Chapter VI Real Estate & Environmental Problems

• Jurisdiction: United States

VI. Real Estate & Environmental Problems

Does "Term" Equal "Time"? Calculation of Lease-Damage Claims after Early Termination¹

Written by:
Harris Winsberg
King & Spalding LLP
Atlanta, Georgia

When a commercial lease tenant files for bankruptcy, the tenant may obtain court approval to reject the lease pursuant to § 365 of the Bankruptcy Code. If the landlord cannot re-let the property to a new tenant or must re-let it at a reduced rent, the landlord may file a claim for damages caused by the tenant's early termination of the lease. Section 502(b)(6) of the Code, however, caps the amount of damages a landlord may assert due to the termination. While § 502(b)(6) caps damage claims, it does not determine damage claims. Instead, "[a] landlord's claim for damages is determined by state law and the terms of the lease and then limited by § 502(b)(6)."² Courts have adopted two methods of calculating the cap set forth in § 502(b)(6). Some courts find that the 15 percent cap corresponds to the rent accruing for 15 percent of the remaining time under the lease, while other courts have held that the cap corresponds to the total amount of rent remaining under the term of the lease. This article addresses the two distinct calculations: the most recent case to address the issue, In re Heller EhrmanLLP³ and the implications of each method of calculation.

The Statute and Calculations

Section 502(b)(6) caps landlord damages as follows:

(b) Except as provided in subsections (e)(2), (f), (g), (h) and (i) of this section, if such objection to a claim is made, the court...shall determine the amount of such claim...as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that—

(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds

(A) 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—

(i) the date of the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease, following the earlier of—
(i) the date of the filing of the petition; and
(ii) the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus

(B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates.⁴

The legislative history shows that Congress enacted § 502(b)(6) to compensate landlords for actual damages while limiting future, speculative damages, which could dilute other creditors' claims.⁵

Some courts hold that the 15 percent cap⁶ corresponds to rent accruing for 15 percent of the remaining time under the lease ("time approach").⁷ Under the time approach, a landlord will multiply the remaining time left on the lease by 15 percent and then determine the rent reserved during that specific time period in the lease. Other courts hold the reference to 15 percent corresponds to the total amount of rent remaining under the term of the lease ("rent approach").⁸ Under the rent approach, a landlord will multiply 15 percent by the total remaining rent due under the lease.

In re Heller Ehrman

In Heller Ehrman LLP,⁹ the landlord leased office space to the debtor under a lease scheduled to terminate in 2018. The debtor obtained court approval to reject the lease in June 2009, and the landlord filed a rejection claim to which the debtor objected as being in excess of the 15 percent cap.

Because the lease had approximately 114 months remaining, the 15 percent cap applied to the landlord's claim. The debtor argued the time approach, which yielded a future lost rent claim of $12.1 million. The landlord argued the rent approach, which yielded a future lost rent claim of $14.4 million.

Plain Meaning

The landlord argued the word "term" in subsection (A) refers to the total rent due under the lease; thus, the one year or 15 percent limitation were alternative ways of calculating the rejection claim. Conversely, the debtor argued the word "term" referred to a measurement of time, which is the remaining time under the lease.

The court found when comparing the greater of two things (i.e., one year or 15 percent not to exceed three years), the two things measured should be the same. Because "one year" refers to time, the court concluded the word "term" must be referring to the remaining time under the lease, not the remaining rent due under the lease. The court noted the phrase "term of lease" commonly refers to the length of a lease based on time, not rent.

Legislative History

The court noted the statute was subject to different interpretations; thus, the court examined the legislative history of the statute. Prior to 1934, a landlord could not recover on a claim for future rent after the tenant rejected the lease because the landlord's claim was considered too speculative.¹⁰ During the Great Depression, Congress amended the Bankruptcy Act to permit landlords to recover on their rejection claims.¹¹ Section 77B of the Bankruptcy Act limited a landlord's rejection damages in a reorganization to "an amount not to exceed the rent, without acceleration, reserved by said lease for the three years next succeeding the date of surrender of the premises to the landlord or the date of reentry of the landlord...¹² and § 63(a) of the Bankruptcy Act limited a landlord's rejection damages in a liquidation to "the rent reserved by the lease, without acceleration, for the year next succeeding the date of the surrender of the premises."¹³ Thus, in the Bankruptcy Act, Congress allowed landlords to recover damages for future rents but limited damages to three years' rent in reorganizations and one year's rent in liquidations.

In 1978, Congress included a similar provision in the new Bankruptcy Code to allow landlords to recover rejection damages. In enacting the cap, Congress combined the two caps into a sliding scale, which removed the words "next succeeding" and added the 15 percent limitation.¹⁴ Unlike the cap in the Bankruptcy Act, the Bankruptcy Code does not distinguish between a reorganization or liquidation case.

In Heller Ehrman, the landlord argued that legislative history supports the rent approach. In rejecting this argument, the court noted the cap under the Bankruptcy Act was measured by time, so the court declined to interpret the 15 percent cap in a manner inconsistent with pre-Code practice without clear congressional intent.

Equity

Finally, the landlord argued that equity favored the rent approach because it takes a sample of the rent negotiated over the term of the lease and more closely satisfies the landlord's expectation to receive the rent bargained for in the lease. The court noted that the landlord's expectancy interest conflicts with the legislative history of § 502(b)(6).¹⁵ Because Congress intended to limit rejection claims, the time approach is more equitable as it limits damages to the rent due right after the termination of the lease.

The Implications

The method used for the rent cap calculation can create different results. The example from New Valley¹⁶ illustrates this point:

A chapter 11 debtor rejects a lease with 10 years remaining under the lease. Each of the first [five] years of the remaining lease term requires rental of $80,000 a year, and each of the last [five] years of the remaining lease term requires rental of $120,000 a year. If the § 502(b)(6) damage cap is calculated as a function of time, 15% of the remaining lease term would be 1.5 years (10 years multiplied by .15), which would make the lessor's rejection damages $120,000 (1.5 years multiplied by $80,000 a year for that period of time). If the damage cap is calculated as a function of rent, the lessor would be entitled to $150,000 in damages ($1 million multiplied by 15%).
Conversely, assume that the lease requires $120,000 annual payments for the first five years and $80,000 for the remaining five years. If calculated as a function of time, the lessor's damages would be $180,000 (1.5 years multiplied by $120,000 a year). If calculated as rent, lessor's damages remains the same—$150,000.

As the example illustrates, the time approach yields different results when the lease payments increase while the rent approach will yield the same result.

Conclusion

Section 502(b)(6) should be modified to clarify how the 15 percent cap works and to give courts clearer direction. If Congress intended that courts use the time approach, it could achieve this clarity by changing only the word "term." In that case, modified § 502(b)(6)(A) should read as follows:

(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds—

(A) 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 time of such lease...

Similarly, if Congress intended that courts use the rent approach, it could achieve this clarity by changing the word "term" to "rent." In sum, Congress should clarify the statute.

Fixing the Qualitech Problem by Revising § 365(h)¹⁷

Written by:
James H. Millar
Wilmer Cutler Pickering Hale and Dorr LLP; New York

In 2003, the Seventh Circuit handed down the Qualitech decision, which considered whether a nondebtor lessee of commercial real property may retain its right to possession of the leased premises under § 365(h), notwithstanding that the debtor had sold the premises free and clear of all interests pursuant to § 363(f).¹⁸ The Seventh Circuit held that under the facts, the lessee had no further rights to possession.¹⁹ Moreover, because the lessee had failed to request adequate protection under § 363(e), it received no compensation whatsoever.²⁰

That decision has generated significant criticism.²¹ Before Qualitech, some courts opined that even though a debtor may satisfy § 363(f), which permits...