Debtors: On Vacating the Premises, Take Your Goo With You!

A landlord has successfully circumvented the “cap” on lease rejection damages imposed under Bankruptcy Code section 502(b)(6). In deciding a case with highly unusual (and sympathetic) facts, Ninth Circuit Judge Alex Kozinski has made some broad statements that will henceforth encourage landlords to structure their claims, and their leases, to try to “beat the cap.” The case is In re El Toro Materials Company, 2007 WL 2822019 (9th Cir., October 1, 2007).

You’ve got to love these facts: The debtor was a mining company which had leased land from the Saddleback Valley Community Church. The rent was $28,000 per month. The debtor rejected the lease and vacated the property, leaving (in Judge Kozinski’s words) “one million tons of its wet clay “goo,” mining equipment and other materials.” Saddleback claimed “$23 million in damages for the alleged cost of removing the mess, under theories of waste, nuisance, trespass and breach of contract.” The bankruptcy court held that this claim was not subject to section 502(b)(6), which limits in amount “the claim of a lessor for damages resulting from the termination of a lease of real property.” The BAP reversed, reluctantly concluding that it was bound by its own precedent in In re McSheridan, 184 B.R. 91 (Bankr. App. 9th Cir.1995). McSheridan contains a broad holding to the effect that any damages arising from breach of any lease covenant is subject to the cap.

Here’s how the Ninth Circuit opinion distinguishes the damages for the abandoned “goo” (which certainly was a breach of a lease covenant) from other damages which would be subject to the cap:

The cap applies to damages “resulting from” the rejection of the lease. 11 U.S.C. § 502(b)(6). Saddleback's claims for waste, nuisance and trespass do not result from the rejection of the lease-they result from the pile of dirt allegedly left on the property. Rejection of the lease may or may not have triggered Saddleback's ability to sue for the alleged damages. But the harm to Saddleback's property existed whether or not the lease was rejected. A simple test reveals whether the damages result from the rejection of the lease: 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? . . . The million-ton heap of dirt was not put there by the rejection of the lease-it was put there by the actions and inactions of El Toro in preparing to turn over the site.

Are you persuaded? Well, as a landlord’s attorney I sure am! The opinion expressly overrules McSheridan to the extent that it holds that the cap is (to quote the El Toro opinion) “a limit on tort claims other than those based on lost rent, rent-like payments or other damages directly arising from a tenant's failure to complete a lease term.” Incidentally, in a footnote Judge Kozinski suggests that the BAP might amend its rules to allow for en banc hearings in order to address questionable precedent like McSheridan.

El Toro obviously will prompt landlords to express their claims not in terms of breach of contract but rather in terms of torts such as conversion, trespass and fraud. Drafters of leases may change language that used to characterize “restore to shell” and similar obligations on termination as rent. Instead, new lease forms may expressly reserve tort claims for these sorts of tenant obligations.