and the following annual rent: (i) remaining years 1-3, $100,000 ($300,000 total); (ii) remaining years 4-6, $200,000 ($600,000 total); and (iii) remaining years 7-10, $400,000 ($1,600,000 total), for a grand total of $2,500,000 for the entire remaining 10 years. Applying the two approaches:
- Under the time approach, the cap would be $150,000, calculated as the rent coming due over the next 15% of the remaining term (1.5 years), not to exceed the next three years of rent ($300,000).
- Under the rent approach, the cap would be $300,000, calculated as 15% of $2,500,000 ($375,000) not to exceed the next three years of rent ($300,000).
Historically, bankruptcy courts in New York’s southern district applied the rent approach, but in In re Cortlandt Liquidation LLC et al., No. 20-12097 (MEW), 2023 WL 1483783 (Bankr. S.D.N.Y. Feb. 2, 2023), the court departed from precedent and endorsed the time approach.
In 2020, Century 21 Department Stores LLC (a big box discount retailer) and certain affiliates filed for bankruptcy due to COVID-19-related store closures. Before the bankruptcy, Century 21 guaranteed the obligations of certain non-debtor affiliated tenants, under leases with two landlords. The tenants defaulted on their leases and vacated their premises. Although the tenants were not in bankruptcy, the guarantor, Century 21, was. Under the rent approach, the landlords’ allowed termination claims collectively totaled about $17 million; under the time approach, the landlords’ claims were about $2 million less.
Before addressing the amount of the cap, the court determined that (i) section 502(b)(6) applied to limit damages against the debtor-guarantor even though the tenants were not in bankruptcy, and (ii) the leases were terminated (even though not rejected) because a lease is “functionally dead” when a tenant vacates the premises even if not technically terminated under state law.
Historically, the majority view of bankruptcy courts across the country favored the rent approach. More recently, the pendulum has swung in favor of the time approach. These courts have found that the “plain language” of the statute favors a time approach and is more consistent with legislative history. Absent controlling circuit court precedent, the Cortland court broke with other bankruptcy court decisions in its judicial district, holding that the time approach governs the calculation of termination damages under section 502(b)(6).
What Is “Rent”?
Besides endorsing the time approach, the court settled whether additional damages asserted by a landlord for store cleanup, mechanic’s liens, and window and other repairs are “rent reserved” and limited by section 502(b)(6).
“Rent reserved” is a charge that (i) is designated “rent” or “additional rent” or imposes obligations on a tenant, (ii) relates to the value of the property or the lease, and (iii) is properly classified as rent because it is a fixed, regular or periodic charge. The court concluded that future rent damages subject to the section 502(b)(6) cap do not include damages that are not fixed, regular or periodic charges, such as an obligation to leave the premises broom-clean on termination of the lease.
Finding that the determination of what damages constitute rent reserved under the statute is a factual issue, the court did not rule on the total amount of the landlords’ claims, and instead directed the parties to negotiate all open issues before scheduling an evidentiary hearing.
The Cortlandt decision is not binding authority. As a result, which approach applies to limit a landlord’s lease termination claim remains unsettled, even in the Southern District of New York. Still, filing for chapter 11 in a district that will likely apply the time approach could reduce unsecured landlord lease termination claims by millions of dollars compared to the rent approach, freeing up funds to negotiate with and pay other unsecured creditors. Until uniformity throughout the country is achieved, the time-rent debate could constitute yet another consideration for debtors with multiple venue choices for a chapter 11.