Chapter Two The Debtor's Obligations to the Landlord Prior to Assumption or Rejection of the Lease

• Jurisdiction: United States

Chapter Two The Debtor's Obligations to the Landlord Prior to Assumption or Rejection of the Lease

I. Introduction

One of the most important rights of landlords is the requirement in § 365 of the Code that a tenant under a lease of nonresidential real property continue to fully and timely perform its "obligations" between the date of the petition and the date on which the lease is assumed or rejected.⁷⁴ Other parties to executory contracts with the debtor typically have no such right. Upon the commencement of the bankruptcy case, pre-petition creditors are stayed from enforcing their pre-petition contract rights under the automatic stay provided by § 362 of the Code. Landlords, however, may enforce the rental obligation because a lease is an executory contract under § 365, hence it is governed by a series of different rules and concepts that presumably were designed to enlarge the rights of a landlord. This important protection may be one reason why landlords sometimes take a passive role in a case, at least as long as they are receiving full rental payments during the post-petition, pre-rejection period.

A landlord's rights with respect to tenants are generally governed by § 365, which is one of the longest and most complicated sections in the Code. Its rules pertain to all contracts that are "executory." Although the Code does not define "executory," all unexpired commercial leases of real property are intrinsically executory.

The basic logic of § 365 is straightforward. A debtor-lessee is given a period of time to decide whether to assume or reject a lease or other executory contract.⁷⁵ Assumption signifies that the debtor's estate will assume and accept all of the obligations under the lease, and hence, the obligations acquire the status of an "administrative claim" (see infra Chapter 2(II)(B) for a discussion on use of this phrase). Rejection is more complex and signifies either a termination or a decision by the estate "not to assume" or to breach.

During the period prior to assumption or rejection, the nondebtor party must fully perform its obligations. With respect to a lease, a debtor must also perform all of its obligations pending assumption or rejection. This is a different rule than that which pertains to other forms of executory contracts and indicates some preferential treatment toward landlords. This chapter examines the duties of the debtor during the period prior to assumption or rejection, and the many related issues that determine the amount of rent that is due and the priority status to which such rent is entitled.

II. The Debtor's Duty to Timely Perform Its Lease Obligations Pending Assumption or Rejection

A. Rationale for the Rule

Between the date on which the petition is filed and the date on which the lease is assumed or rejected, a debtor-tenant is required to timely perform all of its obligations under the terms of the lease. Such obligations are fixed by the terms of the contract, hence the tenant is obligated to pay, on a current basis, the full amount of the contract rent until there is a judicial order approving a rejection of the lease. If not for this rule, then the landlord would be forced to provide services to the debtor — the use of its property, utilities and other services — without payment.

Following the commencement of the case, a debtor as a tenant of commercial real property is obligated to timely perform its obligations under a lease of nonres-idential real property. The basic rule is set forth in § 365(d)(3) of the Code:

The trustee shall timely perform all the obligations of the debtor ... arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding § 503(b)(1) of this title.

Section 365(d)(3) alters the former Bankruptcy Act's rule that the amount of a landlord's claim was limited to the value of the premises or the value of the "use and occupancy." As the Seventh Circuit explained in In re Handy Andy Home Improvement Ctrs. Inc.:⁷⁶

Until [§ 365(d)(3)'s] enactment in 1984, the landlord was in an awkward spot during the interval between the entry of the tenant into bankruptcy and the tenant's decision to assume or reject the unex-pired lease. At the same time that the automatic stay would prevent the landlord from evicting the tenant, the "actual, necessary" provision of section 503(b)(1) ... might prevent the landlord from collecting the rent in full, promptly and without legal expense.... To give relief to landlords, Congress passed section 365(d)(3), which ... allows them during that awkward postpetition prerejection [sic] period to collect the rent fixed in the lease. There is no indication that Congress meant to go any further than to provide a landlord exception to section 503(b)(1), and thus no indication that it meant to give landlords favored treatment for any class of prepetition debts.⁷⁷

The notion that the amount due is governed by "value" is rarely applied and not in keeping with the language of the Code.⁷⁸

Post-petition obligations that arise under a commercial lease are sometimes referred to as "administrative" obligations, although this may be imprecise and misleading. Administrative expense claims are generally obligations that arise from the debtor's post-petition activities and provide value to the bankruptcy estate. Section 503 of the Code defines administrative expense claims as including the "actual, necessary costs and expenses of preserving the estate, including wages, salaries or commissions for services rendered after the commencement of the case."⁷⁹ Section 507(a)(1) of the Code grants first priority in the distribution of the assets of the estate to holders of administrative expense claims. Congress granted first priority in payment to administrative expenses in order to encourage creditors otherwise wary of dealing with a chapter 11 debtor to provide the goods and services required for successful rehabilitation.⁸⁰

Payments to landlords for post-petition rent are viewed by many courts as unique. Although referred to in this text and in many decisions as having "administrative priority," many courts question whether post-petition rental obligations are subject to the normal rules that govern administrative claims.⁸¹ In Child World Inc. v. Campbell/Massachusetts Trust (In re Child World Inc.),⁸² the court held that a post-petition, pre-rejection rent obligation is not technically an "administrative expense" but a special category of payment entitled to priority over all other administrative expenses:

Most courts have characterized payments due under § 365(d)(3) as "administrative expenses." However, the court in In re Duckwall-ALCO Stores Inc., 150 B.R. 965 (D. Kan. 1993), declined to follow this practice in light of the differences in amount and timing between payments due under § 365(d)(3) and payments allowed as administrative expenses under § 503. Id. at 971, n.10. Given the differences between § 365(d)(3) and § 503 noted by the Duckwall court, as well as the different purpose of § 365(d)(3) as described in Senator Hatch's statement, we agree that characterizing payments due under § 365(d)(3) as "administrative expenses" is confusing, and therefore we follow the lead of the Duckwall court in declining to use the common terminology.⁸³

However, because this usage has become widespread, the phrase is applied in this text.

B. The Duty to Perform Lease Obligations Is Independent of the Standards for Administrative Claims

The nearly universal rule is that the landlord is entitled to be paid its full rent after the case is filed, until the date of rejection of the lease, regardless of the value of the premises to the debtor, and even if the premises are vacated.

The courts generally have been consistent in ruling that under § 365(d)(3), the rental obligations are due regardless of whether the rent would otherwise meet the test for an administrative expense. That is, it does not matter whether the debtor is actually using, or needs, the space; the obligation to pay rent continues until there is an order for rejection. For example, in Leather Factory Inc., the bankruptcy court noted:

We have held that claims arising under § 365(d)(3) are entitled to administrative priority even when they may exceed the reasonable value of the debtor's actual use of the property. See In re Pacific-Atlantic Trading Co., 27 F.3d 401, 405 (9th Cir. 1994). We did so because the "notwithstanding section 503(b)(1)" proviso exempts the amount of lease obligations that a trustee must timely pay under § 365(d)(3) from § 503(b)(1)'s limitation of administrative expenses to the fair value of the debtor's use of the property. Id. When the trustee fails to pay an obligation, the amount accorded administrative priority is similarly not subject to the § 503(b)(1) limitation. Id. We reasoned that to hold otherwise would reward trustees for failing to perform lease obligations, a result entirely at odds with § 365(d)(3)'s purpose of ensuring prompt payment for landlords. Id.⁸⁴

The Child World court held that the amount of rent due for the period prior to rejection of a lease is measured by the contract amount and not by the value of the premises or the debtor's use or occupancy:

A debtor's obligation for post-petition rent under an unexpired lease for nonresidential real property is governed by 11 U.S.C. § 365(d)(3).... In establishing the debtor's post-petition obligation at the level required by the unexpired lease of nonresidential property until it is either assumed or rejected, § 365(d)(3) alters the prior rule that the debtor is liable for post-petition use and occupancy only to the extent it reflects a necessary cost of preserving the estate and qualifies as an administrative expense under 11 U.S.C. § 503(b)(1)(A).... Thus, 11 U.S.C. § 365(d)(3) does not require a determination of the reasonable value of the debtor's post-petition use and occupancy and, instead,

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