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Commercial Landlords of Bankrupt Tenants Benefit From Ninth Circuit's Recent Decision

May 31, 2008Cole Schotz DocketAttorney: Ilana Volkov

The United States Court of Appeals for the Ninth Circuit recently held in the case of In re El Toro Materials Company, Inc. that a commercial landlord’s claim for physical damage caused to its property by a debtor-tenant is not capped by the Bankruptcy Code.

The Bankruptcy Code expressly enumerates how a commercial landlord’s claim should be calculated.  The relevant provision attempts to strike a balance between compensating a landlord for economic loss stemming from a debtor’s termination of the lease and permitting a claim so large due to the rejection of a long term lease that it precludes other similarly situated unsecured creditors from recovering a meaningful distribution from the bankruptcy estate.  This balance is reflected in Section 502(b)(6) of the Bankruptcy Code, which imposes a “cap” on a lessor’s claim for damages “resulting from the termination of a lease of real property.”  Under Section 502(b)(6), the landlord’s claim is limited to an amount that is equal to the greater of (a) one year’s rent or (b) 15% of the rent remaining under the lease, not to exceed three years’ rent. 

The issue of whether “collateral” damages to leased real property are subject to the statutory cap has not been decided uniformly by courts across the country.  El Toro Materials appears to be in the majority view in ruling that the statutory cap does not apply to such damages.  The debtor, mining company El Toro Materials, leased property from Saddleback Community Church and rejected that lease in connection with its bankruptcy case.  Saddleback asserted that its damages went far beyond the lost rent that would be subject to the Section 502(b)(6) statutory cap.  Specifically, El Toro left behind one million tons of wet clay “goo,” mining equipment and other materials on Saddleback’s property after rejecting the lease.  Saddleback commenced a lawsuit to recover the cost of removing the mess, which it estimated at $23 million.

The Court of Appeals examined both the plain language and the purpose of the statute in analyzing whether the clean-up costs were part of the landlord’s capped claim or could be asserted independently thereof.  The Court found that capping damages for lost rent was logical, as a landlord may have the ability to mitigate its damages by re-letting or selling the property.  In contrast, damages for destruction of or harm to the property bore little resemblance to the amount of rent, that is, a tenant might cause substantial damage to a premises leased cheaply, or little damage to expensive leasehold property.  Reasoning that the cap should apply only to damages “resulting from” the rejection of the lease, the Court concluded that the landlord’s claim for clean up existed regardless of whether the lease was rejected.  The Ninth Circuit also was concerned that that interpreting the 502(b)(6) cap to include collateral damage claims would create a “perverse incentive” for tenants to reject their lease in bankruptcy instead of staying on the property to preserve the operating value of the business.  Finally, the Court observed that broadening the cap to include collateral damage claims effectively would enable a post-petition, pre-rejection tenant to cause any amount of damage to the premises – either negligently or willfully – without fear of liability beyond the cap.  For all these reasons, the Court held that Saddleback’s claim for damages was not capped by Section 502(b)(6).  In so holding, the El Toro Court expressly overruled a prior Ninth Circuit Bankruptcy Appellate Panel ruling from another, unrelated case that held to the contrary.

Interestingly, the Third Circuit Court of Appeals has not ruled on the issue of whether “collateral” damages to a landlord’s property constitute a claim subject to the statutory cap, although bankruptcy and district courts in the Circuit differ from the El Toro decision.  The divergent views of the courts throughout the country on this issue might provide fertile ground for a Supreme Court reconciliation.

 

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