In re Foamex Int’l, Inc., et al.,1 the United States Bankruptcy Court for the District of Delaware held that the damage cap contained in section 502(b)(6) of the Bankruptcy Code applies not only to rental payments, but also to damages from the breach of any lease covenants, including maintenance and repair obligations. In doing so, the Court reduced a specific landlord’s claim and recovery by more than $700,000 and established precedent that could diminish the claims of landlords in other cases pending and filed in Delaware.

Background

The Debtors in Foamex were manufacturers of flexible polyurethane and advanced polymer foam products. In order to obtain more space for manufacturing facilities and administrative offices, on April 13, 1995, the Debtors and the Lessors entered into two leases of non-residential real property (the “Leases”) for ten-year terms. The Leases were subsequently extended for an additional ten-year period. The Leases required monthly rental payments of $10,701.31 and $2,776.27, respectively. The Leases included provisions whereby the Debtors were required to maintain and make all reasonable repairs at their own expense with respect to the leased facilities, subject to the lessors’ obligation to make repairs that in their reasonable judgment would exceed $5,000.

The Leases provided an option to the Debtors for early termination upon 180 days’ prior written notice. On April 29, 2005, the Debtors sent written notice to terminate both Leases effective October 31, 2005.

On September 19, 2005, the Debtors filed Chapter 11 petitions in the Delaware Bankruptcy Court. On September 28, 2005, the Debtors filed a motion for rejection of the Leases. The order approving the rejection motion was entered on October 18, 2005, with rejection effective September 30, 2005. Subsequent to entry of the lease rejection order, the Debtors confirmed a plan that provided unsecured creditors with full recovery. Therefore, unsecured claims, to the extent allowed and uncapped, would be paid in full.

The Lessors’ Claim

Gungor and Diana Solmaz (the “Lessors”) filed a general unsecured claim (the “Claim”) for lease rejection damages in the amount of $793,872.51, which consisted of (a) $13,477.58 for unpaid rent, (b) $10,994,93 for unpaid taxes and (c) $769,400.00 related to the Debtors’ breach of repair and maintenance obligations under the Leases (the “Repair and Maintenance Damages”). The alleged Repair and Maintenance Damages were associated with the costs to restore the leased premises to the condition they would have been in had the Debtors complied with the repair and maintenance obligations under the Leases.

The Debtors filed an objection to the Claim. The Debtors sought to reduce the Claim by $769,400 and allow the Lessors a general unsecured claim in the amount of $24,472.51, consisting of the unpaid rent and unpaid taxes components of the Claim. The Debtors also asserted that the entire Claim, including any Repair and Maintenance Damages, should be capped pursuant to section 502(b)(6) of the Bankruptcy Code at an amount no greater than one year of rent reserved under the Leases.

The Section 502(b)(6) Cap on Lease Termination Damages

Section 502(b)(6) of the Bankruptcy Code states in relevant part that a claim shall be allowed except to the extent that “if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds—(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 the 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.” The central issue before the court was whether the section 502(b)(6) damage cap applied to the Repair and Maintenance Damages. If so, the Claim would be significantly reduced; if not, the Claim could exceed $750,000.

The Lessors’ Arguments

The Lessors argued that the section 502(b)(6) damage cap was inapplicable to the Repair and Maintenance Damages because such damages were unrelated to, and independent of, termination of the Leases. They asserted that the plain language of section 502(b)(6) limits the cap to claims resulting from the termination of a lease, and damages unrelated to termination, such as the Repair and Maintenance Damages, should not be capped and should therefore be allowed in full.

The Lessors argued that section 502(b)(6) does not contain an express cap on breach of covenant damages, and therefore stands in contrast to the predecessor damage cap provision under the Bankruptcy Act. Specifically, section 63(a)(9) of the Bankruptcy Act included a cap on “damages or indemnity under a covenant contained in such lease...” The Lessors argued that the omission of such language in section 502(b)(6) of the Bankruptcy Code is evidence of Congressional intent to exclude damages for breach of covenants, such as repair and maintenance requirements, from the section 506(b)(6) limitation on a lessor’s lease rejection damages claim.

Further, the Lessors asserted that the legislative purpose behind section 502(b)(6) is to compensate a landlord for the loss suffered upon termination of a lease, while not permitting large claims for future rent under long-term leases. Thus, argued Lessors, the Repair and Maintenance Damages should be excluded from the cap because they are not the large, future rent damages that Congress sought to limit. The Lessors also relied on case authority, including In re Best Products, Inc.,2 which held that damages for such items as maintenance and repairs do not result from the termination of a lease of real property and are therefore not subject to the section 502(b)(6) damage cap. The Best Products Court was unable to find anything in the legislative history suggesting that “Congress intended to do more than change common law rules of law so as to allow landlords to receive a limited portion of future rents in bankruptcy.”

The Debtors’ Arguments

Relying heavily on Kuske v. McSheridian (In re McSheridan),3 the Debtors argued that case law coupled with legislative history required a ruling that the section 502(b)(6) cap applied to the Lessor’s entire Claim without regard to the type of damages involved. In other words, the Debtors asserted that the rejection of a lease constitutes a breach of the lease and all the lease covenants, including those for repair and maintenance. As a result, the Lessors are entitled to file a claim for all damages, including the Repair and Maintenance Damages, but all these damage claims are subject to the section 502(b)(6) damage cap.

Although acknowledging that there was no authority directly on point in Delaware, the Debtors also relied upon a Third Circuit decision, First Bank Nat’l Assoc. v. FDIC,4 that used section 502(b)(6) of the Bankruptcy Code to interpret an analogous provision of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”). In First Bank, the Third Circuit relied on McSheridian and found that section 1821(e)(4) of FIRREA,5 which was modeled after section 502(b)(6) of the Bankruptcy Code, capped all damages, including damages for breaches of covenants. The Debtors contended that First Bank reflected persuasive same-circuit authority that should be adopted by the court.

The Court’s Holding and Rationale

The court held that the entire Claim, including the Repair and Maintenance Damages, was subject to the section 502(b)(6) damage cap. The court stated that McSheridan was the “better view,” particularly in light of the Third Circuit’s First Bank decision, which adopted the reasoning of McSheridian. Accordingly, the court held that the rejection of a real property lease results in a breach of all the lease provisions, including covenants, and section 502(b)(6) caps all the lessor’s damages resulting from rejection. The court noted that McSheridan makes clear that Lessors are only entitled to one claim, including claims based on both pre-petition and post-petition breaches of a real property lease, and that claim is limited by section 502(b)(6).

Adopting the reasoning of McSheridian, the court based its conclusion on two grounds:

(i) Including the Repair and Maintenance Damages in the section 502(b)(6) damage cap fulfills the purpose of discharging the debtor from liability to future suits based upon a long-term real property lease and provides the Lessors with a more certain remedy for a limited amount, in lieu of an inefficient and uncertain result

(ii) Section 502(b)(6) caps damages arising from the breach of any and all lease covenants upon termination of the Leases.

The court noted that the purpose of section 502(b)(6) was served by including the Lessors’ entire Claim in the cap because the section was enacted

to curtail exorbitant future damage claims by landlords on long-term leases that threaten to consume a debtor’s bankruptcy estate to the detriment of other creditors.

Based upon its reasoning, the court sustained the Debtors’ objection to the Claim in part and set an evidentiary hearing for further determination on one issue. Specifically, the court ruled that the Lessors would be allowed an unsecured claim in the amount of $13,477.58 for unpaid rent and $10,994.93 for unpaid taxes. The evidentiary hearing would determine what additional amount, if any, Lessors would be allowed for any breaches of the repair and maintenance provisions of the Leases, subject to the provisions of the Leases and “the Section 502(b)(6) cap.”

Comment

The Foamex decision establishes that in Delaware —an influential bankruptcy jurisdiction—all damages arising out of rejection of a real property lease, including damages for breaches of covenants, are subject to the section 502(b)(6) damage cap. Although there is still authority to the contrary in other jurisdictions, because the Delaware bankruptcy courts have significant influence, this decision may be persuasive authority in those jurisdictions that have not addressed this issue. Currently, courts in Delaware, New Jersey, Texas and the Ninth Circuit have held that the section 502(b)(6) damage cap applies to breaches of lease covenants, while courts in North Dakota, Illinois and Virginia have held the opposite.