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Delaware Bankruptcy Court Examines the Parameters of Bankruptcy Code Section 365(d)(3)

Chief Judge Gross of the United States Bankruptcy Court for the District of Delaware recently issued an opinion further developing the contours of the preferential treatment afforded to commercial landlords under section 365(d)(3) of the Bankruptcy Code.  See WM Inland Adjacent LLC v. Mervyn’s LLC (In re Mervy­­­­­­­­n’s), Adv. Proc. 09-50920 (KG) (Del. Bankr., Jan. 8, 2013).  Section 365(d)(3) requires a debtor in possession to “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.”

In the Mervyn’s adversary proceeding, a commercial landlord sought indemnification from the debtor pursuant to the terms of the lease related to the landlord’s post-rejection settlement of a foreclosure suit in California state court.  The lease provided that the debtor was required “to keep the premises free of mechanics’ liens, and pay [the landlord] as additional rent all amounts and charges due under the Lease, including attorneys’ fees.”  Id. at p. 2.

The foreclosure suit was instituted by a contractor who was owed money by the debtor for work done pre-petition on the property the landlord leased to the debtor.  Following the petition date, but prior to the rejection of the lease, the contractor filed mechanics’ liens against the landlord’s real property and filed the foreclosure suit.  The contractor and the landlord entered into a settlement of the foreclosure suit following rejection of the lease.

The landlord argued that its indemnification claim fell within the ambit of Section 365(d)(3) of the Bankruptcy Code.  The debtor argued that the indemnification obligation gave the landlord a pre-petition, unsecured claim either because (i) the obligation arose upon rejection of the lease under section 502(g) or (ii) it arose prior to the bankruptcy filing at the time that the contractor performed the work for the debtor.

Judge Gross readily rejected the debtor’s first argument, stating that “[t]he damages giving rise to the [the landlord’s indemnification claim] did not stem from the rejection of the Lease. Rather, the damages arose from the filing of mechanics’ liens against the Premises, a matter entirely separate from the rejection of the Lease.  Opinion at 11.

The Court also dismissed the debtor’s second argument.  Citing the Montgomery Ward decision, Judge Gross noted that “[t]he language of section 365(d)(3) refers to an ‘obligation,’ which is ‘something one is legally required to perform under the terms of the lease . . . and such an obligation arises when one becomes legally obligated to perform.’  Montgomery Ward, 268 F.3d at 209.  In the context of section 365(d)(3), the Court of Appeals for the Third Circuit noted the importance of post-petition, pre-rejection performance by debtor tenants ‘at the time required in the lease.’”  Id. at 11-12.  Following the Third Circuit’s directive that the terms of the lease dictate the time that an obligation arises, Judge Gross held that “once [the contractor] recorded the . . . Liens against the Premises . . . and [the landlord] was sued by [the contractor] . . ., the terms of the Lease dictate that Mervyn’s was obligated to indemnify [the landlord].”  Id.  Accordingly, Judge Gross held that the indemnification obligation arose post-petition despite the fact that the conduct and the debtor’s obligation to pay the contractor arose pre-petition.

In the alternative, the debtor argued that the indemnification obligation would not fall within the ambit of section 365(d)(3) of the Bankruptcy Code because the obligation arose when the foreclosure suit was settled after the lease was rejected, which was when the actual dollar amount of the obligation became known.  In addressing this issue, Judge Gross noted that “[i]n the context of section 365(d)(3), the relevant time is when an ‘obligation’ arises, which is different from when a ‘claim’ arises.  The Court of Appeals for the Third Circuit distinguished a ‘claim,’ which is an ‘unmatured right to payment,’ from an ‘obligation,’ which is ‘something one is legally required to perform under the lease.’”  Id. at 13.  Judge Gross then held that “[w]hile the Lease and conduct giving rise to the [indemnification claims] took place pre-petition, the actual “billing date,” or obligation, arose when [the contractor] filed its mechanics’ liens and it sued to foreclose upon them.  Therefore, the [indemnification claims] arose post-petition and pre-rejection under section 365(d)(3) as in Montgomery Ward.”  Id.

The debtor next argued that, even if Section 365(d)(3) was applicable, the landlord could not meet its burden of establishing its right to administrative expense treatment under Section 503(b)(1) of the Bankruptcy Code.  Relying on the language “notwithstanding section 503(b)(1) of this title” in Section 365(d)(3) and Judge Sontchi’s opinion in In re Goody’s Family Clothing, Inc., 401 B.R. 656 (D. Del. 2009) aff’d sub nom. In re Goody’s Family Clothing, Inc., 610 F.3d 812 (3d Cir. 2010), Judge Gross held that Section 503(b)(1) was inapplicable because the landlord’s indemnification claim stemmed from post-petition obligations under the lease pursuant to Section 365(d)(3).

Finally, the debtor raised two public policy arguments.  First the debtor argued that elevating the landlord’s indemnification claim to administrative priority status “’simply by conspiring with a third-party plaintiff’ would encourage a wait-and see hedging of bets regarding an anticipated bankruptcy.”  Opinion at 15.  Second, the debtor argued that granting the landlord administrative claim status would be inequitable.  Judge Gross dismissed both of these arguments because the indemnification obligation “arising from the Lease fits squarely into section 365(d)(3) and the Montgomery Ward rationale.”  Id.

The Mervyn’s opinion is likely correct under Montgomery Ward, which Judge Gross was constrained to follow, and the Montgomery Ward opinion was arguably correct based on a strict construction of Section 363(d)(3).  But the debtor’s public policy arguments raise legitimate questions regarding the application of Section 365(d)(3).  While the landlord and contractor in Mervyn’s may not have conspired to reach the result achieved, it is not hard to imagine a savvy landlord with experienced bankruptcy counsel making strategic decisions when a tenant’s bankruptcy is looming that could dramatically affect the landlord’s recovery.  For example, in Montgomery Ward where, pursuant to the terms of the lease, real property taxes were due upon receipt by the tenant, the landlord’s claim for property taxes for two full years in the amount of $426,729.87 was elevated to administrative expense priority status simply because the landlord sent three property tax bills to the debtor four days after the bankruptcy was filed despite the fact that the post-petition, pre-rejection period lasted approximately two months.  See Montgomery Ward, 268 F.3d at 207.  Judge Mansmann recognized both of these issues in her dissent in Montgomery Ward, stating “[i]n so holding, the majority elevates the accident or artifice of the billing date above the economic reality of the accrual, and thereby inappropriately burdens the administration of the bankrupt estate and unfairly favors landlords over similarly situated pre-petition creditors.”  Id. at 213.  Perhaps it is time for Congress to consider the policy implications of the Third Circuit’s interpretation of Section 365(d)(3).