Daily Development for Tuesday, September 11, 2001

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

BANKRUPTCY; RENT; ADMINISTRATIVE EXPENSE PRIORITY: Payments denominated in a lease as "further rent" will be given administrative priority as rent even though it is undisputed that the payments represent debt obligations owed under an unsecured promissory note.

In re Cukierman, No. 0015085, 01 C.D.O.S. 7911 (9th Cir. 9/7/01)

In December 1985, Cukierman sold two commercial properties to TACMI. Cukierman agreed to "lease and/or operate" the properties and guaranteed certain income to TACMI. In return, TACMI issued Cukierman promissory notes totaling $8.5 million, secured by deeds of trust on the properties.

After a dispute arose over the rights and responsibilities of the parties under the sale agreement, the parties entered into a settlement agreement that restructured the underlying transaction. As part of this restructuring, Cukierman entered into a new lease of the properties and borrowed $600,000 from TACMI through two promissory notes. In the new lease agreement of June 1988, Cukierman agreed to pay TACMI rent of $400,000 per year. Critical to this litigation, the lease includes a provision requiring Cukierman to pay TACMI as "further rent" monthly sums that match Cukierman' s repayment obligations on the promissory notes. For purposes of this appeal, it is not disputed that the "further rent" provision in fact represents the repayment of the promissory notes. No "further rent" payments were due before October 1, 1992.

On November 20, 1992, Cukierman filed for bankruptcy under Chapter 11 of the Bankruptcy Code. As debtorinpossession, he moved to assume the lease, but the bankruptcy court denied the motion in November 1993. This amounted to a rejection of the lease, so the debtor' s obligations under the lease ceased at that point. The case was converted to Chapter 7 in March 1994.

The question then arose whether the obligations of Cukierman denominated "additional rent" enjoyed an administrative priority in the bankruptcy, under § 365(d)(3), for the one year period between filing of bankruptcy and rejection of lease. Cukierman argued that the payments were not payments for occupancy of the property, and therefore should not be given priority as rent.

Under § 365(d)(3), in a Chapter 11 case, until the trustee assumes or rejects an unexpired lease of nonresidential real property, the trustee must perform obligations under that lease except those specified in § 365(b)(2). Although time for performance can be extended, the court may not extend the performance time beyond sixty days after the original 60 day period for evaluating whether to assume or reject the lease, even when (as is commonly the case) the evaluation period is extended for longer. Such expenses enjoy priority as administrative expenses.

11 U.S.C. 503(b)(1) limits administrative expenses to the actual and necessary cost of the debtor's use of leased property. This is the statute Cukierman relied upon. But note that the requirement for performance of lease obligations during the evaluation period, § 365(d)(3), provides specifically that the lease obligations during this period must be paid notwithstanding the provision of § 503(b)(1).

The Ninth Circuit earlier has held that this means that, during the evaluation period, tenants must pay rent that may exceed occupancy value. The court deemed this arrangement a question of fairness for the landlord, since the landlord ought to be entitled to expect prompt payment when the lease is kept alive artificially in order for the court to assess its value as an asset, requiring the landlord to continue to provide services to the bankrupt debtor even after the filing date, a situation that does not apply to other creditors of the debtor. The court had reached this conclusion even when the debtor was not using the premises at all during the evaluation period.

But here, of course, the debtor was making a different argument maintaining that the payments should not be regarded as lease payments at all because, even though contained in a lease, they did not represent payment for occupancy value, but rather retirement of other debt obligations. The court acknowledged the distinction, but nevertheless concluded that the language and policy of Chapter 11 compelled the court to treat them as administrative expenses under § 365.

"Acting either in goodfaith uncertainty about the contours of such a rule or in a badfaith effort to evade their contractual responsibilities, trustees would have an incentive to withhold performance of lease obligations. Such trustees would be motivated by the hope that the bankruptcy court would subsequently exclude the obligation from the reach of §§ 365(d)(3). This potential for dispute and delay would defeat §§ 365(d)(3)' s purpose of ensuring that trustees promptly perform lease obligations."

The Bankruptcy Appellate Panel for the 9th Circuit had held that TACMI' s claim for interest on the unpaid lease obligations arising during the evaluation period also was entitled to administrative priority under California law provisions relating to the accrual of interest on unpaid debts. The Ninth Circuit disagreed, noting that the entitlement to interest is created by statute and not by the lease. Section 365(d)(3) is limited to "all the obligations of the debtor . . . under any unexpired lease of nonresidential real property."

Comment 1: Although the lease characterized the additional payments as "rent," it may not have mattered how the payments were characterized for purposes of the analysis here. If they were "obligations" under the lease, then it would appear that they had to be paid, without regard to Section 503.

Comment 2: Although one might view this case as dealing only with the question of whether payments must be made under the lease when due, and not with the question as to whether they later can be retrieved, it would seem that the payments could not be retrieved under the authority of Section 503.

Comment 3: There may be another argument, however, that could be raised either before or after the payments are made. It may be possible to argue that the lease in fact is two separate agreements embodying two separate deals, even though appearing in one continuous document. The first deal is a traditional real estate lease. The second deal is a leasehold mortgage. There was a debt incurred (and in fact acknowledged), and the debtor agrees to make payments on that or forfeit the debtor's interest in a lease, even though the debtor is paid up on the lease.

Normally, of course, a leasehold mortgagee would be someone other than the landlord. But bankruptcy courts and other courts have had no difficulty identifying transactions that really are secured debts as such, even though they are wrapped in a different paper. This would certainly be an unusual variant, since, as stated, the mortgaged real estate interest would be the leasehold estate held of the lessor/creditor, but stranger things have happened in bankruptcy court.

Comment 4: Regardless of the success of failure of the argument stated above, this case represents an important victory for the landlord and saves the landlord from potentially expensive litigation in order to justify receiving rental on a lease with a bankrupt tenant that otherwise would be in "neither assumed nor rejected Limbo."

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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