New Decision on Lease Rejection Damages

This alert highlights a recent decision by Judge Michael E. Wiles in the Bankruptcy Court for the Southern District of New York (“SDNY”), which held that lease rejection damages should be calculated using the “time approach” rather than the “rent approach” — effectively reducing the maximum claim of landlords whose leases are rejected pursuant to section 365 of the Bankruptcy Code.^[1]

Rejection Damages

A landlord whose lease is rejected pursuant to section 365 of the Bankruptcy Code can assert a general unsecured claim comprised of prepetition arrearages plus “rejection damages.” The “rejection damages” portion of the claim is subject to a statutory cap equal to the greater of rents due for (i) one year; or (ii) 15% of the remaining term, not to exceed three years.^[2] Courts are divided as to whether the calculation pursuant to the second clause is: (i) 15% of the remaining rent under the lease (the “Rent Approach”); or (ii) 15% of the remaining time of the lease (the “Time Approach”), in either event not to exceed three years. The majority of bankruptcy courts in the SDNY previously applied the Rent Approach, but they now apply the Time Approach. Case law is also split as to whether claims relating to maintenance, cleanup costs, repair costs, and costs to dispose of abandoned property are subject to the statutory cap.

Rent Approach or Time Approach

The debate over the Rent Approach vs. Time Approach can “yield significantly different outcomes” for landlords given that rent under commercial leases often escalates over time.^[3]

• The Time Approach places a cap based on rents specified for the first 15% of the remaining lease term (not to exceed three years) and thereby ignores rent escalations that would occur in later years.
• The Rent Approach, on the other hand, imposes a cap based on 15% of all rents that are specified for the entire remaining lease term (not to exceed three years). By applying the 15% to the total amount of rent due and incorporating all future escalated rent, the Rent Approach could result in a much larger claim for rejection damages.

Departing from existing SDNY precedent, the bankruptcy court held that the Time Approach should apply, reasoning:

1. The plain language of the statute makes clear that the Time Approach should be favored given that the entire phrase is worded in terms of periods of time.^[4]
2. Legislative history supports the Time Approach rather than the Rent Approach. Prior Bankruptcy Act provisions were time based, and no legislative history supports that Congress intended to shift away from such approach.
3. Considerations of equity and fairness do not favor one approach over the other.^[5]

Damages Subject to the Section 502(b)(6) Cap

The bankruptcy court also held that additional costs would be subject to the 502(b)(6) cap to the extent that such costs are “attributable to the fact that the term of the lease has come to an end.”^[6] As such, the bankruptcy court held:

• Where a lease provides an obligation to remove furniture and fixtures and leave the property in broom-clean condition, the related cleanup costs are subject to the 502(b)(6) cap because they arise from the termination of the lease.^[7]
• In contrast, (i) a claim for mechanics’ liens placed on the leased premises by unpaid contractors engaged by the tenant is not subject to the 502(b)(6) cap because any damages associated with such liens would have existed regardless of whether the lease was terminated;^[8] and (ii) where a lease requires the tenant to maintain the leased premises, damages caused by the tenant’s negligence or improper conduct are not subject to the 502(b)(6) cap because those damages did not arise from the termination of the lease.^[9]

Takeaways

Although Cortlandt is not binding on other bankruptcy judges, it adds to the growing majority of courts that adhere to the Time Approach. As such, it serves as an important reminder to landlords that, in a tenant bankruptcy, they may not realize a full recovery on future rent escalations or cleanup costs.

^[1] In re Cortlandt Liquidating LLC, 2023 Bankr. LEXIS 266 (Bankr. S.D.N.Y. 2023).
^[2] 11 U.S.C. § 502(b)(6).
^[3] Cortlandt, 2023 Bankr. LEXIS 266, at *5.
^[4] Cortlandt, 2023 Bankr. LEXIS 266, at *8 (“Instead, if the Rent Approach had been intended, the statute would have stated that the allowable rejection damages would not exceed 15 percent of the rent reserved for the remaining term of such lease, provided that such amount will not be less than the rent reserved for the next year of the lease term, and shall not be more than the rent reserved for the next three years of the lease term.”).
^[5] Cortlandt, 2023 Bankr. LEXIS 266, at *13-14 (“I do not believe that considerations of ‘fairness’ or ‘equity’ are helpful in figuring out whether the Rent Approach or Time Approach represents the better interpretation of the statute.”).
^[6] Id. at *16.
^[7] Id. at 17. In this case, the lease expressly stated that “[u]pon expiration or other termination of this Lease, Tenant shall quit and surrender to Landlord the Premises, vacant, broom clean, in good order and condition, ordinary wear and tear and damage for which Tenant is not responsible under the terms of this Lease excepted…” 
^[8] Id. at 18. 
^[9] See id. at 19. 

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