Bad ‘Timing’: Southern District of New York Bankruptcy Court Adopts Time Approach to Limiting Landlord Lease Damages, but Other Damages May Still Be Allowable

Overview

When enacting the Bankruptcy Code, Congress sought to strike a balance amid the confluence of different — and often competing — interests held by debtors, secured creditors and various unsecured creditor constituencies (including landlords) through a framework of statutory protections. This has – at times – led to litigation over differing statutory interpretations as well as circuit splits as courts attempt to reconcile underlying policy goals with the less-than-clear language in various of the Code’s provisions.

One example lies in Section 502(b)(6) of the Bankruptcy Code, which enables a landlord to recover, as a general unsecured claim, damages resulting from termination of a lease for real property — with one caveat: It imposes a cap on certain damages arising from “termination,” calculated based on the formula set forth in subparagraph (A) of Section 502(b)(6) (which is discussed more below). Over the years, courts have disagreed over the correct interpretation of how the statutory cap is to be calculated; some courts apply the “rent approach” (which applies the formula to the total rent reserved under the lease), while other courts apply the “time approach” (which imposes a temporal limitation by solely looking at the rent in the earlier, post-termination years). While the rent approach was previously the majority view, an increasing number of courts have adopted the time approach. Far from being a distinction without a difference, the rent approach method often means a higher recovery to landlords where the leases contemplate rent escalations over a longer post-termination remaining rental period. The time approach method, by contrast, often results in a reduced recovery (by looking only at the earlier years of the remaining lease term) and is thereby favorable to debtors.

In Cortlandt Liquidating LLC, et al. (formally known as Century 21 Department Stores LLC), the U.S. Bankruptcy Court for the Southern District of New York (the Court) recently broke with prior precedent in the Southern District of New York by adopting the time approach over the previously used rent approach. In re Cortlandt Liquidating LLC, et al., Case No. 20-12097-MEW (Bankr. S.D.N.Y. Feb. 2, 2023).

Background

The dispute involved two separate landlords. Both leases involved the same dispute over adopting the time approach versus the rent approach. There were differences in the disputes over the other components of the landlords’ damage claim, which were capped under Section 502(b)(6).

Factually, prior to the bankruptcy filings, two commercial leases (collectively, the “Leases”) were entered into: (1) in January 2011, between Lincoln Triangle Commercial Holding Co. LLC, the landlord (“Landlord A”), and nondebtor affiliate C21 1972 Broadway LLC, the tenant (“Tenant A”); and (2) in November 2015, between AAC Cross County Mall LLC, the landlord (“Landlord B,” and together with Landlord A, the “Landlords”), and nondebtor affiliate C21 CC Blue LLC, the tenant (“Tenant B,” and together with “Tenant A,” the “Tenants”). Certain Century 21 Department Stores affiliates (the “Debtors” or “Guarantors”) guaranteed the Tenants’ obligations under the corresponding Leases.

In April 2020, a notice of default was issued to Tenant B for failure to make certain payments required under its lease. Nevertheless, Tenant B continued to occupy the premises and make base rent payments following the bankruptcy filings.

On Sept. 10, 2020, the Debtors each commenced voluntary Chapter 11 cases in the Southern District of New York.

In October 2020, Tenant A turned over the keys to the premises to Landlord A, prior to expiration of the lease term, thereby breaching the lease. On Dec. 7, 2020, Tenant B vacated the premises and, because Landlord B was unwilling to accept possession of the property, provided the keys to the Debtors’ professionals. As a result, the Landlords each filed proofs of claim for the obligations under their respective Leases, both asserting, among other things, general unsecured claims for future rent and related obligations due and owing for the remaining term of their respective Leases pursuant to Section 502(b)(6). Also asserted in Landlord A’s proof of claim were “additional damages” relating to cleanup costs, repair work, mechanics’ liens and similar other damages incurred.

By order issued on April 26, 2021, the Debtors’ joint plan of liquidation was confirmed, pursuant to which the plan administrator was subsequently appointed to oversee the wind-down of the Debtors’ business. In November 2021, the plan administrator filed objections to both Landlords’ proofs of claim, which were in turn opposed by the Landlords.

In May 2022, the Court issued interim orders, ruling, among other things, that (a) the Section 506(b)(6) statutory cap applied with equal force to limit a landlord’s claim where the debtor is a guarantor, rather than a tenant, under a lease; and (b) under bankruptcy law’s broader concept of “termination,” the termination date of Landlord B’s lease was Dec. 7, 2020, for purposes of Section 506(b)(6). Specifically, the Court reasoned that such lease was “functionally dead” for termination purposes based on Tenant B’s intentional vacatur of the premises and surrender of the keys to the Debtors’ professionals. The interim orders further directed the Landlords and the plan administrator to confer about the appropriate calculation of the Section 506(b)(6) claims.

Opinion

The opinion (by Judge Michael Wiles, who took over the case from retiring Judge Shelly Chapman) addressed certain of the issues that the parties were unable to agree on thereafter, including (i) whether the Section 502(b)(6) statutory cap on a landlord’s damages should be calculated in accordance with the time approach or the rent approach, and (ii) whether certain additional damages asserted, including cleanup costs, repair work and mechanics’ liens, arose from termination of the lease and, therefore, were subject to the statutory cap.

The Time Approach Versus the Rent Approach

As to the first issue, the Court held that the time approach was the correct method for purposes of calculating damages under Section 502(b)(6). In so ruling, the Court deviated from prior precedent in the Southern District, following the rent approach, which had historically been considered the “majority view” for capping a landlord’s allowed damages claim. The Court began its analysis by reviewing the statutory language and the decisions on both sides of the debate.

Section 502(b)(6) caps a landlord’s damages arising from a lease terminated prior to or during bankruptcy, at the amount of the “rent reserved” (i.e., future rent) under such lease “for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease….” 11 U.S.C. § 502(b)(6)(A) (emphasis added). The two approaches differ as to the meaning of “15 percent” under subparagraph (A). The time approach views the 15% as applying to the time remaining under the term of the lease, whereby the claim is capped at an amount equal to the aggregate rent due over the period of (i) one year, if 15% of the remaining lease term is less than three years, or (ii) three years, if 15% of the remaining term is equal to or exceeds three years. Importantly, and as the Court noted, this approach is more favorable to the debtor’s estate, because it does not capture the additional value contemplated by rent and other cost escalation provisions commonly found in long-term lease agreements.

By contrast, the rent approach interprets the 15% as applying to the amount payable under the remaining lease term, by which the amount of damages is capped at the greater of one year’s rent or 15% of the remaining rent due. As the aggregate sum of all rent due over the entire remaining lease term is used as the base on which the 15% is calculated, this approach often results in a greater recovery for landlords. This is because, unlike with the time approach, it captures any rent step-ups contemplated under the lease that apply beyond the three-year period.

The Court found the plain language of Section 502(b)(6) made clear that the time approach is the correct method for calculating the statutory cap. Among other observations, the Court noted that the entirety of Section 502(b)(6)(A) is worded in periods of time — e.g., “one year” and “three years.” Moreover, if the intention were to impose a cap based on 15% of a specific dollar amount, the term “15 percent” would not have been “sandwiched” between two time periods. The Court further observed that its statutory interpretation has been endorsed by both the leading treatise on bankruptcy law, Colliers on Bankruptcy, and the increasing number of courts that have adopted the time approach and no longer follow the rent approach.

While the Court’s rationale was primarily based on the statutory language, it also reasoned that the time approach was supported by the legislative history of Section 502(b)(6). Finally, the Court rejected the rationale often employed by the rent approach advocates: that equitable considerations weigh in favor of the rent approach by allowing landlords to recover damages based on the parties’ bargained-for agreement, including any rent escalations. The Court warned that “we must always be on guard not to substitute our own views of fairness in place of what a statute’s plain language demands.”

What Else Is Captured by a Termination Claim?

As to the second issue — which other additional damages fall within, or outside of, the category of “capped” damages under subparagraph (A) of Section 502(b)(6) — the Court concluded that one category of damages was subject to the statutory cap, while the remaining two categories fell outside of the statutory cap. Like the first issue, there are varying interpretations of Section 502(b)(6) as to what types of damages fall within the “termination” bucket of capped damages. Some courts interpret Section 502(b)(6) broadly, holding that all damages of any kind are subject to the statutory cap; others follow a narrower interpretation, whereby capped damages are only those directly resulting from termination of the lease.

The Court, siding with the narrower (and more landlord-friendly) approach, adopted the “simple test” enunciated by the Ninth Circuit in Saddleback Valley Community Church v. El Toro Materials Co. (In re El Toro Materials Co.), 504 F.3d 978 (9th Cir. 2007), which asks: “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?”

Applying the El Toro test, the Court concluded that Landlord A’s claim for “store cleanup costs” did arise by virtue of the lease termination and was therefore subject to the statutory cap. Under the lease, Tenant A’s obligation to leave the premises in broom clean condition was only triggered “[u]pon expiration or other termination of [such] Lease,” and thus, such obligation would not have arisen in a lease assumption scenario. By contrast, the Court held that the claim for mechanics’ liens filed against the premises was not subject to the statutory cap. The lease required Tenant A to discharge any mechanic’s lien placed on the premises within 30 days’ notice thereof for the duration of the lease term; thus, Landlord A would have a claim for the undischarged mechanics’ liens regardless of whether the lease was terminated or assumed. Finally, the Court held that the claim for various repair work (including window repairs, façade repairs, and restoration costs) was not subject to the statutory cap. Under the relevant contractual provision, and unlike the claim for “store cleanup costs,” Tenant A’s obligation to pay for such repairs and restoration costs was not triggered upon the expiration or termination of the lease; Landlord A would still have such claim were the lease assumed during the bankruptcy.

Why This Case Is Interesting

In large part, this case can be considered a loss for landlords, followed by a small win. Judge Wiles departed from prior precedent in the Southern District of New York by adopting the time approach, which may affect the size of landlord claims with longer-term leases and higher rent escalations. Although the rent approach has become the minority view, it still had applied in the Southern District of New York. However, the Court’s adoption of the El Toro test is favorable to landlords. While other courts view Section 502(b)(6)(A)’s cap as all-encompassing, El Toro carves out a category of “non-termination” damages available to landlords that are uncapped. One of the lessons from the Court’s opinion: If a tenant’s obligation under a lease is solely triggered by expiration or termination of the lease, a court following El Toro’s approach will likely find such damages to be “termination damages” subject to the Section 502(b)(6) cap. If the lease is not drafted in a way that ties payment to termination or expiration of the lease, the opportunity to assert that claim as uncapped is still available.