Bankruptcy Cap Applies to Claims Resulting from Lease Rejection

Facts: A warehouse owner agreed to completely remodel the space into a daycare facility for a tenant. The owner paid for the improvements up front, but the tenant was required to pay back the amount in increments during the lease term, separate from monthly rent. After the tenant filed for Chapter 11 bankruptcy, it rejected its lease.

The owner filed a claim for total damages of over $1.7 million. The tenant argued that the amount of the claim exceeded the statutory limits imposed by U.S. bankruptcy law. It said that the claim should be “capped” at $480,500—representing past due rent as of the petition date, future monthly rent for 15 months, and some real property taxes.

The owner contended that it should be allowed to recover not only those amounts, but also the balance owed for the tenant improvements that hadn’t been repaid, a future real estate commission to re-rent the space, costs to remodel the premises, attorney’s fees, and utilities.

Decision: An Alaska bankruptcy court allowed the owner’s claim, but limited it to $647,758.

Reasoning: Bankruptcy statutes allow owners to recover “damages for lost rental income.” The court noted that the law caps the damages recoverable that arise from the termination of a lease and divides the owner’s claim into two distinct components: past-due rent and "rent reserved." Claims for unpaid rent due as of the bankruptcy petition are recoverable without limitation; claims for rent reserved are allowed for only the greater of one year, or 15 percent, not to exceed three years, of the remaining term of the lease. A cap doesn’t apply to an owner’s claims against the bankrupt tenant for collateral damages that arise independent of the rejection of the lease in bankruptcy.

Here, the owner and tenant agreed that $27,000 in rent was past due and that the applicable "cap" period for future rent is 15 months. The court had to determine the calculation of the monthly "rent reserved" that would be allowed for 15 months, and what components of the owner’s claim, if any, fell outside the cap because they didn’t result from the termination of the lease.

The court applied a test to determine whether the owner’s claims resulted from the rejection of the lease: Assuming all other conditions remain constant, would the owner have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it? In other words, if the tenant had assumed and performed under the lease, would the claim still remain? If so, the claim exists independently of the lease rejection, and is beyond the statutory cap.

The court decided that the owner’s right to receive future rent and recover real property taxes, the balance owed for tenant improvements, future real estate commissions, remodeling costs (other than the removal of tenant improvements), and utilities existed only as a result of the rejection of the lease, and were capped at 15 months under bankruptcy laws as "rent reserved.”

However, the owner had a valid claim for recovery of $110,000 for the cost of removing the improvements it made to the building so the tenant could use it as a daycare center. That amount wasn’t capped because “damages other than those based on a loss of future rental income are not subject to the cap,” said the court. Under the lease, the tenant was required to pay for the removal of the improvements if the owner asked it to upon termination of the lease. The owner testified that there was no market for the space in its current configuration as a daycare center and that, regardless of whether the tenant had filed for bankruptcy or stayed for the remainder of the lease term the result would’ve been the same: The owner would have exercised its right to have the improvements removed at the tenant’s cost.

• In re: Denali Family Services, March 2014