Rejected Leases: When The Obligations End Depends
On What Circuit You’re In
Written By: Patricia B. Fugée
Roetzel & Andress, Toledo, Ohio

Section 365(d)(3) requires chapter 11 debtors to timely perform all obligations “arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected.” Section 365(d)(3) specifically provides that such sums are due “notwithstanding §503(b)(1).” Thus, obligations can be due under §365(d)(3) even when there is no demonstrable benefit to the estate. The question arises as follows: suppose the debtor is a party to a nonresidential lease which provides that rent is due, in advance, on the first day of each month. After filing for chapter 11 relief earlier in the year, the debtor obtains an order rejecting the lease as of November 2. Common sense (and many earlier decisions) suggest that the debtor is obligated to pay two days’ rent for November. Now, however, whether the debtor is obligated to pay only two days’ rent or thirty days’ rent depends on which circuit the case is pending in, and the economic result can be dramatically different.

On September 3, 2003, the Seventh Circuit joined a growing number of courts in ruling that where a lease requires rent to be paid in advance on the first of the month, the entire month’s rent is due under §365(d)(3) as of the first, irrespective of what date the rejection takes effect. In HA-LO Industries, Inc. v. Centerpoint Properties Trust, 342 F.3d 794 (7th Cir. 2003), the debtor notified its landlord that it would reject the lease as of November 2 and tendered $60,000, which represented three days’ rent. The landlord accepted the check but then sought the balance of $600,000 due for the rest of Nov. Id. at 796. After the bankruptcy court found in favor of the landlord and the district court affirmed, the debtor appealed to the Seventh Circuit. Id.

The court began its analysis with the Code itself. Id at 797-798. Without much discussion, the court concluded that because the lease required rent to be paid in advance on the first of the month, the debtor’s obligation to pay Nov. rent arose on Nov. 1. Id at 798. Since the rejection had not yet taken effect, the debtor was obligated to pay the full amount, in this case, more than $600,000. Id

Again without much discussion, the court distinguished its prior ruling in In re Handy Andy Home Improvement Centers, Inc. 144 F.3d 1125 (7th Cir. 1998), in which the court had permitted proration of real estate taxes where they accrued pre-petition, but were not billed until after the bankruptcy filing. Id. at 798. The court reasoned that “[i]n economic terms, the prioritization of post-petition debt enables the debtor (or trustee) to ignore sunk costs -- treat bygones as bygones -- and continue operating as long as the debtor’s business is yielding an economic profit.” Id at 799, quoting In re Handy Andy, 144 F.3d at 1127. In contrast, “[p]ost-petition rent covering a period of time that extends into the post-rejection period is ‘not a sunk cost that relates to a time before the bankruptcy case, but a charge for the consumption of a resource during the administration of the case …, and costs of administration must be paid.’” Id., quoting In re: Comdisco, Inc., 272 B.R. 671, 674-675 (Bankr. N.D. Ill. 2002) (citing 11 U.S.C. §1129(a)(9)(A)).

The court also noted that its conclusion in HA-LO Industries, like its conclusion in Handy Andy, was consistent with the policy served by § 365(d)(3), namely, protection of landlords who cannot evict bankrupt tenants. Id at 799. In addition, the court relied on the Sixth Circuit’s decision in Koenig Sporting Goods, Inc. v. Morse Road Co. (In re: Koenig Sporting Goods, Inc.), 203 F.3d 986 (6th Cir. 2000), which similarly held that rent must be paid on the day it is due even if it will cover a period of time after the lease is rejected. Id. The HA-LO court noted with approval the Sixth Circuit’s rejection of the argument that practical realities support proration, since the debtor could have avoided these realities by simply rejecting the lease as of the end of the month, rather than the beginning. Id. at 799-800. Finally, the court rejected the debtor’s argument that because the lease provided for prorated rent in certain specified circumstances, then proration was appropriate in bankruptcy. Id. at 800. As a result, HA-LO was obligated to pay $600,000 more in rent than it had anticipated, which is obviously a significant difference.

There are decisions to the contrary. For example, in In re National Refractories & Minerals Corp., 297 B.R. 614 (N.D. Calif. 2003), the court analyzed a claim for “holdover rent” for post-rejection periods under §503(b)(1) (requiring proof of benefit to the estate), not under section §365(d)(3) (requiring proof only as to when it was due). Id. at 618-619. Even in those jurisdictions which follow the HA-LO rule, there is some discrepancy as to which lease obligations are to be prorated and which are to be paid when billed. See, e.g., In re Phar-Mor, Inc., 290 B.R. 319 (Bankr. N.D. Ohio 2003) (concluding that real estate taxes are to be prorated); see also In re National Refractories, 297 B.R. at 619 (listing cases on either side of the issue).

Thus, debtor’s counsel must carefully analyze the leases as to the variety of obligations that may be due and applicable law in their circuit before determining the effective date of rejection. Failing to do so can be costly, as experienced by HA-LO, depending upon the amount of the obligations, their due date, and the court’s determination under § 365(d)(3) and 503(b)(1).

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