Delaware Bankruptcy Court Faces Split Among the Courts Concerning Scope of a Landlord’s Claim Against a Tenant in Bankruptcy

The Delaware bankruptcy court will soon be forced to rule on the scope of a landlord's claim in bankruptcy, an issue on which courts around the country have been split for many years. In the case of In re Masonite Corp. (Case No. 09-10844-PJW), currently pending before the Delaware bankruptcy court, a tenant in bankruptcy rejected the lease of real property on which it conducted its business operations. The landlord filed a proof of claim for lease rejection damages, which included amounts owed for HVAC repairs and general repairs and maintenance. The debtor-tenant objected to the landlord’s claim. The landlord filed a response in opposition to the debtor’s objection. The landlord and tenant disagree on whether the landlord’s claim for damages necessary to repair the leased property should fall within the statutory cap for damages owed to a landlord stemming from the rejection of a lease of non-residential real property.

Typically, when a debtor-tenant rejects a lease of non-residential real property, the landlord files a claim for damages as a result of such rejection. 11 USC § 502(b)(6) provides a formula for the claim of a lessor for damages resulting from the termination of a lease of real property that consists of, generally speaking, the unpaid pre-petition rent due under the lease and the forward-looking “rent reserved” under the lease for a specified period of time. The landlord, however, often discovers that in the course of its business operations, the tenant has damaged the leased premises. To the landlord’s dismay, the cost to repair such damage is significant. As a result, the landlord, in its claim for lease rejection damages, may attempt to include the amounts necessary to repair the leased property.

Courts around the country are split as to whether such damages should be limited by 11 USC § 502(b)(6) or whether the statutory cap only restricts the “rent” component of a landlord’s claim and not any other amounts that comprise the debt under applicable non-bankruptcy law. Courts that hold that the landlord is allowed a single claim for all of its damages, including damages relating to repair of the leased premises, include bankruptcy courts in Texas¹, Delaware², Pennsylvania³, New Jersey⁴ and Colorado⁵. Courts that hold to the contrary include bankruptcy courts in Illinois⁶, North Dakota⁷, Virginia⁸, Michigan⁹ and Florida¹⁰, as well as the Ninth Circuit Court of Appeals¹¹.

The first set of courts read the statute expansively and advance many arguments for their position, including the following:

1. When a debtor “rejects” a lease, the debtor is rejecting its future performance of all of the covenants contained within the lease. Rejection effectuates a breach of all of the lease provisions, including covenants, and that breach is what authorizes a landlord to file a proof of claim for damages.
2. The language in Section 502(b)(6) does not qualify or in any way limit the type of damages involved. The damage cap applies to all damages, which are then arbitrarily capped and measured by rent reserved.
3. Section 502(b)(6) was enacted to curtail exorbitant future damage claims by landlords on long-term leases that threaten to consume a debtor’s bankruptcy estate to the detriment of other creditors.

Courts that read the statute narrowly likewise present several arguments in support of their position, including the following:

1. The statutory cap applies solely to those damages that arise as a consequence of the lease being terminated. It does not apply to damages the landlord would have suffered regardless of the premature termination of the lease. Therefore, if instead of rejecting the lease, the debtor had assumed it, a claim that would be part of the cure amount should be allowed in its entirety.
2. Damages for lost rental income based on the amount of expected rent should be capped, as landlords may have the ability to mitigate their damages by re-leasing or selling the premises, but will suffer injury in proportion to the value of their lost rent in the meantime. In contrast, it does not make sense to cap collateral damages, since a tenant may cause significant damage to a premises leased cheaply.
3. An expansive application of the cap would create a perverse incentive for lessees to reject otherwise desirable leases in order to gain the benefit of capping unrelated damages. Rejecting the lease would allow the tenant to cap its liability for any collateral damage to the premises and thus reduce its overall liability, even if staying on the property would otherwise be desirable and preserve the operating value of the business.

The Delaware bankruptcy court currently faces this issue in In re Masonite Corp.¹². Given the ruling in In re El Toro Materials Co., Inc. by the Ninth Circuit, the only circuit court of appeals to have ruled directly on this issue, it will be interesting to see which way the Delaware bankruptcy court swings and how narrowly or expansively it interprets the Section 502(b)(6) limitation.

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¹In re Mr. Gatti’s, Inc., 162 B.R. 1004 (Bankr. W.D. Tex. 1994).
²In re Foamex Intern., Inc., 368 B.R. 383 (Bankr. D. Del. 2007); In re PPI Enters., 228 B.R. 339 (Bankr. D. Del. 1998).
³In re Flanigan, 374 B.R. 568 (Bankr. W.D. Penn. 2007); In re Peters, 2004 Bankr. Lexis 787 (Bankr. E.D. Penn. 2004); In re Blatstein, 1997 U.S. Dist. Lexis 13376 (E.D. Penn. 1997).
⁴In re New Valley Corp., 2000 U.S. Dist. Lexis 12663 (D.N.J. 2000).
⁵In re Storage Technology, 77 Bankr. 824 (Bankr. D. Colo. 1987).
⁶In re Atlantic Container Corp., 133 B.R. 980 (Bankr. N.D. Ill. 1991).
⁷In re Bob’s Sea Ray Boats, Inc., 143 B.R. 229 (Bankr. D.N.D. 1992).
⁸In re Best Products Co., Inc., 229 B.R. 673 (Bankr. E.D. Va. 1998).
⁹In re Energy Conversion Devices, Inc., 483 B.R. 119 (Bankr. E.D. Mich. 2012).
¹⁰In re Q-Masters, Inc., 135 B.R. 157, 161 (Bankr. S.D. Fla. 1991).
¹¹In re El Toro Materials Co., Inc., 504 F.3d 978 (9th Cir. 2007). 
¹²Assuming the matter is not continued, the Delaware bankruptcy court is scheduled to hear the matter on July 23, 2014.