Section 5620(B)(6) Cap on a Landlord's Recovery in not One-Size-Fits-All
In a significant decision for commercial landlords, the U.S. Court of Appeals for the Ninth Circuit, in Saddleback Valley Cmty. Church v. El Toro Materials Co. (In re El Toro Materials Co.), No. 05-56164 WL 2822019 (9th Cir. Oct. 1, 2007), has held that the statutory cap imposed by section 502(b)(6) of the U.S. Bankruptcy Code on claims arising from a debtors lease termination does not limit a landlords claim for tort-related damages. Section 502(b)(6) sets limits on the damages that result from the termination of a lease of real property to the greater of one year, or 15 percent, not to exceed three years of the remaining term of such lease. The provision is designed to provide landlords with compensation for losses due to lease terminations, while preventing excessively large claims from long-term leases that would limit the recovery of other unsecured creditors.
In El Toro Materials, the Ninth Circuit ruled that a landlords claim for $23 million in damages for the alleged cost of removing 1 million tons of wet clay, mining equipment and other materials from the landlords property was not subject to the section 502(b)(6) recovery limitation for damages resulting from the termination of a lease. This is an important decision, as it marks the f irst time that a U.S. Court of Appeals has ruled on whether landlords are constrained in their ability to recover damages on tort-based claims from tenants who reject their leases under bankruptcy protection. As a practical matter, this decision will provide landlords, particularly retail landlords, who often find themselves in the position of incurring costs to restore properties that have been damaged by a rejecting debtor-tenant, with the ability to claim a greater recovery from the debtors bankruptcy estate. Although the ruling is binding only in the Ninth Circuit, we expect that its authorship by the well-respected Judge Alex Kozinski will make it persuasive authority in other courts throughout the country.
El Toro Materials Company (El Toro) f iled its bankruptcy petition on November 18, 2002. At the time of the bankruptcy filing, Saddleback Valley Community Church (Saddleback) owned land that El Toro had leased for its mining operations. Following El Toros rejection of the lease, Saddleback filed a proof of claim for $23 million that included not only lost rent claims stemming from the termination of the lease, but also various tort claims for waste, nuisance and trespass arising from the wet clay goo, mining equipment and other materials allegedly left on the property. El Toro filed an objection, contending that section 502(b)(6) limited Saddlebacks claim to the statutory cap of one years rent, or 15 percent of the remaining lease term.
The Bankruptcy Court held in favor of the landlord, ruling that Saddlebacks tort-based claims for waste and nuisance were not subject to the section 502(b)(6) cap. On appeal, the Ninth Circuit Bankruptcy Appellate Panel reversed the Bankruptcy Courts decision, determining that the damages related to Saddlebacks waste and nuisance claims would be subject to the section 502(b)(6) cap. The Ninth Circuit Court of Appeals reversed the Bankruptcy Appellate Panel, and reinstated Saddlebacks claims for tort-based damages.
Judge Kozinski, writing for the Court of Appeals, noted that the language of section 502(b)(6) refers to claims resulting from the termination of a lease, and that the wet clay and equipment that remained on Saddlebacks property, while costly to remove, did not result from El Toros lease rejection. The Ninth Circuit applied a test to determine whether or not the alleged damages resulted from the termination of the lease: Assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it? In this instance, the court observed that the alleged harm existed regardless of whether the lease was terminated and that Saddleback would still have had the same claims against El Toro.
The court further noted that if the section 502(b)(6) cap included damages that were collateral to the termination of the lease, it might create perverse incentives for debtor-tenants, particularly those facing liability for collateral damage to the leasehold, to reject leases in bankruptcy, even when it might otherwise make economic sense to assume them for the benefit of the estate. An incentive to sacrif ice efficiency in order to exploit a loophole in the liability-capping provisions [of the Bankruptcy Code] would be plainly counter to congressional intent to maximize the value of the estate to creditors.
This ruling will better position landlords to assert tortbased claims against bankrupt tenants that are unrelated to the rejection of the lease by the debtor-tenant. Landlords should consider ways to take advantage of the distinction drawn by the Ninth Circuit so as to better protect themselves when structuring new leases, so that claims that may validly be characterized as tort-related, rather than contract-related (e.g., clean-up costs, waste removal, property damage) can be sought from a debtor-tenants estate without being subject to the section 502(b)(6) cap.
For More Information
Please contact Lawrence T. Burick, Robert C. Folland, Alan R. Lepene, or Louis F. Solimine or any member of our Business Restructuring, Creditors' Rights & Bankruptcy practice group for more information.
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