In Giant Eagle, Inc. v. Phar-Mor, Inc.,1 the United States Court of Appeals for the Sixth Circuit held that a lessor-claimant whose lease was rejected pursuant to section 365(a) of Title 11 of the Bankruptcy Code was entitled to a claim for future-rent damages against the debtor, even though the lessor had entered into a nearly identical substitute lease. The Court concluded that efforts to mitigate damages by the lessor would not be considered in reducing the actual damage claim when those efforts failed to reduce the actual harm suffered by the lessor.

Background

In May 1995, Phar-Mor, Inc. (“Phar-Mor”) signed a 160-month lease with Giant Eagle, Inc. (“Giant Eagle”) for the use of certain warehouse equipment. The lease was scheduled to terminate in September 2008. In September 2001, Phar-Mor filed for bankruptcy and, while in bankruptcy, rejected the lease. Pursuant to the terms of the lease, Phar-Mor was obligated to pay liquidated damages equal to the present value of all future monthly payments once it breached the agreement.

In October 2002, Giant Eagle entered into a substitute lease with Snyder Drugstores, Inc. (“Snyder”). Pursuant to this new lease, Snyder was obligated to pay the same rent that Phar-Mor had contracted to pay for the use of the same equipment. In September 2003, Snyder filed for bankruptcy, and in November 2003, it too breached the agreement by rejecting the lease it had entered into with Giant Eagle. Giant Eagle again attempted to mitigate damages by finding a substitute lessee, but it was unsuccessful.

Giant Eagle then filed a claim in Phar- Mor’s bankruptcy, claiming liquidated damages for future-rent due for the remaining lease term, less the amount it had received under the Snyder lease. Phar-Mor objected to the claim, contending that damages had been fully mitigated when Giant Eagle entered into the lease with Snyder. The Bankruptcy Court upheld Phar-Mor’s objection, concluding that Giant Eagle had fully mitigated its damages by re-leasing the equipment. On appeal, the United States District Court for the Northern District of Ohio affirmed the Bankruptcy Court’s decision on the ground that Giant Eagle had failed to demonstrate that “Phar-Mor’s lease obligations could be revived after they were mitigated and supplanted” by the Snyder lease.2 Giant Eagle appealed to the Sixth Circuit.

Court’s Decision

Pursuant to section 365(a) and (g) of the Bankruptcy Code, subject to the bankruptcy court’s approval, a debtor may reject an unexpired lease. Upon rejection, the lease is deemed to have been breached immediately before the petition date. In addition, under section 502(g), a claim arising from rejection of a lease is given the status of a general unsecured claim.3

On appeal, Giant Eagle argued that, pursuant to section 365(g) of the Bankruptcy Code, it should be granted a general unsecured claim for the damages it suffered when Snyder defaulted under the replacement lease. In response, Phar-Mor contended that when a lessee breaches a lease and the lessor enters into a subsequent lease with a third party that would fully mitigate the potential damages resulting from the prior breach, the original, breaching lessee should be excused from liability. Phar-Mor added that, under such circumstances, the obligation of the prior lessee should be deemed to have ceased on the date the new lease was entered into. Citing Bank of Montreal v. American HomePatient, Inc. (In re American HomePatient, Inc.),4 Phar-Mor further claimed that damages should be determined at the time of the breach of the lease, and thus the subsequent default under the Snyder lease should not affect the damage claim against Phar-Mor.

The Sixth Circuit Court of Appeals rejected Phar- Mor’s argument. The Court explained that while damages are generally determined at the time of the breach, this rule does not eliminate the consideration of mitigating factors that arise later. Further, even if the lessor undertakes to mitigate its losses, the Court must also consider the result of these mitigation efforts. The Court explained: “Phar-Mor insists that the bankruptcy court must ignore the truth and render a decision based on expectations that could have existed at some random point in the past and refuse to let the parties adjust for actual subsequent events. We think not.”5 The Court added: “Let us be very clear: there is no proposition in law or equity that an injured party who attempts to mitigate the damage that results from another party’s misconduct must ‘suffer the consequences’ of its attempting to mitigate.”6

Once the Court determined that Giant Eagle was entitled to damages, it attempted to quantify the claim. The Court explained that, to calculate correctly the damages to which Giant Eagle would be entitled, it was required to consider both state law and the lease itself. Phar-Mor’s lease contained what the Court cited as two important features: “(1) a liquidated damages provision that quantified the benefit of the bargain as the present value of all future monthly payments . . . and (2) an express choice-of-law provision, designating Pennsylvania law as controlling.”7 Although Pennsylvania law provided three other possible ways to calculate damages,8 the Court determined that, because the lease included an uncontested liquidated damages provision, its analysis would “begin and end with the fourth alternative,”9 which allowed Giant Eagle to “[e]xercise any other rights or pursue any other remedies provided in the lease contract,” such as, the Court observed, liquidated damages.10

The Court also found that Pennsylvania law imposes on a lessor a duty to mitigate damages when a lease is breached. Relying on In re Steiner,11 the Court determined that this duty does not conflict with the Bankruptcy Code. The Court thus held that the proper approach to determining damages in this case was first, to compute the benefit of the bargain as of the date on which the petition was filed and second, to assess the actual damages suffered by Phar-Mor under state law. The Court concluded that, in making this latter calculation, damages should be reduced by the amount actually received by Phar-Mor as a result of its mitigation efforts.12

Conclusion

Although it is sometimes true that no good deed goes unpunished, the Sixth Circuit’s opinion in Giant Eagle, Inc. avoids that result. The Court determined that it would not disallow a lessor’s legitimate claim for future-rent damages arising from a lessee’s rejection of a lease merely because the lessor’s reasonable efforts to mitigate its damages by finding a replacement lessee failed when the new lessee also filed for bankruptcy. The Court thus eliminated a down-side risk to mitigating damages that might have been present had the Court affirmed the contrary decisions of the lower courts.

The Giant Eagle, Inc. decision, however, begs the question of what should be considered “successful” mitigation efforts. A lessor could, for example, argue that it suffered damages, despite being able to obtain a replacement lease, because the market value of the substitute lease is less than that of the original lease (due, for example, to the questionable credentials of the new lessee). Similarly unanswered is whether the lessor’s claim against the initial lessee should be further adjusted if the lessor later recovered damages from the failed substitute lessee. These and other thorny questions will make following the ostensibly fair and logical rule of Giant Eagle, Inc. more difficult.