Two recent cases highlight the care landlords need to take when dealing with insolvent tenants both pre- and post-bankruptcy.

A federal district court in Georgia recently ruled that a landlord's receipt of a payment pursuant to a pre-petition termination agreement could constitute a preference payment that was potentially voidable under section 547 of the Bankruptcy Code. In so holding, the district court affirmed a similar determination by the bankruptcy court. Midwest Holding No. 7, LLC, v. Anderson, 387 B.R. 892 (N.D. Ga. 2008).

In Midwest Holding, the landlord and the debtor entered into an agreement pursuant to which the parties agreed to terminate an existing lease of nonresidential real property. In consideration for the termination agreement, the debtor agreed to make certain payments to the landlord. The debtor made all the promised payments; however, within 90 days of making such payments, the debtor commenced a chapter 7 bankruptcy case.

During the pendency of the bankruptcy case, the chapter 7 trustee brought an adversary proceeding against the landlord, seeking to recover the termination payments made by the debtor to the landlord as a preference under section 547 of the Bankruptcy Code.

The landlord argued that the payments were not payments on account of previously existing obligations (i.e., the trustee could not satisfy the "antecedent debt" requirement of section 547). Rather, the landlord asserted the payments were made in exchange for permission to terminate the lease.

The bankruptcy court disagreed.

On appeal, the landlord continued to argue that the termination payments were made in exchange for the agreement to "terminate" all existing and future lease obligations (and was not for simply past due rental obligations).

The district court, relying on a decision from the Bankruptcy Appellate Panel for the Ninth Circuit, overruled the landlord's argument and permitted the trustee's recovery of the termination fee.

The facts of this case continue to raise concerns over whether a landlord can structure lease terminations in a manner that protects itself from ultimate preference recovery. The court makes vague references to possible protection if the debtor received value over and above the release of the obligation to pay future rent; however, it is difficult to determine what "additional value" could be contemplated beyond a simple release of all obligations under the lease.

Post-petition Obligations

In In re Van Vleet, 383 B.R. 782 (Bankr. D. Colo. 2008), the bankruptcy court was confronted with whether a lease continued post-petition and, if it continued, what rental obligations the debtor was required to honor in accordance with section 365(d)(3) of the Bankruptcy Code.

The debtor in In re Van Vleet was a party to a lease of nonresidential real property that expired, by its terms, pre-petition. Despite expiration, the debtor remained in possession of the property. In accordance with the terms of the lease, the lease converted to a "month-to-month tenancy." During the month-to-month tenancy, in October 2006, the debtor filed a chapter 11 bankruptcy case. The debtor remained in possession of the property through January 2007, but failed to pay certain rental obligations.

Although the debtor vacated the premises Jan. 31, 2007, the debtor did not provide 30 days' notice prior to vacating, as required in accordance with the month-to-month tenancy obligations.

Although the bankruptcy estate initially contended that no lease remained in effect (because a lease expired pre-petition), the bankruptcy court noted that the express terms of the lease provided for the conversion to a month-to-month tenancy if the lease expired, but the debtor did not surrender the premises. Because the debtor remained in possession through Jan. 31, 2007, the court easily concluded that a month-to-month tenancy continued to and through that date.

Upon determination that a month-to-month tenancy continued, the court analyzed the debtor's post-petition payment obligations under that lease.

Pursuant to section 365(d)(3) of the Bankruptcy Code, the debtor is obligated to pay all post-petition obligations as and when they arise. The landlord asserted that it was entitled to payment of rent for October 2006 through March 2007. The landlord's position was that the property was in the debtor's possession through Jan. 31, 2007, plus 30 days to make up for the failure to provide notice of intention to vacate the premises.

The debtor agued that it should have no payment obligation because it sought to reject the lease retroactively to the date of the bankruptcy filing.

The court quickly dismissed the "retroactive rejection argument," noting that to allow the estate to retroactively reject the lease to a point that predated the date when the debtors vacated the premises would frustrate the clear and unambiguous language of section 365(d)(3) of the Bankruptcy Code. Although the court concluded that the landlord was entitled to rental obligations for the period prior to Jan. 31, 2007, the court ruled the landlord was not entitled to rent for February and March simply because a debtor failed to provide notice of its intent to vacate the premises.

The court next addressed the debtor's payment obligations for the month of October. The court acknowledged the existence of a split in authority between the "performance rule" and the "proration rule." Under the "performance rule," a debtor is required to perform all obligations that are required to be "performed" under the express terms of the lease during the post-petition period. Therefore, if the lease imposes an obligation on the debtor that is required to be performed during the post-petition period, the performance rule requires that the debtor perform that obligation.

The "proration rule," on the other hand, requires the debtor only to honor obligations that are "allocable" to a post-petition period.

The differences under these rules are most evident in a monthly rental situation. Under the performance rule, if the date for payment of rent comes due during the post-petition period (regardless of the period of time that the rent relates to or whether the debtor is in possession), the debtor is obligated to pay the entirety of the rental obligation. Under the "proration rule," the debtor only is obligated to pay post-petition that portion of the rental obligation that is allocable to the portion of the month for which the debtor remained in possession.

In this case, because the debtor filed its bankruptcy case Oct. 11, 2006, the court applied the proration rule and concluded that the debtor only was obligated to pay the monthly rental obligation for the 20 post-petition days during which the debtor remained in possession.

This case highlights the split in authority concerning whether post-petition obligations under section 365(b)(3) of the Bankruptcy Code are governed by the performance rule or the proration rule. Because these rules vary by appellate circuit (and even by lower court jurisdiction), understanding the appropriate jurisdiction in which a debtor's bankruptcy case is pending is key to determining the scope of the post-petition claim to which the landlord will be entitled.

This article is presented for informational purposes only and is not intended to constitute legal advice.