Thursday, December 4, 2008

Ninth Circuit Limits Section 502(b)(6) Cap on Claims by Landlord to Lost Rental Income, Does Not Extend This Cap to Collateral Claims by Landlord

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

El Toro Materials Co. v. Saddleback Valley Community Church (In re El Toro Materials Co.)
Ninth Circuit Court of Appeals Case No. 05-56164
Filed October 1, 2007
Opinion by Judge Alex Kozinski
(subsequently appointed Chief Judge of the Ninth Circuit)

These Bulletins often present appellate opinions the day after they are released, but this Ninth Circuit opinion from last year is worth a look because 1) the holding and its rationale is quite straightforward, so it's easy to learn from; 2) the opinion involves, directly and indirectly two of the more interesting people living in the Ninth Circuit; and 3) because the subject in controversy is one million tons of mud. Even hard-
working bankruptcy attorneys every once in a while get to come out of the trenches and play in the mud.

The Two Personalities
The opinion's author, Alex Kozinski, who shortly after this opinion became the Chief Judge of the Ninth Circuit Court of Appeals. He became a U.S. Court of Appeals judge at 35, the youngest in the country. His opinions are common-sensical and humorous, reflecting fearless libertarian instincts. Emigrated from Romania at 12, his parents both Holocaust survivors, he still speaks, as he says, "with an accent close to [California Governor] Schwarzenegger's." (Please see my prior Bulletin featuring another opinion he authored: "Major New Student Loan Opinion: 9th Circuit Allows Chapter 13 Discharge of Student Loans WITHOUT Adversary Proceeding by Mere Inclusion in Plan."

The pastor of the successful appellant here, Saddleback Church, is Rick Warren, author of one of the best-selling books in history, "The Purpose-Driven Life," and "unquestionably the U.S.'s most influential and highest-profile churchman" in the opinion of a recent Time article on him His church was the venue for the "civil forum" last August featuring the two Presidential candidates, which he moderated. The event was affirmation of his stature. He is not named in the opinion.

The Simple Facts and the Interpreted Statute
This church is the landlord with the million tons of mud left by the debtor, El Toro Materials, upon its rejection of a lease under § 365(a) of the Code. It brought an adversary proceeding "claiming $23 million in damages for the alleged cost of removing the mess, under theories of waste, nuisance, trespass and breach of contract." § 502(b)(6) states that if an objection is made to a claim by a creditor the bankruptcy court
shall determine the amount of such claim . . . and shall allow such claim in such amount, except to the extent that--
(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds--(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease . . . .
That last subsection is a cap on the amount of the claim at either one year of rent on the remaining term of the lease, or, if it is greater, the rent for 15 percent of the remaining term of the lease, but at most three years of rent. The issue is whether that cap on a claim by "lessor for damages resulting from the termination" of a real estate lease caps not just future rent pegged to the periods stated in subsection (A), but also caps other damages owed by the lessee-debtor to the landlord. Such as the cost of removing two billion pounds of mud.

Judge Kozinski Explains
The holding was one of simple statutory construction supported by case law, but the judge presented it quite differently than most jurists. Instead of going right to the statute and case law, he starts by looking at the purpose of the cap for landlord-creditor claim amounts, its economic and historical context, with the help of a touch of legislative history: "The damages cap was 'designed to compensate the landlord for his loss while not permitting a claim so large (based on a long-term lease) as to prevent other general unsecured creditors from recovering a dividend from the estate.”

Then Judge Kozinski begins the core of his analysis with common sense:
The structure of the cap—measured as a fraction of the remaining term—suggests that damages other than those based on a loss of future rental income are not subject to the cap. It makes sense to cap damages for lost rental income based on the amount of expected rent: Landlords may have the ability to mitigate their damages by re-leasing or selling the premises, but will suffer injury in proportion to the value of their lost rent in the meantime. In contrast, collateral damages are likely to bear only a weak correlation to the amount of rent.
Then he moves to public policy:

One major purpose of bankruptcy law is to allow creditors to receive an aliquot share of the estate to settle their debts. Metering these collateral damages by the amount of the rent would be inconsistent with the goal of providing compensation to each creditor in proportion with what it is owed.
Only then does he seem to even look at the details of the statute at issue:

The statutory language supports this interpretation. The cap applies to damages “resulting from” the rejection of the lease. 11 U.S.C. § 502(b)(6). Saddleback’s claims for waste, nuisance and trespass do not result from the rejection of the lease—they result from the pile of dirt allegedly left on the property. . . . . The million-ton heap of dirt was not put there by the rejection of the lease—it was put there by the actions and inactions of El Toro in preparing to turn over the site.
He then returns back to common-sense public policy:

Interpreting the section 502(b)(6) cap to include damage collateral to the lease would also create a perverse incentive for tenants to reject their lease in bankruptcy instead of running it out: Rejecting the lease would allow the tenant to cap its liability for any collateral damage to the premises and thus reduce its overall liability, even if staying on the property would otherwise be desirable and preserve the operating value of the business
. . . .
This would both reduce the operating value of the business and deny recovery to a creditor—a lose-lose situation counter to bankruptcy policy
. . .
Further, extending the cap to cover any collateral damage to the premises wuold allow a post-petition but pre-rejection tenant to cause any amount of damage to the premises- either negligently or intentionally--without fear of liability beyond the cap.
Almost as an afterthought, in his second-to-last paragraph, the judge refers to only one other court opinion, the only one in the entire body of his opinion that he deigns worthy of mention outside the ancient cases he refers to earlier for historical context, and mentions it only for the purpose of overruling it--a Ninth Circuit BAP opinion that the underlying BAP in this case relied on. He provides no explanation why this prior case was wrongly decided, other than to mention in a footnote that two concurring judges in the current case's BAP "expressed reservations" about it. Other than this, and a short footnote distinguishing a potentially contrary Ninth Circuit opinion from the issue in this case, Judge Kozinski's holding is supported in his opinion by no case law whatsoever, reflecting his usual audacity.

The Judge's Advice to the Entire Ninth Circuit BAP
Perhaps anticipating his ascension to the Chief Judge role, but more likely just reflecting his assertive personality, Judge Kozinski gave the following procedural recommendation to the Ninth Circuit's Bankruptcy Appellate Panel:
When the [BAP] believes that one of its precedents is wrongly decided or otherwise deserves reconsideration [as two of the three judges in the panel did in this case], the goal of judicial efficiency may be best served by allowing the BAP itself to overrule its own precedent. The BAP, promulgating its rules under supervision of the Ninth Circuit Judicial Council, has not yet implemented a rule creating an en banc procedure.[Citation excluded.] As this case suggests, the time may be ripe for the BAP to consider instituting such a procedure.
In other words, he's telling the BAP: don't waste the Ninth Circuit's time on cases relying on bad BAP precedent; instead come up with a procedure for dumping such bad BAP law on your own.

by Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys

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