Klein Sleep Products, Inc., In re

• Decision Date: 16 February 1996
• Docket Number: No. 1532,D,1532
• Citation: 78 F.3d 18
• Parties: , 28 Bankr.Ct.Dec. 816, Bankr. L. Rep. P 76,922 In re KLEIN SLEEP PRODUCTS, INC., Debtor. NOSTAS ASSOCIATES, Appellant, v. Bernard W. COSTICH, Chapter 11 Trustee, and Official Committee of Unsecured Creditors, Appellees. ocket 94-5068.
• Court: U.S. Court of Appeals — Second Circuit

Page 18

78 F.3d 18

64 USLW 2530, 28 Bankr.Ct.Dec. 816, Bankr.

L. Rep. P 76,922

In re KLEIN SLEEP PRODUCTS, INC., Debtor.

NOSTAS ASSOCIATES, Appellant, v. Bernard W. COSTICH, Chapter 11 Trustee, and Official

Committee of Unsecured Creditors, Appellees.

No. 1532, Docket 94-5068.

United States Court of Appeals, Second Circuit.

Argued May 24, 1995.

Decided Feb. 16, 1996.

Michael S. Kopelman, Liebowitz, Hauser, Jurecky & Kopelman, Fort Lee, NJ, for Appellant.

Courtney Slatten Katzenstein, William J. Rochelle, III, Fulbright & Jaworski, L.L.P., New York City, for Appellees.

Howard Seife, Winston & Strawn, New York City (Gerald F. Munitz, Howard Schiff, Winston & Strawn, New York City, of counsel), for Amicus Curiae International Council of Shopping Centers, Inc.

Before: VAN GRAAFEILAND, KEARSE, and CALABRESI, Circuit Judges.

CALABRESI, Circuit Judge:

The liquidation provisions of the Bankruptcy Code contained in 11 U.S.C. § 726 distribute a pro-rata share of a debtor's estate to each unsecured creditor so that similarly situated creditors may be treated alike. This pro-rata rule does not, however, always lead to an equitable distribution of the estate. When one claimant is a landlord holding a long-term lease, its single unsecured claim for twenty or thirty years of future rent could devour so much of the debtor's estate that only crumbs could be left for the other unsecured creditors. Recognizing the potentially distorting effect of claims arising out of long-term leases, Congress capped unsecured claims for future rent at one year. 11 U.S.C. § 502(b)(6). This allows landlords to recover some of their losses from a bankrupt tenant, but sees to it that their recovery will not crowd out the claims of competing creditors.

Bankruptcy law also aims to avoid liquidation altogether when that is possible. Although the Code offers no magical potion to restore a debtor's financial health, it does provide some useful medicine designed to help a debtor get back on its feet and heading towards convalescence. It does this by allowing a debtor to attempt to reorganize rather than fold and by creating incentives for creditors to continue to do business with the debtor while reorganization proceeds. The Code does this, at least in part, by assuring these post-bankruptcy creditors that, if the debtor fails to rehabilitate itself and winds up in liquidation, they can move to the front of the distributive line, ahead of the debtor's pre-bankruptcy creditors. Special priority is therefore accorded to expenses incurred under new contracts with the debtor, as "administrative expenses" of the estate. The same priority is given to expenses arising under pre-existing contracts that the debtor "assumes"--contracts whose benefits and burdens the debtor decides, with the bankruptcy court's approval, are worth retaining.

These two competing bankruptcy policies--promoting parity among creditors and yet granting priority to the claims of creditors who continue to do business with an insolvent debtor--collide in the case before us. After entering bankruptcy, Klein Sleep (the debtor) assumed, with court approval, the unexpired lease it had with Nostas Associates (its landlord). Some eighteen months later, when it became apparent that the reorganization had failed, the newly appointed bankruptcy trustee decided to "reject" the lease. The landlord then sought to recover the future rent that was due under the lease. The bankruptcy court held, and the district court agreed, that Nostas was entitled to recover as an administrative expense only the rent that had come due before the trustee rejected the lease. Beyond that, Nostas could recover as a general unsecured claim only one year's worth of the rent coming due after rejection.

Two questions arise on appeal. We must first decide whether the future rent gives rise to a general unsecured claim that receives no priority or whether it is, instead, an administrative expense entitled to priority. If it is an administrative expense, we must then determine whether the claim is nonetheless capped at a year's worth of rent by § 502(b)(6).

Our task would be far easier if Congress had answered these questions explicitly in the Code, but unfortunately it left its intentions ambiguous. In order to resolve this ambiguity, we turn first to the various provisions of the Code that discuss the timing and priority of claims. Since we do not find an unmistakable Code directive, however, we also seek guidance from the practice prevailing under the Code's predecessor, the Bankruptcy Act. Adhering to that practice, we hold that damages arising from future rent under an assumed lease must be treated as an administrative expense, and we therefore reverse in part.

The conclusion we reach seems on its face to be unduly favorable to landlords. But it may in fact do no more than recognize the existence of a default rule, which the bankruptcy court can use in encouraging landlords and tenants alike to renegotiate leases in bankruptcy so as to treat all the parties, including general unsecured creditors, equitably.

I. FACTS

Nostas Associates, the landlord, appeals from a judgment of the United States District Court for the Southern District of New York (Charles S. Haight, Jr., Judge ), dated October 17, 1994, affirming the bankruptcy court's order--which assigned administrative priority to Nostas's claims for past rent accruing under a commercial lease, allowed another year's worth of future rent as a general unsecured claim, and disallowed any recovery for the rest. Before entering bankruptcy, Klein Sleep, Inc. had leased a store from Nostas in Paramus, New Jersey. Shortly after filing for Chapter 11 relief in June 1991, Klein Sleep (acting as debtor-in-possession) assumed the lease with the approval of the bankruptcy court pursuant to 11 U.S.C. § 365, and accordingly cured all rental arrears to that point. Klein Sleep continued to pay rent through October 1992. By January 1993, however, it had become clear that the reorganization had failed so completely that liquidating the firm's assets would not cover even the administrative expenses of the estate. On January 29, 1993, Klein Sleep's newly appointed Chapter 11 trustee, who was assigned the task of liquidating the estate, rejected the lease and surrendered possession of the store to Nostas. ¹

Nostas argued to the bankruptcy court, to the district court, and now to us on appeal that Klein Sleep's court-approved lease assumption converted all liability under the lease into administrative expenses that warrant a first priority in repayment under 11 U.S.C. § 507(a)(1) (providing that administrative expenses, as defined by 11 U.S.C. § 503(b), are first in the order of repayment of claims and expenses). Under this theory, Nostas seeks administrative expense status for rent arrearages from November 1992 through January 1993, for future rent accruing after January 1993, and for attorneys' and brokers' fees incurred in connection with reletting the space.

The bankruptcy court (Francis G. Conrad, Bankruptcy Judge, sitting by designation from the Bankruptcy Court for the District of Vermont ) allowed Nostas's claims in the following order of priority: (1) Super-priority administrative expense status for rent during the liquidation period, from December 1, 1992, through January 29, 1993 (approximately $18,000, of which 100% will be paid upon distribution of the estate), as "burial expenses" of winding up the estate; (2) priority administrative expense status for rent during the pre-liquidation period, from November 1, 1992, through December 1, 1992 (approximately $6800, of which approximately 85% will be paid upon distribution of the estate); and (3) general unsecured claim status for future damages arising after the trustee rejected the lease (approximately $80,000 ² or one year's future rent as limited by 11 U.S.C. § 502(b)(6), of which nothing will be paid upon distribution of the estate). The bankruptcy court disallowed the attorneys' and brokers' fees that the landlord incurred to relet the premises on the grounds that the lease did not provide compensation for such expenses.

Judge Haight affirmed the bankruptcy court's order. In re Klein Sleep Prods., Inc., 173 B.R. 296 (S.D.N.Y.1994). Relying primarily on this court's decision in Trustees of Amalgamated Insurance Fund v. McFarlin's, Inc., 789 F.2d 98, 101 (2d Cir.1986)--a case that we shall discuss shortly--the district court held that

benefit to the estate as required by section 503(b)(1)(A) ³ must be shown for damages arising from the subsequent rejection of an assumed lease to be afforded administrative priority, even if the expenses are considered post-petition expenses under section 365(g)(2)(A). ⁴ Because the post-surrender damages incurred by Nostas in the instant case conferred no benefit upon Klein Sleep, those expenses are not entitled to administrative priority status.

173 B.R. at 300. The district court also noted that Nostas waived its right to appeal from the bankruptcy court's denial of its $2300 claim for brokerage fees, since Nostas had failed to address that issue in its district court brief. Id. at 300 n. 5. The district court stayed its order pending appeal, however, and directed the trustee to place $175,000 in escrow. In re Klein Sleep Prods., Inc., No. 93 CIV. 7599 (CSH), 1994 WL 652459 (S.D.N.Y. Nov. 18, 1994).

II. DISCUSSION

A. Administrative Expense Status

According to 11 U.S.C. § 503(b)(1)(A), "the actual, necessary costs and expenses of preserving the estate" constitute administrative expenses entitled to priority status upon distribution of the estate. The crux of Nostas's argument is that a trustee's or debtor-in-possession's assumption of an unexpired lease transforms all liability under the lease, including damages that stem from a subsequent rejection of the lease, into administrative expenses. There is strong bankruptcy court precedent directly on point that supports this...