The writer, a member of Sulmeyer, Kupetz, Baumann & Rothman in Los Angeles, specializes in bankruptcy, business reorganization and related litigation. His practice focuses on representation of debtors, secured lenders, unsecured creditors' committees and other parties involved in business restructuring or reorganization situations.

The Ninth U.S. Circuit Court of Appeals has recently settled court cases regarding lease agreements that modify the interpretation of the Bankruptcy Code. Landlords and tenants unaware of the latest developments in bankruptcy law should be familiar with how these hearings have affected the prevailing adaptation of the Bankruptcy Code. Following are two specific case studies that outline the recent Appellate Court decisions affecting the law's perception of lease agreements:

Lease Cure Requirement Applies to Former Landlord

The Bankruptcy Code provides that, subject to court approval, a debtor in possession (or bankruptcy trustee) may assume any unexpired lease of the debtor. The Code was designed to allow a debtor to elect not to continue to perform under a burdensome real property lease (or other executory contract) while permitting the debtor to force the other party to the lease to continue to perform under a lease valuable to the bankruptcy estate. A debtor in default under an unexpired lease may nonetheless assume the lease if it cures (or provides adequate assurance that it will promptly cure) such default, compensates (or provides adequate assurance of prompt compensation) for any pecuniary loss of the other party resulting from such default, and provides adequate assurance of future performance under the lease. 11 U.S.C. ñ 365(b)(1).

In re Building Block Childcare Centers, Inc., 234 B.R. 762 (Bankr. 9th Cir. 1999), involved a situation where a lessee/debtor was in default under a lease of retail space in a shopping center. The original landlord/creditor assigned its interest in the lease to a successor landlord, but retained the right to receive the delinquent amounts owing from the lessee/debtor. Under these circumstances, the bankruptcy court erroneously determined that the lessee/debtor was not required under Sec. 365 to cure prepetition defaults owing to a former landlord in order to assume its lease with a successor landlord.

On appeal, the Bankruptcy Appellate Panel of the Ninth Circuit ("BAP") held that the language of Sec. 365(b)(1) "clearly and unambiguously requires the cure of all defaults before a lease may be assumed." 234 B.R. at 765. The BAP ruled that the bankruptcy court had erred by engrafting a distinction into the Bankruptcy Code between former and existing or current landlords. Thus, where the former landlord specifically retained the right to receive the cure payments, the debtor was nonetheless obligated to make such payments owed to the former landlord in order to assume a lease with a successor landlord.

The Court Should Have Donned Lease Damage Cap

In In re Arden, 176 F.3d 1226 (9th Cir. 1999), the Ninth Circuit Court of Appeals held that the cap under the Bankruptcy Code, which limits a lessor's claim for damages resulting from termination of a lease, is applicable to a debtor/guarantor. In this case, the debtor had unconditionally guaranteed a lease. Following a breach of the lease, the lessor filed suit in state court and obtained a prejudgment writ of attachment in the sum of $2,700,000. In response, the debtor/guarantor commenced a chapter 11 bankruptcy reorganization case.

Bankruptcy Code Sec. 502(b)(6) caps the claim that a landlord may assert for damages resulting from the termination of a lease of real property (the "Cap"). Such a claim is limited to "[t]he rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease," and " [a]ny unpaid rent due under such lease, without acceleration ...." 11 U.S.C. ñ 502(b)(6). To determine the Cap on its allowable lease termination damage claim, a landlord should (1) calculate the total rent due under the lease from the earlier of the date of the commencement of the debtor's bankruptcy case or the date on which the landlord repossessed or the lessee surrendered the leased property, (2) determine whether 15 percent of that total is greater than the rent reserved for one year following the bankruptcy filing, (3) determine whether the 15 percent sum exceeds the rent reserved for three years following the filing, and (4) then arrive at the potential allowable amount of its total lease termination damage claim. This calculation, however, is premised on the existence of a claim. For example, if a lessor has relet premises at a higher rent, the lessor will have no section 506(b)(6) claim. Thus, Sec. 506(b)(6) does not provide a formula for determining the amount of the landlord's damage claim. The way the provision works is that, after the landlord computes its claim under applicable non-bankruptcy law, the claim is capped pursuant to the statutory maximum set forth in Sec. 502(b)(6).

In In re Arden, the creditor/lessor was the only party to file an unsecured creditor's claim, which was submitted in the amount of the prejudgment attachment. The debtor/guarantor failed to file a plan of reorganization while he had the exclusive right to do so. As a result, the creditor/lessor filed its own plan. The central feature of this plan was a proposed compromise of the creditor/lessor's $2.7 million claim for $1.7 million. Under Bankruptcy Code Section 1123(b)(3)(A), a bankruptcy court may approve the compromise of a claim as part of a plan of reorganization. The bankruptcy court confirmed the creditor/lessor's plan over the objection of the debtor/guarantor. In doing so, the court held that the Cap did not apply to a lease guarantor. Further, since it believed that the Cap did not apply, the court failed to consider the effect that the Cap would have had on the amount of the claim of the creditor/lessor.

On appeal, the Ninth Circuit found that the court erred in confirming the plan based on the compromise of the creditor/lessor's claim. The appellate court held that Sec. 502(b)(6) is triggered by the claim of a lessor, not the status of the lessee or its agent or guarantor. Accordingly, while appellate courts generally give wide latitude to a bankruptcy court's consideration of factors involved in approval of a compromise pursuant to a plan, that discretion does not extend to a situation where the court misconstrues the law. In this case, the bankruptcy court should have considered the effect of the Cap on the amount of the creditor/lessor's claim in reaching its determination fundamental to confirmation of the plan that the compromise was fair and equitable. The Ninth Circuit concluded that "[b]ecause the Cap snugly fits, the court should have donned it." 176 F.3d at 1229.

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