The Court of Appeals for the Sixth Circuit has addressed lease rejection damages in bankruptcy and the impact of an equipment lessor’s attempt to mitigate its damages on the amount of its allowable damage claim. The decision in Giant Eagle, Inc. v. Phar-Mor, Inc., 528 F. 3d 455 (6th Cir. 2008) contains a number of positive rulings for equipment lessors, rejecting arguments by the debtor that the lessor’s rights should be limited both as to the amount of its unsecured claim for rejection damages and as to the administrative claim for the debtor’s post-petition retention of the equipment prior to the debtor’s formal rejection of the lease.

Statutory Framework
Section 365 of the Bankruptcy Code gives a debtor in Chapter 11 a reasonable time to determine whether to assume or reject an unexpired lease of personal property after the debtor files for bankruptcy protection. If the debtor rejects the lease, the lease is treated as a breach deemed to have occurred immediately prior to the petition date. [See 11 U.S.C. §365(g).] The debtor’s decision to reject a lease is subject to court approval. [See 11 U.S.C. §365(a).] Under Bankruptcy Code §502, a claim is allowed in the amount determined to be due as of the petition date “except to the extent such claim is unenforceable against the debtor.” 11 U.S.C. §502(a), 502(b)(1). Unless there is a conflict with a provision of the Bankruptcy Code, the calculation of the amount due the lessor under the rejected lease is determined under the terms of the lease contract and applicable nonbankruptcy law.

Giant Eagle Dispute
Prior to the debtor’s bankruptcy filing, Giant Eagle had entered into multiple equipment leases with the debtor for warehouse equipment, including lift trucks and other equipment used to move inventory as well as items such as inventory shelving and rack systems. The term of the lease was 160 months (slightly over 13 years). With seven years remaining under the terms of the leases, the debtor filed a petition under Chapter 11 of the Bankruptcy Code. For the next ten months while its case was pending, the debtor continued to use the equipment subject to the leases.

Approximately ten months after the petition date, the court entered an order for the sale of substantially all of the debtor’s assets. The asset sale, however, did not include the equipment leases with Giant Eagle. In connection with the sale of its assets, the debtor held final liquidation sales and performed inventory counts using some of the Giant Eagle equipment subject to the leases. The debtor did not formally reject the Giant Eagle leases until more than two months later.

The Giant Eagle leases each contained liquidated damages provisions, which provided for damages based on the present value of the unpaid future rent due under the leases from the date of breach to the end of their stated terms, using a discount rate of 7%. After the lessor recovered the equipment, Giant Eagle attempted to mitigate its damages by leasing the warehouse equipment to a third party under new leases for the same price but with different termination dates. The new lessee, however, later defaulted on the leases, filed bankruptcy and rejected the leases. Through the new lessee’s bankruptcy proceeding, the new lessor paid Giant Eagle for administrative rent for its post-petition use of the equipment and a small percentage of its general unsecured claim, which was calculated based on the estimated percentage unsecured creditors would receive in the case.

Giant Eagle filed two claims in the Phar-Mor case. It filed an administrative claim under its leases for administrative rent calculated based on the monthly lease payments for the period from the date of the debtor’s bankruptcy filing up to the date of the formal rejection of the leases. Giant Eagle also filed a general unsecured claim for the amount of liquidated damages due under the terms of the leases from the date of rejection, discounted at the 7% discount rate provided for in the leases, less the actual sums received from the third-party lessee through its mitigation efforts, and including the payments made to Giant Eagle on its claim in the new lessee’s bankruptcy case.

Rulings for Equipment Lessors
The debtor contested the amount of the administrative claim asserted by Giant Eagle, arguing that because the debtor only made minimal use of the equipment after the court approved the sale of substantially all of its assets, the lessor was not entitled to administrative rent thereafter. The Court of Appeals disagreed and held that the lessor was entitled to administrative rent for the use and retention of the equipment up to the date of the formal rejection of the leases, calculated based on the monthly lease payments provided for under the leases.

The debtor also argued that the only damages to which Giant Eagle was entitled were damages up to the date of the lessor’s new leases with the third party made pursuant to the lessor’s duty to mitigate its damages under applicable state law. The debtor claimed that the new lease fully mitigated Giant Eagle’s damages through the replacement leases for all the equipment and that Giant Eagle was required to bear the risk of the failure of the new lessee to meet its lease obligations. The debtor in effect argued the new leases operated as a novation, eliminating any further liability of the debtor under the original leases from the point that the new leases were entered into.

The Sixth Circuit again rejected the debtor’s arguments. Examining state law and the Bankruptcy Code claim provisions providing for calculation of the claim for breach of the leases as of the date of the petition, the court ruled that Giant Eagle had properly calculated its unsecured claim. The court held that the actual damages under the leases, including the future rent due discounted to present value, should be reduced by the amounts “actually or reasonably mitigated” under Pennsylvania law, which in that case was the amount actually paid by the subsequent lessee under the new leases. The court rejected the concept that the mitigation efforts by the lessor resulted in any extinguishment of the original lessee’s obligations under its leases with Giant Eagle. The Sixth Circuit found no unfairness in this result and, to the contrary, found that the debtor benefited from the lessor’s efforts to re-let the equipment and recover some value for the equipment although the subsequent lessee later defaulted.

Practice Point
The Sixth Circuit suggested that the debtor’s contention that it was relieved of liability under the equipment leases “might have some legitimacy” under different circumstances, specifically if the leases had been assigned to the new lessee and if the new lessee had assumed the debtor’s obligations under those leases. The court stated that had the new lessee under that circumstance subsequently defaulted, the debtor could have argued it was being asked to act as a guarantor of the new leases and that its liability was cut off through the assumption and assignment of the leases.

The lease damages in this case amounted to millions of dollars. The rejection of the leases was costly to both the lessee and the lessor. The Sixth Circuit’s suggestion that the debtor could have possibly avoided incurring this large claim through an assumption and assignment of the lease is a practice point to be considered, but one which has practical limitations.

For example, the most likely new lessee for the equipment in question would have been the entity acquiring the debtor’s assets. Yet, it seems likely under the facts of the case that the buyer had no interest in the equipment or otherwise could not come to mutually acceptable terms with the debtor and lessor for the assumption and assignment of the leases or acquisition of the equipment, or the equipment would have been included in the sale.

It is also unlikely in most circumstances that the debtor would be able to locate a new lessee for the equipment unless the entity purchasing the debtor’s assets is interested in the equipment or unless the lease has below market or other favorable terms, which is typically more likely to exist with real property leases rather than equipment leases. Nevertheless, in a case where the debtor, the lessor and a new buyer may be able to strike an accord on the financial terms that would allow the buyer to obtain the equipment as part of an asset sale, this decision demonstrates the advantage structuring the take over as an assumption and assignment of the lease will have for the debtor and its bankruptcy estate, and the disadvantage such a structure may have for the equipment lessor.

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Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, LLP, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies such as the Federal Trade Commission and Securities and Exchange Commission. Hawes is a regular contributor to the Monitor and other legal journals, and she has lectured for the National Business Institute and other organizations. She graduated Order of the Coif from University of Southern California law school and earned her undergraduate degree in political science magna cum laude from University of Southern California.