Restructuring professionals cite giving the debtor a “fresh start” as one of the goals of bankruptcy.  In order to assist the debtor, the Bankruptcy Code contains a number of provisions capping claims.  One of these provisions is section 502(b)(6), which caps the claims of landlords for rent and other damages resulting from the termination of a lease of real property.  Judge Carey of the Delaware Bankruptcy Court recently examined application of this section and issued an opinion setting forth his views on how to apply the formula set forth in section 502(b)(6).

Background:

Connecticut/DeSales, as landlord, executed a retail lease with Raleigh Stores Corporation.  The lease had an original term of 20 years, with four options to renew for additional terms of 10 years, and provided that upon expiration or termination, the tenant had an obligation to surrender the property “broom clean, free of debris and Tenant’s personal property . . . .”  Subsequently, Filene’s Basement took over the lease from Raleigh Stores Corporation and exercised an option to renew the lease.

Filene’s filed for bankruptcy in the United States Bankruptcy Court for the District of Delaware in 2011 and ultimately rejected its lease with Connecticut/DeSales.

Claims:

Connecticut/DeSales, as landlord, timely filed a proof of claim consisting of a claim for rent unpaid as of the petition date, plus a claim for future rent capped by section 502(b)(6) of the Bankruptcy Code.  The landlord subsequently amended the claim to add damages claims relating to the costs of removing abandoned furniture and fixtures from the leased premises, as well as satisfying a mechanic’s lien that a creditor of Filene’s had imposed against the landlord’s property.  The landlord asserted that the new claims were not subject to the 502(b)(6) cap.  Filene’s objected to the landlord’s claim asserting that the claim exceeded the amount allowed by section 502(b)(6) because (1) the landlord improperly calculated the cap, and (2) the additional damage claims should have been included within the cap.

Section 502(b)(6) caps claims for damages resulting from the “termination” of a lease of real property at

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

Does the “Time” or the “Rent” Approach Apply to the 502(b)(6) Calculation?

The landlord calculated the amount of the 502(b)(6) rent cap by determining the total base rent and other “rent” amounts due for the remaining term of the lease and multiplying that by 15 percent.  This method of calculation is also called the “rent” approach, and courts adopting this approach hold that the 15 percent referred to in section 502(b)(6) is 15 percent of the total rent due for the remaining term of the lease.

On the other hand, Filene’s argued that the reference to 15 percent in section 502(b)(6) is a reference to the amount of time remaining under the lease term.  This approach is also known as the “time” approach.  Courts following the “time” approach hold that the 15 percent is a measure of the time remaining under the lease term.  In other words, damages would be capped at the amount of rent due for the first 15 percent of the time remaining under the lease, such time period not to exceed three years.

The difference between the two approaches can be significant because the amount of rent and other expenses such as insurance and property taxes frequently increase over the life of the lease.  Under the “rent” approach, the landlord would be able to take advantage of escalators over the lifetime of the lease, whereas under the “time” approach, a landlord would only obtain those increases captured in the first 15 percent of the term (with a minimum of one year) to a maximum of three years remaining on the lease.

By way of example, 85 months remained under the terms of the Filene’s lease.  Under the time approach, the landlord’s capped rent would be obtained by multiplying 85 months by 15 percent to obtain a 12.75 month period.  The base rent due for the first 12.75 months was $1,845,524.25.  The rent approach, on the other hand, would be calculated by multiplying the total amount of base rent remaining due under the lease, or $13,009,242.00 by 15 percent, which sum was $1,951,386.30.

The bankruptcy court noted that caselaw supported both the “rent” and the “time” approaches.  The court began by examining the text at issue – “rent reserved under the lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term” – supported the “time” approach.

The court reasoned, “Structurally, in comparing the greater or lesser of two things, the measurements of those things must be parallel, e.g. time versus time” and that further the phrase “without acceleration” in section 502(b)(6)(A) lent further support to the “time” approach, because the “rent” approach would render that phrase superfluous.  Accordingly, the court concluded that the text of section 502(b)(6)(A) required application of the 15 percent cap based on the “time” approach.

What Damages Are Subject to the 502(b)(6) Cap?

The court then turned to the landlord’s two additional claims: (i) for the cost of the removal of abandoned furniture and fixtures from the leased premises and (ii) for the amount needed to remove a mechanic’s lien on the property.  Filene’s asserted that these additional amounts arose from the termination of the lease and were subject to the section 502(b)(6) cap.

The question under section 502(b)(6) is whether these types of claims are for “damages resulting from the termination of a lease of real property.”  If so, these additional amounts would be subject to the cap.  If not, they would not be subject to the cap.

As the bankruptcy court discussed, courts are also divided on how to determine which claims resulted from termination of the lease.  The landlord argued that the court should rely on El Toro, in which the Ninth Circuit stated in part “a simple test reveals whether the damages result from the rejection of the lease: Assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it?”  The court found this reasoning persuasive and found that section 502(b)(6) did not prevent the landlord from asserting a separate claim for damages that did not directly arise from the termination of the lease.

Under this test, the court determined that the abandoned property claim constituted damages arising from termination of the lease because it was a breach of Filene’s obligation to surrender the property in a “broom clean” condition free of personal property upon termination or expiration of the lease.  The landlord would only have needed to remove the abandoned fixtures upon termination of the lease, and therefore would not have had the same claim if Filene’s assumed the lease.  The court found that the abandoned furniture and fixtures claim therefore fell within section 502(b)(6) and could not be asserted as a separate claim.

On the other hand, the court concluded that the mechanic’s lien claim, which was based on the landlord’s cost to remove a mechanic’s lien on the property resulting from Filene’s nonpayment of a contractor, existed independently of whether the lease was terminated.  Accordingly, the court ruled that the mechanic’s lien claim could be asserted as a separate claim.