New Ninth Circuit Court of Appeals Ruling Expands Landlord Rights in Bankruptcy

A. Kenneth Hennesay
(949) 553-1313
khennesay@
allenmatkins.com

PLEASE CONTACT US if you have questions regarding this decision:
Anton N. Natsis
Michael S. Greger
Ivan M. Gold
Robert R. Barnes

In a case published this month, the U.S. Court of Appeals for the Ninth Circuit has ruled that the cap on lease termination damages under Bankruptcy Code Section 502(b)(6) does not limit a landlord's right to recover certain damages that are "collateral" to rejection of a lease.  Saddleback Valley Community Church v. El Toro Materials Company, Inc. (In re El Toro Materials Company, Inc.), (9th Cir. Oct. 1, 2007).  In some cases, like El Toro, this can be a multi-million dollar issue. A full understanding of this important new precedent is critical to any commercial landlord that is presently: 

1. litigating lease termination claims;
2. negotiating lease termination agreements or threatened with lease termination and/or bankruptcy by a tenant;
3. structuring or re-structuring long-term leases with substantial construction, maintenance, premises restoration or other tenant obligations that are not directly related to the rental value of the premises; or
4. negotiating credit enhancements for new or re-structured leases.

The Bankruptcy Lease Termination Damages Cap

As landlords know all too well, Bankruptcy Code Section 502(b)(6) operates as a cap on the amount of lease termination damages a landlord may recover from a debtor's bankruptcy estate.  In general, it limits a landlord's maximum recovery from a bankruptcy estate for lease termination damages at the greater of either one year's rent under the lease or 15% of the rent due for the remaining term not to exceed three years; plus any unpaid rent due as of the tenant's bankruptcy petition date. 

Prior Law:  A Landlord Is Entitled to a Single Capped Claim, on Account of All Damages

Before El Toro, the leading case in the Ninth Circuit held that the cap restricted the landlord to a single claim for lease termination damages, including all damages resulting from the breach of each and every provision of the lease, with that single claim measured by Section 502(b)(6).  Kuske v. McSheridan (In re McSheridan), 184 B.R. 91, 102 (9th Cir. B.A.P. 1995).  Courts within the Ninth Circuit have since followed McSheridan, sometimes with draconian results for commercial landlords.  For example, in the Edwards Theatres case, one landlord was denied any recovery for the tenant's total breach of its build-to-suit construction obligations, leaving the landlord with a large undeveloped parcel and a relatively small claim calculated from rent that was negotiated at a reduced rate based on the tenant's construction obligations.

The El Toro Decision:  Damages that Are "Collateral" to Lease Termination Are Not Capped

El Toro Mining Company operated a sand and gravel mine on property subject to an indefinite lease with a mutual termination right on two-years notice.  The company filed chapter 11 and rejected its lease, which had a  monthly rent of $28,000 at that time.  The company abandoned its mining equipment on site, along with other materials and “one million tons of its wet clay 'goo'" which allegedly cost the landlord $23 million to remove.  The Bankruptcy Appellate Panel ("BAP") followed McSheridan and held that the landlord was entitled to a single claim, measured by the Section 502(b)(6) cap (the company contends the cap amount is only $480,000).  The Ninth Circuit reversed the BAP, holding that the landlord’s clean-up expenses, asserted under theories of waste, nuisance, trespass and breach of contract, were not limited by Section 502(b)(6). 

The Ninth Circuit reasoned that a landlord's claim for clean-up damages (which it characterized as "collateral" to lease termination, future rent damages) should not be capped.  Applying the cap to such "collateral" damages would go farther than limiting future rent claims and, at the same time, deny landlords the right to receive compensation from the estate in proportion to what is presently owed.  Moreover, the Ninth Circuit expressly referred to future cases:

"Landlords in future cases may have significant claims for both lost rental income and for breach of other provisions of the lease.  To limit their recovery for collateral damages only to a portion of their lost rent would leave landlords in a materially worse position than other creditors.  In contrast, capping rent claims but allowing uncapped claims collateral damage to the rented premises will follow congressional intent by preventing a potentially overwhelming claim for lost rent from draining the estate, while putting landlords on equal footing with other creditors for their collateral claims."  [Emphasis added].

Allen Matkins has long been a pioneer in structuring sophisticated lease transactions with credit enhancements to help its landlord clients prepare for and manage risks associated with potential tenant defaults or insolvency.  The firm has unparalleled experience in resolving cutting-edge commercial tenant default issues and landlord remedies, including recovery against letters of credit and security deposits, the proper application of the Section 502(b)(6) cap in bankruptcy, recovery on tenants' non-rental obligations outside of the cap, and prosecution and recovery of claims against related parties.  We encourage you to contact us to discuss how to use the El Toro holding to your best advantage.

Related Links

• Ninth Circuit Court of Appeals Decision