In a departure from prior precedent in the United States Bankruptcy Court for the Southern District of New York (SDNY), a recent opinion by Judge Michael E. Wiles in In re Cortlandt Liquidating LLC,1 effectively lowered the Bankruptcy Code section 502(b)(6) cap on rejection damages that a commercial real estate landlord may claim, by holding that the cap should be calculated using the "Time Approach," rather than the "Rent Approach."
Calculation of Lease Rejection Damages
When a debtor-tenant rejects a real property lease of "non-residential real property" (e.g., a ground lease or a space lease), section 502(b)(6) of the Bankruptcy Code provides for a statutory "cap" on the amount of a landlord's unsecured rejection damages claim in an amount equal to:
- the rent reserved by such lease, without
acceleration, for the greater of one year, or 15
percent, not to exceed three years, of the remaining term of such
lease, following the earlier of—
- the date of the filing of the petition; and
- the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus
- any unpaid rent due under such lease, without acceleration, on the earlier of such dates.
11 U.S.C. § 502(b)(6) (emphasis added).2, 3 This "damage cap" is, in essence, social policy enacted by Congress to prevent commercial lease rejection damage claims from dwarfing all other unsecured claims and has been codified in the Bankruptcy Code since 1934. See In re Connectix Corp., 372 B.R. 488, 491–92 (Bankr. N.D. Cal. 2007) (citing Oldden v. Tonto Realty Corp., 143 F.2d 916, 918 (2d Cir. 1944)).
Courts are divided on how to interpret "fifteen percent, not to exceed three years, of the remaining term of such lease" in section 502(b)(6)(A).
- A majority of courts have adopted the "Time Approach," wherein the lease rejection damages are capped at the rent that is specified for the first 15% of the remaining lease term, so long as that time period is at least one year and no more than three years.
- A minority of courts, which had included SDNY, have adopted the "Rent Approach," wherein lease rejection damages are capped at 15% of the total dollar amount of the rent that would be payable for the entire remaining term of the lease, so long as that amount is at least equal to the rent reserved for the next one year and does not exceed the rent reserved for the next three years of the lease term.
Because rents under a commercial real estate lease generally escalate over time, the "Rent Approach" typically results in a higher rejection damages amount—sometimes significantly so. This is because the Time Approach ignores rent escalations that occur after the first 15% of the remaining lease term, whereas the Rent Approach captures any rent escalations occurring during the entire duration of the lease. In doing so, the Rent Approach usually results in a higher cap amount.
Split in Authority Between Rent Approach and Time Approach
As noted by Judge Wiles in Cortlandt, each position finds support in modern case law. On the one hand, courts in districts including Alaska, California, Colorado, Delaware, Florida, North Carolina, and Pennsylvania have applied the Time Approach. See, e.g., Sunbeam-Oster Co. v. Lincoln Liberty Ave. Inc. (In re Allegheny Int'l, Inc.), 145 B.R. 823 (W.D. Pa. 1992); In re Keane, No. 19-05635-5-DMW, 2020 Bankr. LEXIS 2900 (Bankr. E.D.N.C. Oct. 14, 2020); In re Filene's Basement, LLC, No. 11-13511 (KJC), 2015 Bankr. LEXIS 1350 (Bankr. D. Del. Apr. 16, 2015); In re Denali Family Servs., 506 B.R. 73 (Bankr. D. Alaska 2014); In re Shane Co., 464 B.R. 32 (Bankr. D. Colo. 2012); In re Connectix Corp., 372 B.R. 488 (Bankr. N.D. Cal. 2007); In re Ace Elec. Acquisition, LLC, 342 B.R. 831 (Bankr. M.D. Fla. 2005). On the other hand, courts in districts including Illinois, Michigan, and New York have found the Rent Approach to be more consistent with congressional intent. See, e.g., In re Rock & Republic Enters., No. 10-11728, 2011 Bankr. LEXIS 2401 (Bankr. S.D.N.Y. June 20, 2011); In re Andover Togs, Inc., 231 B.R. 521, 547 (Bankr. S.D.N.Y. 1999); In re Gantos, Inc., 176 B.R. 793 (Bankr. W.D. Mich. 1995); In re Fin. News Network, Inc., 149 B.R. 348, 351 (Bankr. S.D.N.Y. 1993); Schwartz v. C.M.C., Inc. (In re Communicall Cent., Inc.), 106 B.R. 540 (Bankr. N.D. Ill. 1989). None of the Circuit Courts of Appeals have ruled on the issue.
SDNY Bankruptcy Court Adopts Time Approach
Against this backdrop, SDNY Bankruptcy Judge Wiles had now departed from prior SDNY precedent to adopt the Time Approach. In doing so, he noted that, in the 10-year period since the last SDNY bankruptcy case to adopt the Rent Approach, the vast majority of the reported opinions and other precedent had adopted the Time Approach. Judge Wiles found the latter cases and authority to be more consistent with both the plain language of the statute and the legislative history. Judge Wiles also cautioned against substituting one's own views of equity and fairness in place of a statute's plain language.
While it remains to be seen if other SDNY judges will follow Judge Wiles in adopting the Time Approach, the Cortlandt decision calls into doubt whether landlords will be able to take advantage of the Rent Approach when asserting future rejection damages claims in SDNY. Until Congress clarifies the meaning of section 502(b)(6)(A), or the Second Circuit Court of Appeals weighs in, there will be uncertainty as to the proper method for calculating landlord rejection damages claims in SDNY.
Footnotes
1. 648 B.R. 137 (Bankr. S.D.N.Y. 2023).
2. Notably, a landlord is also entitled to a claim for any unpaid prepetition rent in addition to the capped amount for rejection damages claim. In addition, a landlord has an administrative claim under section 365(d)(3) of the Bankruptcy Code for rent and charges incurred from the petition date through the date that the debtor assumes or rejects the lease.
3. The "cap" excludes secured claims, such as pledged cash security deposits and letters of credit.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
© Morrison & Foerster LLP. All rights reserved
