Rejecting a Commercial Lease: 5 Rules That Cap the Landlord's Claim

The drugstore chain Rite Aid and office-space provider WeWork have been in the news lately for using Chapter 11 to shed leases. Once your business enters a Chapter 11, you can throw out leases you cannot afford, and Chapter 11s also limit future-rent claims landlords like to make. When a Chapter 11 tenant rejects a commercial lease, Section 502(b)(6) places a limit on the claim for the lost rent. The formula is the greater of:

• (1) one year of rent at the lease rate, or
• (2) the amount of rent for fifteen percent (15%) of the balance of the term, but not more than 36 months of rent.

Rejecting a lease in Chapter 11 counts as a breach that happened just before the bankruptcy was filed. The landlord is left with only a damages claim, and that is a general unsecured claim that gets paid last of all claims - after the secured creditors are paid, after administrative claims, and after priority claims. General unsecured claims in Chapter 11s often get wiped out.

First, the Bankruptcy Code caps the rent on a rejected lease as of the earlier of the filing date or the date you returned the keys. It will not accept a clause that attempts to inflate the rent by bringing forward later payments. Section 502(b)(6) is not limited to what you think is rent. Certain non-rent charges, such as real estate taxes, property insurance and common-area maintenance fees, can be counted as rent.

Two Ways of Counting up the Rent

Second, there are two ways of counting up the rent to use the 15 percent alternative, and courts across the country are still split over what to do. Under the rent approach, you would take 15 percent of all the rent over the remaining term. In contrast, under the time approach, you would take the rent for fifteen percent (15%) of the remaining time. You can compare using a simple example, say where you have 10 years left on your commercial lease. Your rent is $100,000 per year in the first five years and $150,000 per year in the last five. The time approach would look at the first fifteen percent, or 1.5 years, and only allow rent for that time, $150,000 total. The rent approach would take 15 percent of the $1.25 million, and allow a claim for $187,000.

The rent approach favors the landlord if rent rises during the lease term, because it will pull forward higher rents into the damages calculation. A majority of courts have chosen the rent approach. Delaware is among the minority that uses the time approach. A Manhattan court said the time approach was better. The two methods of figuring the value of the 15 percent can bring out a large difference, so knowing which method applies is vital.

A Separate Claim, on Top of What the Cap Allows

Third, whatever the allowed amount, that number only covers lost rent from going forward into the future. The unpaid rent at the time of filing remains a separate claim, on top of what the cap allows. Many courts will ask whether the claim would exist if the lease were still ongoing. Under that test, the same holds true for landlords’ claims for repairs. Same, for any mechanics’ liens against the property. Legal fees to collect unpaid rent, for example, might not be capped.

Fourth, a security deposit a landlord holds can be applied against the capped claim. If the capped amount happens to be less than the deposit, then the excess gets turned over to the debtor’s bankruptcy estate. When the deposit was a letter of credit instead of cash, courts often treat the bank’s promise to pay the same as a cash deposit.

Fifth, if you personally guaranteed the lease, and you did not also file a bankruptcy, you can face a full and uncapped claim for the lease payments. Think of the rule in this way: the creditor has a claim against you and the debtor. The bankruptcy filing pulls the creditor off of the debtor, but the creditor is left where it was with you unless you file. If you file, the same limits from the debtor’s bankruptcy now get picked up for you.

120 Days

A Chapter 11 gives a tenant 120 days to deal with the lease, plus some extra time under certain circumstances. Those days pass quickly, and if the lease remains undecided after that, it will be rejected by operation of the law, and the space will turn back over to the landlord. The deadline on a lease can be pushed out up to 90 days more because of something special. Beyond that, the landlord can always agree to extra time, by writing. During the decision period, you still need to pay rent on time and in full.

Find out which way your district will apply the cap, so you know which damages formula to use. See if you are personally guarantying the lease, because that might wipe out most of the damage cap for you. Do the math. Also, don’t forget to check what happens to a deposit. The courts can help you toss out a bad lease and move on with your life.