Recent Bankruptcy Decision Embraces “Time Approach” for Calculating Damages on Rejected Commercial LeaseMay 22, 2023
In a rare move against long-standing precedent, the Bankruptcy Court for the Southern District of New York recently reversed course in its district on calculating allowed damages when debtor-tenants in bankruptcy reject commercial leases. This decision could limit landlords’ damage claims if those rejected leases are long term and contain rent escalation clauses. The case, In re Cortlandt Liquidating LLC, et al. Case No. 20-12097-MEW (Bankr. S.D.N.Y. Feb. 2, 2023), is the latest in a growing number of authorities endorsing the debtor-friendly “Time Approach” for calculating lease termination damages available to landlords. In contrast to the previously used “Rent Approach,” the Time Approach usually caps commercial landlord damages at lower amounts due to a different interpretation of the Bankruptcy Code.
Damage Approaches Generally
The Bankruptcy Code is designed to provide a “fresh start” to debtors. Consistent with this purpose, the Bankruptcy Code affords a debtor in bankruptcy the right to “reject” a burdensome unexpired lease. Rejection relieves the tenant from further rent payments. After a tenant rejects a lease, a landlord generally is entitled under Section 502 of the Bankruptcy Code to an unsecured claim for damages for some amount of the future unpaid rent, plus any amounts due prior to the bankruptcy case filing. Amounts of future rent recoverable pursuant to Section 502 have been the subject of much litigation.
Section 502 caps a landlord’s lease rejection damages claim at “the rent reserved . . . for the greater of one year, or 15 percent, not to exceed three years” of the remaining lease term. Courts have interpreted the “15 percent” portion as applying either to the dollar amount of the total rent remaining or to the rent owed for a specific period of the time remaining under the term of the lease. A second upper limit is placed on the rent cap that provides the 15% calculation cannot be more than the next three years’ rent total. Courts agree that the purpose of the rent cap is to permit landlords a claim for future rent but also to limit any landlord claims so that the remaining creditor body is not unduly diluted.
Under the Rent Approach all rent amounts due over the remaining lease term are totaled, then multiplied by 15 percent. In this method, future rent increases are included in the calculation of the landlord’s claim. Because rent increases are captured, this approach is landlord-friendly. The Time Approach, on the other hand, totals only the rents due for the first 15% of the remaining lease term and is thus indifferent to later-scheduled rent increases. That indifference makes it debtor-friendly.
By way of example, assume a lease with 10 years remaining and the following annual rent: years 1–3 require $200,000 annually ($600,000 total); years 4–6 require $300,000 ($900,000 total); and years 7–10 require $400,000 ($1,600,000 total); for a cumulative total of $3,100,000. Under the Time Approach, the landlord’s damages would be capped at $300,000 (calculating only the rent due for the upcoming 15% of the lease, i.e., 1.5 years of the 10 years remaining, not exceeding three years), but under the Rent Approach the landlord’s damages would be capped at $465,000 (calculated at 15% of the total rent due, not exceeding the next three years’ rent).
In the Cortlandt case, which stemmed from Century 21 Department Stores’ bankruptcy filing, the court acknowledged that “the Rent Approach . . . captures an element of rent escalation that the Time Approach does not capture, and in doing so results in a higher cap on the relevant parts of the landlord’s claim.” The court also noted that two decades of cases in the same district had used the Rent Approach, as had the majority of courts across the country from the same time period. Nevertheless, the court determined that the weight of the relevant authority in other districts has shifted very strongly in favor of the Time Approach and that the Time Approach was more consistent with the statutory language. Specifically, the court determined that the statutory language was “worded in periods of time” and so the computation of damages must also be done by reference to time.
The Cortlandt decision was not all bad for landlords, however. The court found that certain “Additional Damages,” such as the cleanup and repairs required under the lease, fell outside of the rent cap and therefore could also be included in the claim. Other courts, though, have applied the rent cap to all lease-related damages. The Cortlandt decision is not binding on any other bankruptcy court, and this particular issue may be an area of ongoing discussion in future cases.
Considering the continued high volume of post-Covid rent defaults, landlords should be aware of the differences in the Rent Approach and the Time Approach when calculating lease rejection claims. Application of the Time Approach could result in landlords recovering a smaller sum than under the Rent Approach. Understanding the landlord’s rights and the scope of its claims requires a careful analysis of the parties’ relationship and the applicable law, which may vary. Landlords' rights to bring claims against debtor-tenants who reject leases, and in some cases against guarantors of those leases, including for any additional non-rent damages, can be assisted through the advice of experienced counsel.