United States: Recent Bankruptcy Developments Impacting The Landlord-Tenant Relationship

In drafting the provisions of the Bankruptcy Code relating to nonresidential real property, Congress intended commercial landlords to be "entitled to significant safeguards."¹ Examples of the protections afforded to commercial landlords include requiring a debtor to remain current in its payment of post-petition rent;² allowing landlords to drawdown on a letter of credit without prior bankruptcy court approval;³ permitting landlords to and/or lease rejection damages;⁴ setoff pre-petition unpaid rent against a security deposit recognizing that a tenant's possessory rights in nonresidential real property have been extinguished, and the lease cannot be assumed, where the lease is terminated in accordance with its terms and applicable law;⁵ and limiting the time within which a debtor may extend the time it has to assume or reject the commercial lease in the absence of landlord consent.⁶

Notwithstanding these protections, the landlord–tenant relationship can be a complicated one, and landlords with a tenant in bankruptcy often end up feeling held hostage. Recent decisions in bankruptcy courts in the District of Delaware and the Central District of California shed new light on the contours of this relationship and offer additional guidance to both landlords and tenants attempting to navigate the process.

Indemnification

Commercial leases commonly contain indemnification language, pursuant to which a tenant is obligated to indemnify the landlord for liability incurred during the lease term. When a tenant files for bankruptcy protection, what happens to that indemnification right? Though the answer may ultimately depend on the timing of events and the jurisdiction, Judge Gross in the United States Bankruptcy Court for the District of Delaware recently held that a claim arising from an indemnification provision in a nonresidential real property lease rejected post-petition was entitled to administrative priority pursuant to section 365(d)(3) of the Bankruptcy Code.⁷

In January 2008, Mervyn's LLC (Mervyn's), a department store chain, entered into a lease for commercial property in San Bernadino, California, owned by WM Inland Adjacent LLC (WM Inland). Before it moved in, Mervyn's arranged for improvements to be made to the premises and on January 28, 2008, Mervyn's entered into a construction agreement with Fischer Development Inc. (Fischer) for work to be done at a cost of over $6 million. Both the lease and the construction agreement contract with Fischer required Mervyn's to indemnify WM Inland for various liabilities occurring prior to, during and after the term of the lease. Among the indemnification obligations was the duty to keep the leased premises free of mechanics' liens. Fischer began construction, as scheduled, on March 3, 2008.

On July 29, 2008, Mervyn's and certain of its affiliates filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. At that time, construction was still incomplete and Fischer stopped all work. Between mechanics' liens against the premises in the total amount of $5.5 million. On October 8, 2008, Fischer filed suit against WM Inland to foreclose on the two liens, which were ultimately settled for $1.7 million. Mervyn's rejected the unexpired lease effective November 21, 2008. September 9 and October 3, 2008, Fischer recorded mechanics' liens against the premises in the total amount of $5.5 million. On October 8, 2008, Fischer filed suit against WM Inland to foreclose on the two liens, which were ultimately settled for $1.7 million. Mervyn's rejected the unexpired lease effective November 21, 2008.

In the chapter 11 cases, WM Inland sought treatment under section 365(d)(3)⁸ of the Bankruptcy Code for the $1.7 million payment to Fischer. Pointing to the Third Circuit's decision in Montgomery Ward,⁹ in which the Court of Appeals held that for the purposes of section 365(d) (3) of the Bankruptcy Code an obligation arises when the legally enforceable duty to perform arises under the lease, WM Inland urged adoption of a "billing date" approach to determination of when the indemnification claims arose.

Mervyn's objected to the claim and argued that the indemnification obligation was a general unsecured claim because (1) the indemnification claim arose either from rejection of the lease or from execution of the lease and construction agreement, both of which occurred pre-petition; or (2) the "billing date" did not occur until WM Inland and Fischer settled the dispute, which was a post-rejection event. Either way, the debtors argued, the claim should be treated as unsecured under section 502(g).

The bankruptcy court rejected Mervyn's arguments. The court adopted the Montgomery Ward court's interpretation of 365(d)(3) and made clear the distinction between an "obligation," which is "something one is legally required to perform under the terms of the lease" and that of a "claim," which is an "unmatured right to payment." The court further found that WM Inland was not obligated to demonstrate that the indemnification obligations were actual, necessary costs and expenses of preserving the estate because the provisions of 503(b)(1) are inapplicable to post-petition obligations under section 365(d)(3). Ultimately, the court concluded that the obligation to indemnify WM Inland arose when Fischer recorded the mechanics' liens and sued to foreclose upon, them and the claim was therefore entitled to administrative status under section 365(d)(3). The court reasoned that once Fisher recorded the liens against the leased premises and initiated a lawsuit, the terms of the lease dictated that Mervyn's was obligated to indemnify WM Inland.

A Debtor's Retroactive Rejection

The flexibility afforded to debtors by the terms of section 365(a) of the Bankruptcy Code¹⁰ is particularly valuable where the debtor is a tenant paying over-market rent or plans to close certain of its retail or office locations. However, the terms of section 365(a) offers no guidance regarding the effective date of rejection or whether the rejection date can be retroactive. In a recent decision, Judge Carroll in the United States Bankruptcy Court for the Central District of California concluded that under certain circumstances, a commercial lease may be rejected retroactively to a date prior to the date of the filing of the motion to reject.¹¹

In New Meatco, debtor New Meatco Provisions, LLC (New Meatco), as tenant, and ML Long Beach, LLC (ML), as landlord, were parties to a commercial lease. On May 8, 2013, New Meatco filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code. On May 10, 2013—only two days after the petition date—New Meatco surrendered the premises to ML in broom-clean condition and turned over the keys to ML. On May 24, 2013, New Meatco filed a motion to reject, among others, the lease with ML retroactive to May 10, the date of surrender. Receiving no opposition, on June 18, 2013, the bankruptcy court entered an order approving the lease rejection. Thereafter, ML filed a motion for reconsideration and asserted that the retroactive rejection was barred as a matter of law.

Judge Carroll held that bankruptcy courts may authorize the retroactive rejection of a nonresidential lease and that the retroactive date may be earlier than the motion filing date. The decision was fact-intensive. In affirming the rejection retroactive to May 10, Judge Carroll found that there was no "appreciable delay" in seeking relief under section 365(d) and noted the specific facts that were presented, specifically the short time between the petition date, the surrender of the premises and the filing of the rejection motion. ML also admitted that it knew prior to the petition date that New Meatco was preparing to vacate the premises. Finally, in deciding that the retroactive rejection was appropriate, the bankruptcy court found persuasive the amount of rent (over $200,000 per month) that would accrue under the lease as an administrative expense, which would cause significant harm to New Meatco, its estate and its creditors.

Conclusion

In order to most effectively utilize all tools available to it and to maximize financial recovery, a landlord must develop a strategy as soon as possible after the tenant's petition is filed. A landlord should be mindful of the decision in Mervyn's when filing proofs of claim to preserve its pre- and post-petition claims relating to its debtor-tenant's lease obligations. In addition, both Mervyn's and Meatco make clear that the effective date of rejection is often important in order to assess the nature of a tenant's liability and the priority of payment thereof. Particularly in the current financial climate, it is important for landlords to be vigilant in the protection of their rights.

Footnotes

1. In re Memphis-Friday's Assocs., 88 B.R. 830, 834 (Bankr. W.D. Tenn. 1988).

2. 11 U.S.C. § 365(d)(3).

3. See, e.g., Kellogg v. Blue Quail Energy, Inc. (In re Compton Corp.), 831 F.2d 586, 589 (5th Cir. 1987) (noting that letters of credit and their proceeds are not generally found to be property of the bankruptcy estate). Note, however, that there is a split in authority regarding how much pre-petition rent can be recovered by a landlord drawing down on a letter of credit, specifically whether a landlord may use a letter of credit to circumvent the statutory cap found in Bankruptcy Code section 502(b) (6). Compare In re PPI Enterprises (U.S.), Inc., 324 F.3d 197, 208-10 (3d Cir. 2003) (finding that where a letter of credit is intended as a security deposit, the statutory cap is applicable and a landlord could not use a letter of credit to end-run around the restrictions of 502(b)(6)) and In re Mayan Networks Corp., 306 B.R. 295, 300-01 (9th Cir. BAP 2004) (same) with In re Stonebridge Technologies, 430 F.3d 260, 271 (5th Cir. 2005).

4. 11 U.S.C. § 553. See also, e.g., In re Johnson, 215 B.R. 381, 385 (Bankr. N.D. Ill. 1997) (finding that a landlord holding the debtor's security deposit as collateral to ensure future payment is entitled to setoff, and thus is a secured creditor, to the extent of the security deposit); In re Mainstream Access, Inc., 134 B.R. 743, 750 (Bankr. S.D.N.Y. 1991) (holding that the landlord's claim for lease rejection damages was secured to the value of the security deposit).

5. 11 U.S.C. § 365(c)(3).

6. 11 U.S.C. §365(d)(c)(4).

7. WM Inland Adjacent LLC v. Mervyn's LLC ( In re Mervyn's Holdings LLC), No. 08-11586, Adv. Pro. No. 09-50920, 2013 WL 85169 (Bankr. D. Del. Jan. 8, 2013).

8. Section 365(d)(3) of the Bankruptcy Code provides that a debtor must timely perform all of its obligations under an unexpired lease until that lease is assumed or rejected.

9. Centerpoint Properties v. Montgomery Ward Holding Corp., 268 F.3d 205 (3d Cir. 2001). 10 Section 365(a) authorizes debtors to reject, with court approval, executory contracts and unexpired leases.

11. In re New Meatco Provisions, LLC, No. 13-22155, 2013 WL 3760129 (Bankr. C.D. Cal. July 16, 2013).

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.