By: Franklin Barbosa, Jr., Esq.

In its February 2, 2023 opinion in Cortlandt Liquidating LLC, et al, the Bankruptcy Court for the Southern District of New York reversed long-standing district precedent and joined the chorus of courts and commentators endorsing the debtor-friendly “Time Approach” method for calculating landlord damages under Section 502(b)(6) of the Bankruptcy Code as opposed to the “Rent Approach.” In re Cortlandt Liquidating LLC, et al., Case No 20-12097-MEW (Bankr. S.D.N.Y. Feb. 2, 2023). 

The application of the Time Approach significantly limits the future rent claims of landlords that are parties to long-term leases contemplating appreciable rent escalations in the later stages of such agreements. 

Landlord Damages in Bankruptcy Cases

As a general matter, a landlord is entitled to a general unsecured claim for damages arising from the termination of a real property lease by a tenant in bankruptcy, including future unpaid rent.  However, the damages relating to future unpaid rent is capped under Section 502 of the Bankruptcy Code.  Specifically, Section 502(b)(6)(A) sets forth a formula for calculating the cap on landlord damages:

(A) the 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, following the earlier of—

(i) the date of the filing of the petition; and

(ii) the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus

11 U.S.C. 502(b)(6) (emphasis added).

Initially, courts interpreting the phrase highlighted above diverged in their approaches for calculating the rent cap.  The courts disagreed over the meaning and application of the phrase “15 percent.”  For a period of time, the majority approach was the “Rent Approach.”  Courts employing the Rent Approach interpreted the 15% cap as applying to the rent amount owed on the balance of the lease.  By way of illustration, a landlord subject to the Rent Approach method could recover the greater of one year’s rent or 15% of the remaining rent due.  This landlord-friendly approach is most favorable when a lease contemplates appreciable rent escalations beyond the three-year limitation period referenced in Section 502(b)(6)(A).

In contrast, the Time Approach applies the 15% cap to the time remaining on the lease term.  By way of illustration, under the Time Approach, if 15% of the remaining lease term is equal to or more than three years, then the landlord’s future rent damages are capped at three years of rent, whereas if 15% of the remaining lease term is less than three years, then the landlord is capped at one year of rent.  The Time Approach is more debtor-friendly because, unlike the Rent Approach, it does not account for rent escalations that may occur later in lengthy lease terms.

While the Time Approach was historically the minority view, it has gained popularity in recent history and overtaken the Rent Approach as the majority view.  Prior to its decision in Cortlandt Liquidating, the SDNY Bankruptcy Court was firmly in the Rent Approach camp.

The Bankruptcy Court Overturns Precedent and Endorses the “Time Approach”

In Cordtlandt, the Court addressed the chapter 11 plan administrator’s objections to proofs of claim filed by two commercial landlords.  In calculating their claims, the landlords utilized the “Rent Approach” method.  Furthermore, one of the landlords included certain other damages – store cleanup, mechanics’ liens, window repairs and other repairs (“Additional Damages”) – in addition to its claim for rent.  The plan administrator objected to both claims, arguing that the “Time Approach” to rent calculations was applicable and therefore, the landlords’ claims must be reduced.  The plan administrator also argued that the Additional Damages asserted by the one landlord were subject to the statutory rent cap and could not be asserted as standalone damages.

The Court ultimately adopted the “Time Approach” for rent calculation.  While the Court acknowledged that the district precedent was to apply the Rent Approach, it found that the Time Approach was more consistent with the plain language of Section 502(b)(6)(A) and harmonious with the spirit and intent of the rent cap.  With respect to the wording of Section 502(b)(6)(A), the Court noted that the 15% cap is phrased in terms of time, not in terms of rent amount. The Court pointed to the fact that the 15% cap is “sandwiched” between temporal references – i.e., one- and three-year periods of time.  The plain language of the statute weighed heavily in favor of the Court’s decision to apply the Time Approach.  Additionally, the Court found that the Time Approach was copacetic with the legislative history of Section 502(b)(6), stating that the entire purpose of the cap was to permit landlords a claim for future rent while limiting such claim to avoid dilution of the remaining creditor body.

The Court’s decision is further bolstered by the trend of recent court decisions and treatises abandoning the Rent Approach for the Time Approach.

When One Door Closes, Another One Opens

The Court’s decision was not wholly negative for landlords.  Although the Court took a restrictive approach to rent calculation, it favorably concluded that certain of the Additional Damages were not subject to the statutory rent cap.

As a general matter, rent damages arising from termination of the lease are subject to the cap set forth in 502(b)(6).  Some courts interpret the statutory cap as applying to all lease-related damages, whereas other courts only apply the cap to damages directly arising from termination of the lease.

The Court followed the latter approach and applied the test articulated by the Ninth Circuit in Saddleback Valley Community Church v. El Toro Materials Co. (In re El Toro Materials Co.) 504 F.3d 978 (9^th Cir. 2007).  To determine whether a particular claim arises from termination of the lease, the Saddleback Valley test poses the following question: “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?”

Applying the Saddlebrook Valley test, the Court concluded that the damages relating to mechanics’ liens and repair work did not result from termination of the lease and thus, were not subject to the statutory damages cap.  The Court reasoned that under the terms of the applicable lease, the tenant was required to discharge mechanics’ liens and was responsible for repairs during the term of the lease.  On the other hand, the tenant’s obligation for cleanup costs was triggered upon termination of the lease.  As such, the cleanup costs were subject to the statutory cap.

What does the Cortlandt Decision Mean for Landlords?

The Cortlandt decision is not precedent, but it is consistent with the trend favoring the Time Approach over the Rent Approach.  As such, it is likely to become the de facto precedent in the district unless or until the Second Circuit weighs in on the issue.  Notwithstanding, landlords filing proofs of claim in the Southern District of New York may try their luck with other judges in the district and continue to apply the Rent Approach when calculating their claims, but those landlords should not be surprised if their claims are reduced through the application of the Time Approach.

Furthermore, landlords should not assume that all of their lease-related damages are subject to the statutory damages cap set forth in Section 502(b)(6).  Landlords should consult with their attorneys regarding application of the Saddleback Valley test to determine which of their damages are not triggered by lease termination and, therefore, evade the statutory cap.

For more information, contact Franklin Barbosa, Jr. at FB@spsk.com or 973-539-1013.

DISCLAIMER: This Alert is designed to keep you aware of recent developments in the law. It is not intended to be legal advice, which can only be given after the attorney understands the facts of a particular matter and the goals of the client.