One of the advantages of filing a chapter 11 bankruptcy is to rid an entity of its obligations under a lease of non-residential real property. See In re PPI Enterprises, 228 B.R. 339 (Bankr. D. Del. 1998). Considering the various economic changes in the past several years, a lease of non-residential real property may have had a higher market value when executed than it does now. In other words, it may be much cheaper for the leasee to move across the street and take advantage of current, lower-lease market conditions than it is currently obligated to pay. The Bankruptcy Code provides for a cap on lease-rejection damages that a lessor may claim for non-residential real property. See 11 U.S.C. §502(b)(6). Therefore, in order to reduce overhead, rejection of a now-overvalued lease may very well constitute an exercise of the debtor's best business judgment.

The reduction of rent may also result in the reduction of other expenses related to that lease. For example, many leases of non-residential real property require the lessee to satisfy obligations over and above base rent such as taxes, insurance, utility charges and common area maintenance (CAM) charges. These charges can aggregate to a significant amount over the lease's base rent. The rejection of a lease, therefore, not only reduces the debtor/lessee's base rent, but ancillary expenses as well.

Despite §502(b)(6)'s lease-rejection damages cap, the Bankruptcy Code does not specifically address such ancillary expenses or whether such ancillary expenses are (1) allowable in addition to the rent as calculated by §502(b)(6), (2) included in and thereby limited by §502(b)(6) or (3) simply disallowed. Fortunately, numerous courts have provided guidance as to the components of a lease-rejection claim under §502(b)(6) and how to treat expenses that are not addressed by §502(b)(6).

The Lease-rejection Damage Model

Pursuant to §502(b)(6):

(b) [T]he court shall...allow such claim in such amount, except to the extent that—

(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds—

(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...

"The purpose of [§502 (b)(6)'s] statutory cap is to fairly compensate the landlord for its loss due to the breach without allowing such large damages as to deprive other creditors of a reasonable recovery." In re Farley, 146 B.R. 739, 744-45 (Bankr. N.D. Ill. 1992). Thus, a lessor of a rejected non-residential real property lease has a lease-rejection damages claim for its "rent reserved," as calculated and limited by §502(b)(6). Section 502(b)(6) does not, however, define "rent reserved." Nor, does §502(b)(6) address ancillary expenses.

Courts addressing these issues have developed certain tests, which differ slightly but are conceptually similar. For example, the Ninth Circuit BAP created a three-prong test to determine the applicability of §502(b)(6) to the various components of a lease-rejection damages claim. See Kuske v. McSheridan (In re McSheridan), 184 B.R. 91 (BAP 9th Cir. 1995). Specifically, the court held that to constitute "rent reserved," the expense at issue must:

1. (a) be designated as "rent" or "additional rent" in the lease or (b) be provided as the tenant's/lessee's obligation in the lease,
2. be related to the value of the property or the lease thereon, and
3. be properly classifiable as rent because it is a fixed, regular or periodic charge.

See McSheridan, 184 B.R. at 99-00; see, also, In re Crown Books Corp., 291 B.R. 623, 627 (Bankr. D. Del. 2003) (holding that "rent reserved" included CAM charges, taxes and insurance premiums, but did not include brokerage commissions).

While most courts examining what constitutes "rent reserved" cite McSheridan for authority, certain courts adopted a slightly different test. See, e.g., In re Rose's Stores Inc., 179 B.R. 789, 791 (Bankr. E.D.N.C. 1995). In Rose's Stores, the court adopted a two-prong test to determine what constitutes "rent reserved:" (1) The charge must be provided for in the lease as the tenant's obligation, though it need not be denominated as rent, and (2) the charge must be related to the value of the property and the value of the lease thereon. See Rose's Stores, 179 B.R. at 791; citing In re Heck's Inc., 123 B.R. 544, 546 (Bankr. S.D. W.Va. 1991).

In applying its test, the Rose's Stores court held that taxes and insurance were not only the lessee's obligation, but also related to the value of the property and the lease. See Id. The court distinguished general maintenance and utility charges as being generally related to the lessee's use of the property, rather than the value of the property, thereby excluding such expenses from the "rent reserved" under §502(b)(6). See Id.

Courts applying the McSheridan and Rose's Stores factors have almost universally held that "rent reserved" includes real estate taxes, insurance costs and CAM charges. Fifth Avenue Jewelers Inc. v. Great East Mall Inc. (In re Fifth Avenue Jewelers Inc.), 203 B.R. 372, 381 (Bankr. W.D. Pa. 1996); In re Andover Togs Inc., 231 B.R. 521, 540-41 (Bankr. S.D.N.Y. 1999). Despite the widespread use of the McSheridan and Rose's Stores factors, various courts differ on what constitutes a CAM charge. For example, at least one court has specified that CAM charges may include costs for services such as window-washing, elevator maintenance, cleaning services and replacements and improvements in the building's infrastructure. See Andover Togs, 231 B.R. at 540-41.

Other courts have focused the "rent reserved" inquiry on whether said expenses are prospective damages. See In re Best Products Co. Inc., 229 B.R. 673, 677-79 (Bankr. E.D. Va. 1998); citing In re Atlantic Container Corp., 133 B.R. 980, 987-88 (Bankr. N.D. Ill. 1991). In Best Products, the court held that §502(b)(6) applied only to those lease damages that occurred after rejection, not those that occurred prior to rejection. Id. Also, all other damages were in addition to §502(b)(6)'s lease-rejection damages model, not limited thereby. Id.; see, also, In re Farley, 146 B.R. 739, 746 (Bankr. N.D. Ill. 1992) (holding that such prospective damages include future rent, future CAM charges, future insurance, future taxes and future capital improvement fees).

Just as courts have differed on the appropriate factors to apply and the appropriate items included in CAM charges, courts have also differed on the appropriate treatment of non-"rent reserved" components of a lessor's claim, which are not included in §502(b)(6)'s lease-rejection damages model.

Damages Outside of §502(b)(6)'s Purview

Although §502(b)(6) applies to "rent reserved" only, lessors suffer other damages as well. For example, many debtors strategically default on their rent obligations just prior to a bankruptcy filing in order to build available cash. Pre-petition rent, however, is not "rent reserved" and is not a prospective damage. Nonetheless, pre-petition rent is specifically addressed by §502(b), which provides that a lessor's claim includes "any unpaid rent due under such lease...," which is in addition to the "rent reserved." Indeed, "a landlord [should be able to] claim any and all unpaid amounts due it under the lease as of the petition date." Andover Togs, 231 B.R. at 544.

In fact, "§502(b)(6) is not a formula for determining the total allowable damages incurred by a lessor...[but r]ather...casts a limitation on the amount a lessor may claim for unpaid rent." See Fifth Avenue Jewelers, 203 B.R. at 376; citing In re Steven Windsor Inc., 201 B.R. 133, 135 (Bankr. D. Md. 1996). "Congress only placed said limitations on a landlord's claim for post-petition damages, while ensuring that said landlord recovers on those damages incurred up to the earlier of lease termination or the petition filing." Fifth Avenue Jewelers, 203 B.R. at 379.

Certain courts have expanded on this concept and held that non-prospective damages are allowable in addition to the lease-rejection damages allowable under §502(b)(6). See Best Products, 229 B.R. at 677-79; citing In re Atlantic Container Corp., 133 B.R. 980, 987-88 (Bankr. N.D. Ill. 1991). Best Products held that §502(b)(6) applied only to those lease damages that occurred after rejection, not those that occurred prior to rejection. Id. Therefore, pre-petition damages are allowable and not subject to §502(b)(6)'s cap.

Conversely, courts more often hold that post-petition, non "rent reserved" damages are not allowable. For example, liquidated damages, attorneys' fees caused by a lease rejection, general maintenance fees and utility fees are not "rent reserved" and accordingly are not only excluded from a lessor's §502(b)(6) lease rejection damages claim, but are not allowable at all. See Crown Books, 291 B.R. at 627 (where the court held that brokerage commissions were not properly included in the §502(b)(6) lease rejection damage calculation, thereby requiring the reduction of the allowed amount of the lessor's claim); PPI Enterprises, 228 B.R. at 348-49 (holding that §502(b)(6) represents that maximum amount recoverable as a result of the termination of the lease, thereby disallowing attorneys' fees); In re Gantos Inc., 181 B.R. 903, 907 (Bankr. W.D. Mich. 1995) (disallowing the construction allowance portion of a lessor's claim because it was not rent, as it was not a regular, fixed payment classifiable as rent).

As Congress intended to limit the amount of a lessor's rejection damages claim, the disallowance of ancillary expenses, which accrue because of the rejection of the lease but do not meet the definition of rent reserved, appears to be the more logical approach. Nonetheless, contradicting authority exists, which lessors will certainly cite to increase the amount of their claim.

Conclusion

In calculating a lease-rejection claim, practitioners must do more than calculate the limitation under §502(b)(6). Careful and perhaps creative thought must be given to various components of the claim. After all, the differing components are treated differently, some of which are limited while others are not. Therefore, the classification of a lease expense determines how such expense is treated upon rejection. And, as in so many other circumstances, how such an expense is classified is determined by the operative legal documents. Stated otherwise, the determination of a lease rejection claim begins with the formulation of the lease itself.