Landlords Are Entitled To Priority Treatment of Lease Payments Which First Come Due During the Gap Period of an Involuntary Bankruptcy

In a case of first impression, Judge Montali had to decide whether a landlord’s claim for payment of rent during the gap period of an involuntary bankruptcy is entitled to priority.

Before delving into the facts of the case, a quick primer is appropriate. The treatment of a commercial landlord’s claims in bankruptcy is too complicated and will be discussed in more depth in a future article so this “quick primer” is very limited.

When a company files for bankruptcy, the landlord in a nonresidential context is usually the most powerful player in the scene. The landlord is entitled to be paid contract rate lease payments until the Debtor decides to either reject or assume the lease. This is provided for under § 365(d)(3) which states that “The trustee shall timely perform all the obligations of the debtor … arising from and after the order for relief under any unexpired lease of nonresidential real property … until such lease is assumed or rejected, notwithstanding section 503 (b)(1) of this title….”

That last bit, the “notwithstanding section 503 (b)(1)” portion means that the landlord is entitled to payment until the lease is rejected; even if it is not an actual, necessary cost or expenses of preserving the estate. Not only is the landlord entitled to an administrative claim, but the payments must commence immediately (for the most part).

Howrey LLP was a global law firm that practiced antitrust, global litigation and intellectual property law. At its peak Howrey had more than 700 attorneys in 17 locations worldwide. In early 2011, Howrey began to wind down its business and was hit with a petition for an involuntary Chapter 7 petition. For simplicity, we are going to assume the case was never a Chapter 7 case; meaning it went from an involuntary Chapter 7 to a voluntary Chapter 11.

 

Section 502(f) states that “In an involuntary case, a claim arising in the ordinary course of the debtor’s business or financial affairs after the commencement of the case but before the earlier of the appointment of a trustee and the order for relief shall be determined as of the date such claim arises, and shall be allowed … the same as if such claim had arisen before the date of the filing of the petition.”

Furthermore, even though the claim is an unsecured prepetition claim, it is entitled to priority under § 507(a)(3): “(3) Third, unsecured claims allowed under section 502 (f) of this title.”

The creditors’ committee and Chapter 11 Trustee argued that the landlord’s claims did not fall under § 502(f) because § 502(f) “only applies to claims arising in the ordinary course of a debtor’s business or financial affairs after the commencement of the case.” The court rejected this argument for several reasons including that the code was designed to protect landlords and that the landlord’s claim arose during the gap period and not when the lease was signed.

The creditors’ committee also argued that § 502(g)(1) applied to this situation. That argument was summarily dismissed because § 502(g)(1) applies to rejected leases; the leases were not rejected during the gap period.

Most surprising was the Court’s relatively short discussion on whether the landlord’s claims were incurred during the ordinary course of Debtor’s business.  The creditors’ committee argued that since the Debtor was winding down its business, the rents were no longer in the ordinary course of the Debtor’s business. In rejecting that argument, the Court took the position that “the focus is on the circumstances under which the right to payment of current rent “arises”, which is when the occupancy continues, when the status quo vis-a-vis the Landlords continues.”

The result is fair but I am not sure whether it is technically correct. I would have expected a more detailed vertical and horizontal dimension analysis. Assuming no bankruptcy, would creditors or even the landlord expect the Debtor to stay current on rent? If not, why is this payment ordinary course?

You can find the case here.