By I. Bruce Speiser

A commercial tenant’s bankruptcy may be cause for a landlord’s heartburn, especially because the rules used by the various bankruptcy courts differ depending on the locale. Such differences include how bankruptcy courts treat leases during the period in which the unexpired commercial lease is in “limbo” -- that is, the period pending the assumption or rejection of the lease by a debtor/tenant.

Assumption or Rejection
Absent an extension of time granted by a bankruptcy court, a tenant in bankruptcy has 60 days to assume or reject a commercial lease. If the tenant elects to assume the lease, it must bring the lease current (or give adequate assurance of “prompt cure”). On the other hand, if the tenant elects to reject the lease, the tenant’s bankruptcy estate is obligated to make certain payments to the landlord as compensation for terminating the lease. The landlord’s claim to such payments, however, is generally a prepetition general unsecured claim. Consequently, the landlord’s claim may be of questionable value because the landlord will need to stand in line with the rest of the unsecured creditors.

The Limbo Period
Courts do not fully agree, however, on how to handle the debtor/tenant’s obligations during the interim “limbo” period. The Bankruptcy Code provides, with limited exceptions, that the debtor/tenant must timely perform all of the obligations arising after the entry of the order for relief (i.e., typically the filing date for the voluntary petition) under an unexpired commercial lease prior to assuming or rejecting its lease. Although the statute appears relatively straightforward, courts have used different approaches, as demonstrated by two recent appellate cases, in considering payment of pass-through items, such as property taxes and common area maintenance expenses.

Pro-Ration Approach
The Seventh Circuit Court of Appeals determined that a Chapter 11 debtor was not obligated to immediately reimburse a landlord for the payment of property taxes that accrued pre-petition, even though the payment deadline under the lease was the same date as the entry for the order for relief. The court reasoned that the obligation did not arise after the order for relief. The Court’s rationale in employing this “pro-ration” or “accrual” principle was that past taxes are a “sunk cost”, and should not affect the current operations of a bankrupt tenant. In re Handy Andy Home Improvement Centers, Inc., 144 F.3d 1125 (7th Cir. 1998).

Lease Interpretation Approach
On the other hand, the Third Circuit Court of Appeals has taken a different view. Even if a landlord’s liability for property taxes and assessments (and other pass-through charges) may accrue prior to the entry of the order for relief, the lease may provide that the obligation of the tenant to reimburse the landlord does not “mature” until a later point in time. This later point in time could be a date after the entry of the order for relief; and if it is, the debtor/tenant is obligated to make immediate reimbursement to satisfy its obligations under the Bankruptcy Code. Accordingly, in lieu of using the Seventh Circuit’s pro-ration approach, the Third Circuit based its holding upon the terms of the unexpired lease. In re Montgomery Ward Holding Corp., 268 F.3d 205 (3rd Cir. 2001). It is interesting to note that the Montgomery Ward lease conditioned the tenant’s reimbursement obligation for tax liabilities upon its receipt of an invoice from the landlord, and that the landlord first provided the debtor/tenant with invoices (for two tax years in an amount in excess of million) four days after the entry of the order for relief (i.e., the date Montgomery Ward filed is bankruptcy petition).

The Law in California
Other courts, including those in California, have not yet decided the issue. A recent decision by the Ninth Circuit Court of Appeals, whose jurisdiction includes California, suggests that the “lease interpretation” approach should be followed. Specifically, the Ninth Circuit determined that the Bankruptcy Code section pertaining to a debtor/tenant’s obligations following the entry for an order for relief should be interpreted as a “bright line rule, encompassing all obligations contained in a bargained for agreement.” In re Cukierman, 265 F.3f 846, 850-51 (9th Cir. 2001).

Conclusion
The division among the various courts continues, and the landlord’s treatment in one jurisdiction may differ from its treatment in another. Rights and remedies that may be denied in Chicago, may be available to the landlord in Philadelphia.

So long as the law remains inconsistent, landlords must remain familiar with the principles employed by the various bankruptcy courts. In those jurisdictions that may follow the lease interpretation approach (and California appears to be among them), the landlord may be able to take advantage of a lease providing that any tenant reimbursement obligation for pass-through items will not arise until the landlord triggers that obligation (such as by transmitting an invoice and demanding payment). Any such lease provision would permit the landlord, when a tenant is teetering on the brink of bankruptcy, to defer making any demand for reimbursement and thereby enhance its chances of prompt repayment in the event of a bankruptcy filing. The first step, of course, is for landlords to review their lease forms, and ensure that they are best positioned for the limbo-period in bankruptcy. That, in itself, will at least offer a stronger positioning if the tenant declares bankruptcy, and may even avoid additional problems created by the limbo period.

*About the author: I. Bruce Speiser is a partner with Pircher, Nichols & Meeks. Founded in 1983, the law firm is nationally recognized with a diversified real estate practice that includes litigation, bankruptcy, corporate and tax expertise.