New York Bankruptcy Court Breaks from Precedent in Ruling that "Time Approach" Should Be Used to Calculate Landlord's Claim for Lease Termination Damages
To prevent landlords under long-term real property leases from reaping a windfall for future rent claims at the expense of other creditors, the Bankruptcy Code caps the amount of a landlord's claim against a debtor-tenant for damages "resulting from the termination" of a real property lease. Unfortunately, the language of the provision of the Bankruptcy Code—section 502(b)(6)—that specifies the maximum allowed amount of a landlord's claim for lease termination damages is confusing and has led to a disagreement among bankruptcy courts regarding the proper way to calculate the amount of the statutory cap.
Two approaches on this issue generally have been employed by the courts—the "Time Approach" (the majority view) and the "Rent Approach"—the latter of which is more favorable to landlords under long-term leases containing rent escalation clauses because it takes the rent escalations into account when calculating the capped amount of a landlord's claim. The Time Approach, by contrast, calculates the capped amount based on the rent reserved for the time period beginning at lease termination.
The U.S. Bankruptcy Court for the Southern District of New York recently considered which of these approaches should apply in In re Cortlandt Liquidating LLC, 648 B.R. 137 (Bankr. S.D.N.Y. 2023). The court held that, based on the plain language of section 502(b)(6), its legislative history, and other recent rulings considering the question, the Time Approach represented "the correct view." In so ruling, the bankruptcy court departed from previous bankruptcy court rulings in the Southern District of New York applying the Rent Approach.
Statutory Cap on Landlord Future Rent Claims
Section 502(b)(6) of the Bankruptcy Code provides that the maximum allowable amount of the claim of a lessor for damages resulting from the termination of a lease of real property is limited to:
(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, 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, without acceleration, on the earlier of such dates.
11 U.S.C. § 502(b)(6) (emphasis added). The purpose of this rent cap is to balance the interests of landlords and other unsecured creditors by allowing a landlord "to receive compensation for losses suffered from a lease termination while not permitting a claim so large as to prevent general unsecured creditors from recovering from the estate." Solow v. PPI Enterprises, Inc. (In re PPI Enterprises (U.S.), Inc.), 324 F.3d 197 (3d Cir. 2003); see generally Collier on Bankruptcy ("Collier") ¶ 502.03[7][a] (16th ed. 2023). The scope of section 502(b)(6) is limited to lease terminations. Lease damages claims for items such as physical damages to the premises are not subject to the cap. See Kupfer v. Salma (In re Kupfer), 852 F.3d 853 (9th Cir. 2016); Saddleback Valley Cmty. Church v. El Toro Materials Co. (In re El Toro Materials Co.), 504 F.3d 978 (9th Cir. 2007).
The language of section 502(b)(6)(A) that is italicized above has long been a source of consternation among the courts, largely because its perceived ambiguity has created confusion over how it should be applied. See "Final Report and Recommendations of the American Bankruptcy Institute Commission to Study the Reform of Chapter 11" (2014) V.A.6, p. 135 (noting that "many courts have confused or misapplied the formula and that, simply stated, the cap should be the rent reserved under the lease for the greater of (i) one year and (ii) the shorter of 15 percent of the remaining term and three years, plus unpaid rents").
Courts have applied two competing approaches to determining the maximum allowable amount of a landlord's lease termination claim—the Rent Approach and the Time Approach.
The focus of the Rent Approach is on the dollar amount of rent payable for the entire remaining lease term. According to the Rent Approach, section 502(b)(6) imposes a cap equal to 15% of that amount, provided that it is at least equal to the rent reserved under the lease for one year and does not exceed the rent reserved for the next three years of the lease term. See In re Financial News Network, Inc., 149 B.R. 348, 351 (Bankr. S.D.N.Y. 1993) (applying the Rent Approach without any discussion of the Time Approach); In re Andover Togs, Inc., 231 B.R. 521, 547 (Bankr. S.D.N.Y. 1999) (holding that the Rent Approach is the "logically sounder" approach); In re Rock & Republic Enterprises, 2011 WL 2471000, *20 (Bankr. S.D.N.Y. 2011) (declining to depart from the precedents set in Financial News and Andover and ruling that the Rent Approach should govern).
The Time Approach, by contrast, is anchored to the remaining term of the lease, not the remaining rent payable. According to this approach, section 502(b)(6) imposes a cap equal to the rent reserved under the lease for the time period beginning at lease termination equal to 15% of the remaining lease term, provided that time period is at least one year and no more than three years. See In re Keane, 2020 WL 612296, *2 (Bankr. E.D.N.C. Oct. 14, 2020); In re Filene's Basement, LLC, 2015 WL 1806347, *7 (Bankr. D. Del. Apr. 16, 2015); In re Denali Family Servs., 506 B.R. 73, 83 (Bankr. D. Alaska 2014); In re Shane Co., 464 B.R. 32, 39 (Bankr. D. Col. 2012). The Time Approach would appear to be the majority view among courts that have recently considered the question. See Collier at ¶ 502.03[7][c] (citing cases and noting that the Rent Approach "does not appear to be in accord with the language of the statute").
Because many real property leases contain rent-escalation clauses during the latter stages of the lease, the Time Approach does not take such escalations into account when computing the maximum amount of the landlord's claim, whereas the Rent Approach does, thereby resulting in a higher cap on the landlord's lease‑termination claim. See Collier at ¶ 502.06[7][c] ("The choice of methodology will make a difference only where the remaining rent under the lease is not constant. If the rent is increasing over the remaining term, the latter methodology will impose a lower limit, favoring the estate. If the rent is decreasing, the latter methodology will favor the landlord. If the rent is variable, it will depend on when in the lease the termination occurs.").
Cortlandt Liquidating
On September 10, 2020, Century 21 Department Stores LLC ("Century 21") and certain affiliates filed for chapter 11 protection in the Southern District of New York. The bankruptcy court confirmed a liquidating chapter 11 plan for Century 21 and its affiliates—thereafter known as Cortlandt Liquidating, LLC (the "debtors")—on April 26, 2021. Pursuant to the liquidating plan, many of the real property leases for the debtors' stores were rejected under section 365 of the Bankruptcy Code.
The court-appointed administrator of the debtors' liquidating chapter 11 plan objected to the claims of various real property landlords with respect to Century 21 store locations, including Lincoln Triangle Commercial Holding Co. LLC ("Lincoln") and AAC Cross County Mall, LLC (together with Lincoln, the "landlords"), for damages arising from the termination of their leases. Even after extensive discussions, the plan administrator and the landlords could not agree on the proper calculation of the lease termination claims under section 502(b)(6). The plan administrator argued that the damages should be calculated under the Time Approach, whereas the landlords claimed that the Rent Approach should be used.
The parties also disagreed over: (i) whether certain maintenance and repair claims arose from the lease terminations and were therefore subject to the section 506(b)(6) cap; and (ii) the manner in which projected future rent assumptions for real estate taxes and operating expense escalations should be calculated to determine the "rent reserved" under the leases.
The Bankruptcy Court's Ruling
The bankruptcy court ruled in favor of the plan administrator on the question of the proper approach for calculating the statutory cap. U.S. Bankruptcy Judge Michael E. Wiles wrote that he did not "lightly depart" from precedent to the contrary in Financial News, Andover, and Rock & Republic, but that "I am convinced that the Time Approach represents the correct view." Cortlandt Liquidating, 648 B.R. at 141.
"First and most importantly," he explained, the plain language of section 502(b)(6) "makes clear that the Time Approach is the correct one" because the entire phrase "for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease" is "worded in periods of time" rather than the dollar amount of rent. If lawmakers had intended the Rent Approach to apply, Judge Wiles noted, section 502(b)(6) "would have stated that the allowable rejection damages would not exceed '15 percent of the rent reserved for the remaining term of such lease, provided that such amount will not be less than the rent reserved for the next year of the lease term, and shall not be more than the rent reserved for the next three years of the lease term.'" Id. According to Judge Wiles, those are not the words of section 502(b)(6), "and they cannot reasonably be derived from the language that does appear." Id.
Next, Judge Wiles explained that the Time Approach is supported by the legislative history of section 502(b)(6), which indicates that, in enacting the provision in 1978 (then designated as section 502(b)(7)), lawmakers did not clearly express the intention to change from the Time Approach employed in cases under the former Bankruptcy Act to a "total rent"-based formula. Id. at 142-43 (citing Filene's, 2015 WL 1806347, at *6; In re Connectix Corp., 372 B.R. 488, 493-94 (Bankr. N.D. Cal. 2007)).
Judge Wiles disagreed with courts that have ruled that: (i) considerations of equity or fairness favor the Rent Approach over the Time Approach; and (ii) the former better implements lawmakers' intent or the purposes of section 502(b)(6). According to the judge, the plain intent of section 502(b)(6) was to limit landlords' claims and to "strike a balance between the interests of landlords and the interests of other creditors." However, he emphasized,"[i]dentifying that general intent is of no help in deciding whether Congress intended that the Rent Approach or the Time Approach would be used." Id. at 143. Judge Wiles further noted that considerations of fairness and equity are not instructive in determining which approach should be employed.
The bankruptcy court accordingly ruled that, in accordance with the Time Approach, the section 502(b)(6) cap with respect to the landlords should be "calculated by reference to the rents reserved under the relevant leases for the first 15% of the remaining lease terms, provided, that such amounts shall not be less than the rents reserved for the first remaining year of the relevant lease terms, and shall not be greater than the rents reserved for the first three remaining years of the relevant lease terms." Id. at 144.
Finally, addressing the remaining disputes before him, Judge Wiles held that: (i) because "the statutory cap applies only to damages that are attributable to the fact that the term of the lease has come to an end," the store cleanup costs incurred by Lincoln were subject to the cap because they arose from the termination of its lease; (ii) Lincoln's claim for mechanic's liens placed on the leased premises by unpaid contractors engaged by Century 21 was not subject to the cap because "any damages associated with mechanic's liens plainly would have existed regardless of whether the lease was terminated"; (iii) Lincoln's claim for repairs required under the terms of its lease did not arise from the termination of the lease and was not subject to the cap; and (iv) although real estate taxes and certain operating expenses were properly included in calculating the "rent reserved" under Lincoln's lease as well as the amount of the section 502(b)(6) cap, the absence of certain facts regarding projected future rent assumptions precluded the court from ruling on that issue.
Outlook
In Cortlandt Liquidating, the bankruptcy court determined that the plain language of section 502(b)(6) dictated the use of the Time Approach in calculating the cap on a landlord's lease termination claim. Court rulings to the contrary in the Southern District of New York and elsewhere, however, suggest that the approach required by the provision may be less clear cut. Despite the pendulum swing toward the Time Approach in recent decisions, the debate likely will continue until appellate guidance or legislative action clarifies the issue.
Until then, the key takeaway from Cortlandt Liquidating is that parties to real property leases should know which approach has been adopted by the bankruptcy courts in a district where the debtor-tenant files (or is likely to file) for bankruptcy—but even then, a particular judge may not follow the prior precedent in the district. In cases where the contractual rent increases over the life of a long-term lease, the Time Approach is less favorable to landlords because it results in a lower cap on lease termination damage claims.
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