Daily Development for
Wednesday, May 22, 1996

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
randolphp@umkc.edu

BANKRUPTCY; ADMINISTRATIVE EXPENSES; RENT: Future rent under a lease assumed by a bankrupt tenant/debtor in Chapter 11 is an administrative expense entitled to priority and is not capped by the "one year rule" under 502(b)(6) even though the lease is later rejected by a newly appointed trustee of the tenant. Nostas Associates v. Costich, 78 F.3d 18 (2d Cir. 1996).

If a bankruptcy trustee rejects the debtor/tenant's during the sixty day "affirmance/rejection" period, the claim of the landlord for damages resulting from that rejection constitutes a general unsecured claim. Further, that claim is capped (in most cases) at one year's rent. The purpose for the cap is to protect the estate from the "no mitigation" rule in many states that landlords can continue to leave the premises empty and collect rent.

Here, however, the estate first affirmed the lease, making the rental payments an administrative expense. A successor trustee later concluded that the lease was not beneficial to the estate, and elected to terminate the lease. In this case, it appears that the "termination" was nothing more than an outright breach of the lease. The trustee argued, however, that this subsequent rejection flipped the landlord's claim back to unsecured status and subject to the "one year cap." The District Court bought this argument.

Judge Calabresi's opinion reversed the District Court and held that the affirmance of the lease in the first instance conclusively established that the continuation of the lease was a benefit to the estate. Consequently, the damages payable for a subsequent breach of the lease were chargeable as an administrative expense, notwithstanding the subsequent determination of the trustee that the lease had not been such a good deal after al.,

In so concluding, Judge Calabresi filled a legislative gap in the Bankruptcy Code by reference to the Code, case law, the former Bankruptcy Act, and respected commentators. He also addressed the collision of two competing bankruptcy policies--promoting parity among creditors and yet granting priority to the claims of creditors who continue to do business with an insolvent debtor.

Admitting that the conclusion on its face seems to be unduly favorable to landlords because it gives them the lion's share of estates upon liquidation, Judge Calabresi stated that it in fact does no more than recognize the existence of a default rule, which the bankruptcy court can use in encouraging landlords and tenants alike to renegotiate leases in bankruptcy so as to treat all the parties, including general unsecured creditors, equitably. According to Judge Calabresi, bankruptcy courts using the court's rule will rarely find that assuming liability for all future rent under a long-term lease is in the best interest of the estate--including the interest of the general creditors--unless the rental terms are highly advantageous. Bankruptcy courts will therefore block assumption of such leases except in unusual cases. As a result, landlords will find themselves with unsecured claims capped at one year's worth of future rent.

Comment: Judge Calabresi's opinion seems well grounded in the language of the statute. Although the editor salutes the court for looking for an explanation for its result in bankruptcy policy as well as in the precise statutory language, the editor is less comfortable with the somewhat "paternalistic" view that the law is designed to put the parties at an early stage of bankruptcy (during the sixty day evaluation period) in a "pressure cooker" environment so that they will fully evaluate leases before they assume them. Such a view ascribes more psycholigical motivation to the drafters than the editor is willing to accept.

Items in the Daily Development section generally are extracted from the Quarterly Report on Developments in Real Estate Law, published by the ABA Section on Real Property, Probate & Trust Law. Subscriptions to the Quarterly Report are available to Section members only. The cost is nominal. For the last five years, these Reports annually have been collated, updated, indexed and bound into the Annual Survey of Developments in Real Estate Law, volumes 1-5, published by the ABA Press. The Annual Survey volumes are available for sale to the public. For the Report or the Survey, contact Laprica Mims at the ABA. (312) 988 6233.

Items reported here and in the ABA publications are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. Accuracy of data and opinions expressed are the sole responsibility of the DIRT editor and are in no sense the publication of the ABA.