BANKRUPTCY; LEASES; "OBLIGATIONS" PRIOR TO REJECTION OR AFFIRMANCE: Express continuous operation duty in a lease is not an "obligation" which debtor must perform prior to assumption or rejection. Further, damages resulting from trustee's nonperformance of such duty is not payable either as an "obligation" under the lease assumption statute (12 U.S.C. 365(d)(3) or as an administrative expense, where covenant is unenforceable as inconsistent with trustee's duty to maximize assets R.H. Macy & Co., Inc. 170 B.R. 69 (Bkrtcy S.D. N.Y. 1994)

Debtor owned a Bullock's department store in a California mall. The lease required continuous operation during specified hours, specifically as a Bullock's store, and the allegations were that the debtor's rent was considerably lower than market in exchange for this covenant. Trustee, pursuant to court order held a "closing business sale" during hours that did not comply with the covenant and under a different name. Thereafter, the store remained vacant while trustee continued to "shop" the lease to find a party to take it over and pay some value to the estate for it. During this entire period of time, the court continued the period during which the trustee had to assume or reject the lease. Ultimately, after almost two years of dithering, for most of which time the store was dark, the lease was deemed rejected. Mall owner claimed almost $1 million in damages from the breach of the operating covenant.

The Bankruptcy Code requires that, prior to affirmance or rejection of a lease, the trustee, out of estate assets "shall perform all the obligations of the debtor . . . arising from . . . any unexpired lease or nonresidential real property, until such lease is assumed or rejected. . . . " 12 U.S.C. 365 (d )(3)

The bankruptcy court here held that the issue was not whether the continuous operation duty was an "obligation," but rather whether it was "an obligation which must be timely peformed in concert with the Debtor's obligation to maximize estate assets for the benefit of all parties in interest."

Although the court makes a feint at conforming to the "plain language" approach that seems to have been embraced by the Supreme Court, it ultimately concludes that the word "obligation" must be viewed in context of the overall bankruptcy policies. Basically, it appears that the judge is saying that the federal bankruptcy law preempts the enforcement of state law made contracts to the extent that it prohibits parties from being obligated to do things that contravene bankruptcy policies. Bankruptcy law instructs the trustee to shut down a losing operation and to liquidate saleable assets promptly. A pre-bankruptcy contract, even a lease, cannot restrict the trustee from carrying out that responsibilty.

The court concedes that other cases have held that money payments payable under the lease, even those attributable to pre-petition periods, constitute obligations, as to obligations to repair and maintain, and even a damages claim for excess where and tear. But in those cases, the court seems to be arguing, the tenant's duties did not run afoul of the trustee's express bankruptcy responsibilities.

In what appears to the editor to be somewhat convoluted reasoning, the court appears ultimately to conclude at one point that the breach of the covenant is not even a breach of the lease because the court had ordered the trustee to do it in order to "maximize the estate." Consequently, it may be even that the court will not recognize the landlord's claim for damages as a prepetition claim, which normally would be the case for damages resulting from breach of rejected leases.

The mall owner argued in the alternative that the damages constituted administrative expenses. Lessees must pay the reasonable benefit conferred for the use of the premises. Typically the lease rental payments will be used as a guide to establish the value of the benefit conferred. But the court concluded that here the estate received no benefit from the lease beyond the "going out of business sale," and consequently rental obligations of any kind relating to the period after the sale (the bulk of the period in question) were not administrative expenses. As to the period of the sale itself, the court ruled that conformance to the requirements of the covenant would have made disposition of the debtor's goods less beneficial, and that therefore the debtor would have derived no benefit from it. The only administrative payment to the landlord would be the lease rental for the period prior to and during the sale.

Reporter's Comment 1: There is in fact a "bankruptcy policy underlying the rules for balancing the interests of the landlord against those of the rejecting debtor. It is said to be "grounded in the principles of ratable distribution," that is, in principles arising from years of experience in bankruptcy cse law. In re McSheridan, 184 B.R. 91, 97 (9th Cir. 1995). Thus, the R.H. Macy opinioin souns a theme recognizable to most real estate/bankruptcy lawyers when it says that the definition of "obligation" should be understood in light of the duty of the trustee to maximize estate assets.

Editor's Comment 1: What about the holding on administrative expenses. Administrative expenses are allowed to the extent of a benefit to the estate. If, as the court seems to accept here as true, the lease rent was substantially lower because of the operations covenant, then the contract rental would not be an accurate reflection of the value of the leasehold estate unencumbered by the covenant. Consequently, an administrative expense claim should have been allowed for the true value the estate received - the market rent. Normally, the lease might be used to establish the market rent, but that is not so here.

In the editor's view, the administrative expense argument remains even after the occupancy ends, since the trustee was extending the period prior to automatic rejection for the express purposes of "shopping" the lease. If the trustee was keeping the lease "alive" for the sole purpose of attempting to resell it to someone else, why isn't this activity of "benefit" to the estate?

Editor's Comment 2: Finally, where does the Code say that when a court orders a debtor to take certain actions that breach an outstanding contractual obligation, this means that the action is not a breach of contract? There at least should be a damages claim available as a prepetition unsecured creditor's claim. There may be one here, but the court's language that breach of the continuous operation clause is not a breach of the lease may suggest even that there is no damage claim.

Reporter's Comment 2: Assuming that there is a damage claim for breach, an interesting unanswered question is whether the landlord's damages claim is subject to the limitations of Section 502 (b) (6) - the amount of a landlord's claim under this section may not exceed the greater of one year, or 15%, not to exceed three years, of the remaining rent reserved. The problem is acute here because the tenant was supposed to add contract value to the center sas part of the consideration flowing to the landlord, and the contract rent is correspondingly quite low.

In In re McSheridan, supra, the court held that a landlord was not entitled to a separate claim for significant restoration and reletting expenses which exceed one year's reserved rent - applying the 502 (b) (6) limitation to each and every element of damages. The response obvious to lease drafters would be to include practically all lease charges within the definition of rent. The equally obvious judicial reply might be to scrutinize such definitions, lest bankruptcy limitations be "nullified by crafty draftsmanship in particular cases." Oldden v. Toronto Realty Corp, 1433 F.2d 916, 920 (2nd Cir. 1994), cited and discussed in McSheridan.

Be that as it may, there still are things that the landlord's lawyer can try. For example, consider drafting a base rent clause due unconditionally; then provide that the tenant can earn a monthly rent accommodation by fulfilling certain other lease covenants - such as continuous operation. Such an approach may be more than "crafty draftsmanship," insoar as it addresses one of the underlying bankruptcy rationales for limiting landlord damages claims in the first place - that such damages are "dontingent and difficult to prove. McSheridan, 184 B.R. at 97.

(Reporter's comments are by Jim Stillman of Murphy, Weir & Butler, Los Angeles)..

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