Under the Bankruptcy Code, a bankruptcy trustee or chapter 11
debtor in possession ("DIP") is required to satisfy
postpetition obligations under any unexpired lease of commercial
property pending a decision to assume or reject the lease.
Specifically, section 365(d)(3) requires the trustee, with limited
exceptions, to "timely perform all the obligations of the
debtor . . . arising from and after the order for relief"
under any unexpired lease of nonresidential real property with
respect to which the debtor is the lessee.
The application of section 365(d)(3) and, in particular, the timing
of certain "obligations" arising under an unexpired lease
has created some controversy. A Delaware bankruptcy court added
fuel to the fire in a ruling handed down earlier this year. In a
matter of first impression, the court held in WM Inland Adjacent
LLC v. Mervyn's LLC (In re Mervyn's Holdings, LLC), 2013 BL
5408 (Bankr. D. Del. Jan. 8, 2013), that a claim arising from an
indemnification obligation under a commercial lease was entitled to
administrative expense status under section 365(d)(3).
Payment of Postpetition Commercial Lease Obligations
As noted, section 365(d)(3) provides that a trustee or DIP, with
certain exceptions, "shall timely perform all the obligations
of the debtor . . . arising from and after the order for relief
under any expired lease of nonresidential real property, until such
lease is assumed or rejected, notwithstanding section 503(b)(1) of
this title." Added to the Bankruptcy Code in 1984, the
provision was intended to ameliorate the immediate financial burden
borne by commercial landlords pending the trustee's decision to
assume or reject a lease. Prior to that time, landlords were
routinely compelled to seek payment of rent and other amounts due
under a lease by petitioning the bankruptcy court for an order
designating those amounts as administrative expenses. The process
was cumbersome and time-consuming. Moreover, the landlord's
efforts to get paid were hampered by the standards applied in
determining what qualifies as a priority expense of administering a
bankruptcy estate.
Section 503(b)(1) of the Bankruptcy Code provides that allowed
administrative expenses include "the actual, necessary costs
and expenses of preserving the estate." Rent payable under an
unexpired commercial lease during a bankruptcy case arguably falls
into this category. Even so, section 503(b)(1) has uniformly been
interpreted to require that in addition to being actual and
necessary, an expense must benefit the bankruptcy estate to qualify
for administrative priority. Prior to the enactment of section
365(d)(3), "benefit to the estate" in this context was
determined on a case-by-case basis by calculating the value to the
debtor of its "use and occupancy" of the premises, rather
than looking to the rent stated in the lease. Moreover, even if a
landlord's claim for postpetition rent was conferred with
administrative priority, the Bankruptcy Code did not specify when
the claim had to be paid.
Section 365(d)(3) was designed to remedy this problem. It requires
a trustee or DIP to remain current on lease obligations pending
assumption or rejection of a lease. Nevertheless, courts have
struggled with the precise meaning of the provision. For example,
courts are at odds over whether the phrase "all the
obligations of the debtor . . . arising from and after the order
for relief" means: (i) all obligations that become due and
payable upon or after the filing of a petition for bankruptcy; or
(ii) obligations that "accrue" after filing the
bankruptcy petition. The former approach—commonly referred to
as the "performance" or "billing date"
rule—has been adopted by some courts. See, e.g., Centerpoint
Properties v. Montgomery Ward Holding Corp. (In re Montgomery Ward
Holding Corp.), 268 F.3d 205 (3d Cir. 2001); Koenig Sporting Goods,
Inc. v. Morse Road Co. (In re Koenig Sporting Goods, Inc.), 203
F.3d 986 (6th Cir. 2000); HA-LO Indus., Inc. v. Centerpoint Props.
Trust, 342 F.3d 794 (7th Cir. 2003). The second approach is
sometimes referred to as the "proration" or "pro
rata" approach. According to this view, real estate taxes and
other nonrent expenses that accrue in part prior to a bankruptcy
filing but are payable postpetition are akin to "sunken
costs" that need not be paid currently as administrative
expenses pending a decision to assume or reject the lease. See,
e.g., In re Treesource Indus., Inc., 363 F.3d 994 (9th Cir. 2004);
In re Handy Andy Home Improvement Ctrs., 144 F.3d 1125 (7th Cir.
1998).
Section 365(d)(3) has also been controversial in cases where the
timing of a bankruptcy filing creates "stub rent." Stub
rent is the rent that is due for the period following the
bankruptcy petition date until the next rent-payment date. For
example, if a lease calls for the prepayment of rent on the first
of each month, and the petition date falls on the 10th day of the
month, assuming that rent was not paid prior to the petition date,
the stub-rent period would be from the 10th day of the month
through the end of the month. Because section 365(d)(3) requires
current payment of obligations "arising from and after the
order for relief," it could be argued that stub rent need not
be paid under section 365(d)(3) because the payment was due prior
to the petition date. Some courts have rejected this approach,
ruling that section 365(d)(3) requires a debtor to pay stub rent on
a prorated basis as part of its duty to "timely perform"
its obligations arising under its unexpired leases. Other courts
reject this interpretation, holding that stub rent need not be paid
under section 365(d)(3).
Courts also disagree whether section 365(d)(3), rather than section
503(b)(1), is an appropriate basis for conferring administrative
priority on (as distinguished from requiring performance of) a
postpetition-lease obligation. For example, in In re Goody's
Family Clothing Inc., 610 F.3d 812 (3d Cir. 2010), the Third
Circuit ruled that section 365(d)(3) does not supplant or preempt
section 503(b)(1). The court concluded that the DIP's use of
the leased premises postpetition to produce income provided an
"actual and necessary" benefit to the estate and that
commercial landlords were thus entitled to stub rent as an
administrative expense. Other courts have held that section
365(d)(3) provides authority to confer administrative status on a
claim independent of section 503(b)(1). See, e.g., In re The
Leather Factory Inc., 475 B.R. 710 (Bankr. C.D. Cal. 2012).
By its terms, section 365(d)(3) requires performance of all
postpetition "obligations" under an unexpired commercial
lease, not merely the payment of postpetition rent, pending the
trustee's decision to assume or reject. Whether an obligation
other than payment of rent should be treated as an administrative
expense was among the issues addressed by the Delaware bankruptcy
court in Mervyn's.
Mervyn's
In January 2008, Mervyn's Holdings, LLC, and certain
affiliates (collectively, the "debtors"), operators of a
California-based department-store chain, leased commercial property
in San Bernardino, California, from WM Inland Adjacent LLC
("Inland"). The debtors also entered into a separate
construction agreement with Inland governing prospective
improvements to the leased premises. Both agreements contained
provisions requiring the debtors to indemnify Inland for various
liabilities arising prior to, during, and after the lease term.
These obligations included a duty to keep the premises free of
mechanics' liens and to pay all amounts, charges, and
attorneys' fees due under the lease.
The debtors later entered into a separate agreement with contractor
Fisher Development Inc. ("Fisher") to provide labor and
materials for building improvements to the leased premises. The
debtors filed for chapter 11 protection in Delaware in July 2008
while construction was still underway.
Fisher reacted to the bankruptcy filing by stopping all work on the
premises and by filing two mechanics' liens against the
property to secure claims aggregating $5.5 million. Fisher then
filed suit against Inland in October 2008 to foreclose on the
liens. To settle the case, Inland agreed to pay Fisher
approximately $1.8 million in February 2010.
The debtors rejected the lease effective November 21, 2008. Inland
filed two proofs of claim for amounts due under the lease and the
construction agreement. Inland sought administrative priority under
section 365(d)(3) for the $1.8 million paid to Fisher under the
indemnification provisions of the lease and construction
agreements.
Inland maintained that the indemnity claim arose postpetition and
prior to rejection of the lease and was therefore entitled to
administrative priority pursuant to section 365(d)(3). According to
Inland, the indemnity-claim obligation arose either when
Fisher's liens were recorded or when Fisher sued the landlord,
both of which occurred postpetition prior to rejection of the
lease. Inland cited Montgomery Ward as authority for the
proposition that section 365(d)(3) creates administrative expense
priority, in the context of unexpired commercial leases, for
"all obligations that arise after an order for relief is
entered and before the lease is rejected."
The debtors countered with four principal arguments. First, they
maintained that the indemnity claim arose from rejection of the
lease and was therefore a prepetition unsecured claim pursuant to
section 502(g). Second, citing Jeld-Wen, Inc. v. Van Brunt (In re
Grossman's Inc.), 607 F.3d 114 (3d Cir. 2010), for the
proposition that common-law and statutory claims arise when the
conduct giving rise to the injury occurs, rather than when the
injury manifests, the debtors argued that the indemnity-obligation
claim arose when they and Inland entered into the lease and
construction agreements and derived from prepetition improvements
to the premises by Fisher, both "billing dates" prior to
the bankruptcy-petition date. Third, the debtors asserted that
there is no precedential authority applying Montgomery Ward to a
lease-indemnification claim, and contrary precedent indicates that
indemnification obligations in executory contracts should be
treated as prepetition unsecured claims. Fourth, the debtors argued
that, even if Montgomery Ward applies and the indemnification
obligation arose postpetition, Inland cannot meet its burden under
section 503(b)(1).
The Bankruptcy Court's Ruling
The bankruptcy court granted summary judgment in favor of
Inland. Addressing the debtors' first argument, the court noted
that "the damages arose from the filing of mechanics'
liens against the [p]remises," rather than from rejection of
the lease. Next, the court concluded that the argument that the
debtors' contractual obligation to indemnify Inland arose
prepetition "runs counter to the holding in Montgomery
Ward" because it ignores the meaning of the term
"obligation" in section 365(d)(3).
"In the context of section 365(d)(3)," the court wrote,
"the relevant time is when an 'obligation' arises,
which is different from when a 'claim' arises." In
Montgomery Ward, the court explained, the Third Circuit
distinguished a "claim," which is "an unmatured
right to payment," from an "obligation," which is
"something one is legally required to perform under the terms
of the lease." According to the court in Mervyn's, the
indemnity obligation arose when Fisher filed the mechanics'
liens and sued Inland, rendering the obligation legally binding
under the lease.
Addressing the debtors' third argument, the court reasoned that
"the strictures of the analyses by the Third Circuit Court of
Appeals are not inapplicable merely because this question has not
yet been posed." "The issue is one of first
impression," the court wrote, "and the Court is both
guided and constrained by the holdings of Montgomery Ward where the
Court of Appeals determined that such obligations in nonresidential
real property leases fall under section 365(d)(3)."
The court also rejected the debtors' argument that the
indemnification claim was not entitled to administrative treatment
because it did not confer a substantial benefit on the estate, as
required by section 503 of the Bankruptcy Code. The court explained
that section 503(b)(1) sets forth a two-part test for whether a
claim is entitled to administrative priority: (i) the expense must
have arisen from a postpetition transaction involving the debtor;
and (ii) the transaction must have substantially benefited the
estate.
Even so, the court concluded that Inland's claim was not
subject to this two-part administrative expense test. Because the
express language of section 365(d)(3) includes the clause
"notwithstanding section 503(b)(1)," the court reasoned,
section 365(d)(3) "creates a new and different
obligation—one that does not necessarily rest on the
administrative expense concept." According to the court,
"The phrase operates as a 'carve-out' exempting these
expenses from 'the usual burdens and procedures' "
(citing Goody's). Therefore, the court ruled that, because the
indemnification claim stemmed from a postpetition obligation under
section 365(d)(3), "section 503(b)(1) is
inapplicable."
Finally, the court was not persuaded by the debtors' argument
that "applying the section 503(b)(1) exemption set forth in
Goody's creates bad public policy" because elevating
Inland's claim to administrative status "simply by
conspiring with a third-party plaintiff" would encourage
"a wait-and-see hedging of bets regarding an anticipated
bankruptcy." "This is not gamesmanship among pre-petition
unsecured creditors," the court wrote, concluding that its
holding "fits squarely" into section 365(d)(3) and the
rationale of Montgomery Ward.
Outlook
Mervyn's is a logical application of section 365(b)(3) and
applicable case law. However, it does create the potential for
doubt about certain claims that may appear to be unsecured,
prepetition claims. The decision suggests that although a claim may
exist before bankruptcy, if the obligation to pay arises
postpetition, it may be treated as an obligation which must be paid
immediately under section 365(d)(3). Any potential increase in such
payment obligations could make it a challenge for some debtors to
reorganize successfully. One of the effects of the decision may be
that a DIP or trustee might be forced to accelerate the decision to
assume or reject an executory contract or unexpired lease to
minimize the risk that a postpetition, prerejection
"obligation" will create a substantial immediate-payment
obligation.
The court in Mervyn's was careful to point out that, in its
view, the landlord and the contractor were not engaging in
"gamesmanship" which would justify denial of the
landlord's request as a matter of public policy. However, the
story might be otherwise in other cases—it is not difficult
to imagine an astute landlord making a strategic decision to time
the assertion of claims for obligations due under a lease in a way
designed to maximize its recovery in 100 cent dollars.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.