The Bankruptcy Code limits the amount a landlord may recover from a bankrupt tenant for damages caused by the termination of a lease of real property. But what if the tenant trashes the landlord's property before turning over the premises? Does the damage limitation apply to the landlord's claim for the cost of cleaning up the mess? In a recent case favorable to landlords, the Ninth Circuit Court of Appeals has held that the damage limitation does not apply to a landlord's $23 million tort claim against its bankrupt tenant for cleaning up the mess caused by the tenant's leaving behind a million tons of wet clay goo.

In light of the opinion, a landlord of a bankrupt tenant under a rejected lease should consider recharacterizing the landlord's breach of lease claims as tort claims and/or as claims not arising from rejection of the lease, in order to avoid application of the damage limitation to the claims.

Mining Company Leaves a $23 Million Mess

Saddleback Community Church leased certain real property to mining company, El Toro Materials Company, Inc., for $28,000 per month. El Toro filed for Chapter 11 bankruptcy and rejected the lease. In preparing to turn the lease over to the landlord, El Toro allegedly left behind one million tons of its wet clay "goo," mining equipment and other materials on Saddleback's property. Saddleback then brought an adversary proceeding against El Toro, claiming $23 million in damages for the alleged cost of removing the mess, under theories of waste, nuisance, trespass and breach of contract.

Bankruptcy Court and BAP Disagree on Application of the Damages Cap

Section 502(b)(6) of the Bankruptcy Code limits the claims of a landlord against a bankrupt tenant arising from the termination of a lease of real property. Because the section 502(b)(6) limitation is calculated as a portion of the rent payable under the lease,1 applying the limitation to Saddleback's claims for the cost of removing the mess would severely limit those claims. El Toro asked the bankruptcy court to apply the section 502(b)(6) cap to Saddleback's claims.

The bankruptcy court, on a motion for partial summary judgment, found that Saddleback's recovery would not be limited by the section 502(b)(6) cap. On certified cross-appeal, the Bankruptcy Appellate Panel reversed, holding that any damages would be capped. Saddleback appealed to the Ninth Circuit.

Ninth Circuit Says the Cap Does Not Apply to "Collateral Damages" to the Rented Premises

In Saddleback Valley Community Church v. El Toro Materials Company (In re El Toro Materials Company),2 the Ninth Circuit analyzed the history, structure and language of the section 502(b)(6) cap and concluded that the cap does not limit a landlord's claims for "collateral damage" to the rented premises. The court noted that metering a landlord's collateral damages by the amount of the rent would be inconsistent with the goal of providing compensation to each creditor of a bankrupt in proportion with what it is owed. In contrast, said the court, capping rent claims, but allowing uncapped claims for collateral damage to the rented premises, will follow congressional intent by preventing a potentially overwhelming claim for lost rent from draining the estate, while putting landlords on equal footing with other creditors for their collateral claims.

The court found that the language of the statute supported its conclusion, in that the cap applies to damages "resulting from" the rejection of a lease. The court found that Saddleback's claims for waste, nuisance and trespass did not result from the rejection of the lease — they resulted from the pile of dirt allegedly left on the property. According to the court, "The million-ton heap of dirt was not put there by the rejection of the lease — it was put there by the actions and inactions of El Toro in preparing to turn over the site."3

Based on its analysis of the section 502(b)(6) cap, the court reversed the decision of the Bankruptcy Appellate Panel and remanded the case for a determination of the merits of Saddleback's claim.

Landlords May Consider Recharacterizing Their Claims

The breadth of the Ninth Circuit's opinion in El Toro Materials is uncertain. Portions of the opinion suggest that the section 502(b)(6) cap applies only to claims for loss of future rental income. Other portions of the opinion suggest that the damage limitation applies to all claims arising in connection with the rejection or termination of a lease of real property other than "tort claims other than those based on lost rent, rent-like payments or other damages directly arising from a tenant's failure to complete a lease term."4 The landlord in El Toro Materials escaped application of the section 502(b)(6) cap by characterizing its claims as claims arising in tort and arguing that its claims did not result from the rejection of the lease. Landlords in other circumstances may seek to adopt the same strategies in order to invoke El Toro Materials as a basis for avoiding application of the section 502(b)(6) cap to their claims.

The El Toro Materials opinion conflicts with decisions of other courts,5 and the law regarding the scope of the section 502(b)(6) cap continues to evolve. A landlord's recharacterization of a breach of lease claim as a claim arising in tort may adversely affect the landlord's ability to establish the tenant's liability and/or the damages recoverable or may adversely affect the landlord in other ways. The conduct of the parties to a lease following any purported breach of the lease may materially affect the ability of the landlord to characterize its lease-related claims as claims arising in tort, as claims not arising from the rejection of the lease or as claims otherwise exempt from application of the section 502(b)(6) cap in any bankruptcy of the tenant. Accordingly, in order to best preserve their legal rights, landlords and their tenants both should carefully follow the developments in the law and consult with their legal advisers before talking any action with respect to any present or future breach, rejection or termination of a lease of real property.