Lessors Entitled To A Chapter 11 Administrative Priority Claim for Rent under A Post-Bankruptcy Lease after A Chapter 7 Conversion

When a Chapter 11 debtor assumes a real property lease and then subsequently defaults, the lessor is granted an administrative claim for future rent under the assumed lease. But what happens to a lessor, who had no pre-bankruptcy dealings with a Chapter 11 debtor, but who enters into a post-bankruptcy lease with a debtor prior to debtor's converting its case to a Chapter 7? Recently, the United States Court of Appeals for the Fourth Circuit confronted the issue, and ruled that the lessor's claim for future rent deserved the same Chapter 11 administrative priority treatment as a debtor-in-possession who assumes and then rejects a pre-bankruptcy lease.

In In re Merry-Go-Round Enterprises (June 8, 1999), the Fourth Circuit found that a Chapter 11 administrative claim effectuated the best balance between the "competing interests of (1) encouraging parties to do business with a Chapter 11 estate against (2) preserving a Chapter 7 trustee's discretion" to effectuate a liquidation of the estate including a breach of the lease and the return of the leased property to the lessor. Merry-Go-Round involved a shopping center lease for a retail clothing business. The Fourth Circuit also determined that the lessor's administrative priority claim was founded on Section 503(b)(1)(A) of the Bankruptcy Code, which offers priority claim status for all "actual, necessary costs and expenses of preserving the estate." At the time the post-bankruptcy lease was executed, it benefited the debtor by permitting the debtor to continue in business.

The Fourth Circuit expressed great concern for the policy of encouraging landlords to enter long term leases with a debtor-in-possession by recognizing a landlord's right to administrative priority for claims arising from subsequent breaches. (Note: Despite the split among the circuits, the Fourth Circuit also found that Section 502(b)(6)(A) did not operate to limit the administrative claims of the lessor to the greater of 12months rent or 15% of the remaining lease term.)

For landlords, the Merry-Go-Round decision can provide significant protection and comfort when considering lease agreements with a debtor-in-possession. Nevertheless, landlords still need internally to evaluate the benefit of prospective Chapter 11 administrative claims, which are: (i)subordinate to Chapter 7 administrative claims; and (ii) subject to a lessor's duty to mitigate damages under the rejected lease.

Charles Sterbach can be reached at 530-8566 or via Internet e-mail: crs@gknet.com.