United States: Stub Rent Claims Entitled To Administrative Priority

The Bankruptcy Code requires current payment of a debtor's post-petition obligations under a lease of nonresidential real property pending the decision to assume or reject the lease. However, if a debtor fails to pay rent due at the beginning of a month and files for bankruptcy protection sometime after the rent payment date—thereby creating "stub rent" during the period from the petition date to the next scheduled rent payment date—it is unclear how the landlord's claim for stub rent should be treated. A ruling recently handed down by a Delaware bankruptcy court addresses this controversial issue. In In re Goody's Family Clothing, the court ruled that even if section 365(d)(3) of the Bankruptcy Code does not require immediate payment of stub rent claims, such claims may nevertheless be entitled to administrative priority whether or not the lease is later assumed.

Payment of Post-Petition Commercial Lease Obligations

Section 365(d)(3) of the Bankruptcy Code provides that a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") "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)." 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 these amounts as administrative expenses. The process was cumbersome and time-consuming. Moreover, the lessor'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." It might appear that rent payable under an unexpired commercial lease during a bankruptcy case 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) in 1984, "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. Even if a landlord's claim for post-petition 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 statute. For example, courts are at odds over whether the phrase "all 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 a petition for relief. The former approach—commonly referred to as the "performance" or "billing date" rule—has been adopted by the Courts of Appeal for the Third, Sixth, and Seventh Circuits. An alternative approach employed by other courts (representing the majority view), including the Second, Fourth, and Ninth Circuits, 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 post-petition are akin to "sunken costs" that need not be paid currently as administrative expenses pending a decision to assume or reject the lease.

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 pre-payment 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, including the Seventh Circuit, 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. Others, including the Third Circuit, reject this interpretation, holding that stub rent need not be paid under section 365(d)(3).

If the DIP or trustee were to assume the lease, there is no question that unpaid stub rent would have to be paid in full prior to assumption by operation of section 365(b)(1)(A), which conditions assumption of an unexpired lease upon cure of payment defaults. However, under section 502(g), a claim arising from the rejection of an unexpired lease is treated as if it arose prior to the bankruptcy filing, so that in some cases, a landlord's claim for unpaid rent (even stub rent) may be treated as a general unsecured claim. The interaction of these provisions (sections 365(d)(3), 365(b)(1)(A), 502(g), and 503(b)(1)) and, more specifically, whether section 365(d)(3) is the sole basis for conferring administrative priority on a commercial landlord's claim for stub rent were addressed by the bankruptcy court in Goody's Family Clothing.

Goody's Family Clothing

Goody's Family Clothing, Inc., and its affiliates ("GFC") operated a 350-store chain of family apparel retail stores located throughout the U.S. At the time that it filed for chapter 11 protection in Delaware in June 2008, GFC was a tenant under a number of nonresidential real property leases for its stores. Some of these leases obligated GFC to pay monthly rent on the first of each month. GFC, however, did not pay the rent due to the landlords on the first of the month preceding the petition date, thus giving rise to claims for stub rent. Three landlords sought an order from the bankruptcy court designating their stub rent claims as administrative claims and directing that the claims be paid immediately.

GFC objected, arguing that: (i) an administrative claim was not available under 365(d)(3) because the stub rent obligation did not arise post-petition; (ii) section 365(d)(3) (and, in the event that the lease was assumed, section 365(b)(1)(A)) provided the sole basis for awarding an administrative claim to a landlord for post-petition rent; and (iii) even assuming that an administrative claim for stub rent was authorized under section 503(b)(1), immediate payment should not be required.

The Bankruptcy Court's Ruling

Section 365(d)(3), the court explained, does not apply to the landlords' request for allowance and payment of stub rent because GFC's obligation to pay rent arose on the first day of each month—in this case, eight days prior to the petition date. Even so, the court emphasized, the pre-petition nature of the payment obligation did not necessarily preclude administrative status for the stub rent claims. The court's analysis on this point turned on the meaning of the phrase "notwithstanding section 503(b)(1)" in section 365(d)(3). According to GFC, the presence of the word "notwithstanding" in section 365(d)(3) means that section 365(d)(3) alone establishes the criteria for conferring administrative priority on post-petition lease obligations (unless the lease is assumed and the cure obligations of section 365(b)(1)(A) are triggered) and that the standards for administrative priority in section 503(b)(1) do not apply.

The court rejected this approach. The meaning of "notwithstanding," the court noted, is "in spite of," such that, under section 365(d)(3), a debtor must timely perform its obligations under an unexpired lease of nonresidential property "in spite of the terms of section 503(b)(1)." Stated differently, the court explained, the statute effectively reads: "forget what § 503(b)(1) says." Thus, the court held that section 365(d)(3) gives landlords a remedy in the event that the debtor has an obligation under an unexpired lease in addition to the right under section 503(b)(1) to seek an administrative claim and immediate payment. In other words, the court held, section 365(d)(3) does not preempt 503(b)(1). Although the burden is on the claimant under section 503(b)(1) to establish that its asserted administrative expense claim is an actual, necessary expense of preserving the debtor's estate, a debtor's occupancy of premises is sufficient, in and of itself, to meet the burden under section 503(b)(1). Because the debtors in this case continued to occupy and operate out of the locations covered by the leases at issue, the court allowed the landlord's administrative expense claim for the amount of the stub rent.

According to the court, whether GFC ultimately decided to assume or reject the leases had no bearing on the stub rent claims' entitlement to administrative status under section 503(b)(1). Administrative expense status, the bankruptcy court emphasized, is routinely conferred upon claims arising from post-petition occupancy and use of real property, where there is a benefit to the estate, even when the debtor has rejected the lease or the lease expired pre-petition.

Immediate Payment Not Required

Unlike claims made under section 365(d)(3), however, administrative expense claims under section 503(b)(1) for post-petition rent need not be "timely paid." Rather, the timing of the payment is in the court's discretion. Most of the Delaware bankruptcy court decisions addressing the timing of payment of an administrative expense claim for stub rent, citing judicial economy, have not permitted the immediate payment of such amounts, instead deferring liquidation and payment of claims to plan confirmation or lease assumption. In In re HQ Global Holdings, Inc., the bankruptcy court identified four factors to consider when evaluating the timing of payment: (i) bankruptcy's goal of orderly and equal distribution among creditors; (ii) preventing a race for the debtor's assets; (iii) the particular needs of the administrative claimant; and (iv) the length and expense of the case's administration.

In Goody's Family Clothing, GFC had filed a chapter 11 plan, and confirmation hearings were scheduled imminently. Under the proposed plan, administrative claims would be paid in full. Thus, the bankruptcy court found, there would be little delay in payment, and the risk of administrative insolvency was low. The court further found that the debtors' decision not to pay the stub rent immediately was "a business judgment made in good faith upon a reasonable basis." Thus, the court denied the landlords' motions for an order directing immediate payment of their stub rent claims but granted the claims administrative priority.

Outlook

The timing of a chapter 11 filing is an important element of any company's pre-bankruptcy planning. A cash-starved prospective debtor that is a tenant under nonresidential real property leases may be able to time its chapter 11 filing in a way that at least defers the obligation to pay stub rent until sometime later in the bankruptcy case.

The ruling in Goody's Family Clothing is consistent with the bankruptcy court's prior decision in In re Valley Media, Inc., where Judge Peter J. Walsh held that section 365(d)(3) could be read to say that "aside from administrative expenses provided for in § 503(b)(1), § 365(d)(3) creates a new and different kind of 'obligation'—one that does not necessarily rest on the administrative expense concept." Both rulings can be viewed as a positive development for commercial landlords, but only to a point. Although the landlord of a debtor in Delaware will have an administrative claim for unpaid stub rent, it may have to wait until confirmation of a chapter 11 plan to get paid.

It should be noted that in determining whether the landlords' administrative claims should be paid immediately, the bankruptcy court in Goody's Family Clothing applied both the HQ Global factors as well as the business judgment test customarily applied in bankruptcy to a proposed nonordinary-course use, sale, or lease of estate property. Although courts generally do not apply the business judgment standard to the payment or nonpayment of post-petition rent, the bankruptcy court concluded that it was a "logical and appropriate" standard to apply. It ultimately held that the GFC's proposal to defer payment to the plan-confirmation stage of the case was appropriate under both the HQ Global factors and the business judgment standard.

Confusion persists regarding the proper treatment under the Bankruptcy Code of a commercial landlord's claim for stub rent, with bankruptcy courts arrayed in relatively equal numbers on both sides of a growing divide. For example, a New York bankruptcy court ruled on December 17, 2008, in In re Stone Barn Manhattan LLC that section 365(d)(3) requires payment of stub rent, but recognizing that the proration approach has been rejected by three circuit courts and a number of intermediate appellate courts, the bankruptcy court stayed its decision so that the parties would have an opportunity to appeal the ruling immediately to the Second Circuit Court of Appeals, which has not yet considered the issue.

In re Goody's Family Clothing, Inc., 392 B.R. 604 (Bankr. D. Del. 2008).

In re Handy Andy Home Improvement Centers, Inc., 144 F.3d 1125 (7th Cir. 1998).

Koenig Sporting Goods, Inc. v. Morse Road Co. (In re Koenig Sporting Goods, Inc.), 203 F.3d 986 (6th Cir. 2000).

Ha-Lo Industries v. Centerpoint Properties Trust, 342 F.3d 794 (7th Cir. 2003).

In re Montgomery Ward Holding Corp., 268 F.3d 205 (3d Cir. 2001).

In re HQ Global Holdings, Inc., 282 B.R. 169 (Bankr. D. Del. 2002).

In re Valley Media, Inc., 290 B.R. 73 (Bankr. D. Del. 2003).

In re Stone Barn Manhattan LLC, 398 B.R. 359 (Bankr. S.D.N.Y. 2008).

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