§ 102.5     Rejection Generates Unsecured Claim
Cite as:    Keith M. Lundin, Lundin On Chapter 13, § 102.5, at ¶ ____, LundinOnChapter13.com (last visited __________).
[1]

Rejection of an executory contract or unexpired lease typically generates an unsecured claim with the same status as any other prepetition, nonpriority, unsecured claim. Section 365(g)(1) provides that the rejection of an executory contract or unexpired lease that has not previously been assumed constitutes a breach of the contract or lease “immediately before the date of the filing of the petition.”1 Under § 502(g), “a claim arising from the rejection, under section 365 of this title or under a plan under chapter . . . 13 . . . of an executory contract or unexpired lease of the debtor that has not been assumed shall be determined . . . the same as if such claim had arisen before the date of the filing of the petition.”2

[2]

But rejection hardly is the end of problems for a Chapter 13 debtor with executory contracts or unexpired leases. Rejection of a contract or lease can generate enormous unsecured claims that affect the rights of all creditors through the plan. Many executory contracts have liquidated damages provisions. Rejection constitutes an event of default, and the liquidated damages provision of the contract will be enforceable in bankruptcy unless so excessive as to constitute a forfeiture or penalty.

[3]

For example, the unsecured claim that results from rejection of a car lease is often measured by contract in terms of the difference between the balance of the payments under the lease and the liquidation value of the car. Damages upon rejection of a car lease usually include repairs attributable to the debtor.3 Rejecting a car lease can expose the Chapter 13 debtor to a very large unsecured claim for damages.

[4]

Subject to the limitations in 11 U.S.C. § 502(b)(6), damages from the termination of a lease of an apartment or a home often will be a full year’s rent plus any unpaid rent due at the petition.4 When a nonresidential lease was rejected automatically under § 365(d)(4), the resulting rejection damages claim included two months of postpetition administrative rent prior to rejection plus contract rent between rejection and re-letting of the property.5 In the unusual situation when the Chapter 13 debtor is a landlord rejecting a lease, the nondebtor lessee has an option to seek damages for nonperformance by the debtor.6

[5]

If the debtor’s plan pays less than 100 percent of unsecured claims, rejection of the lease results in an unsecured claim that can be compromised through the plan. If the plan pays a high percentage of unsecured claims and rejection of a lease or executory contract will generate a substantial claim, the debtor may be better off assuming the lease or assigning the lease to someone else, even at a discount, rather than rejecting and paying full damages.

[6]

Perhaps the worst thing the debtor can do with respect to an executory contract or unexpired lease is to first assume and then reject the contract in the same Chapter 13 case. Under § 365(g)(2), when the debtor rejects a lease that was previously assumed, the resulting claim is a postpetition debt entitled to priority as an administrative expense and to full payment through the Chapter 13 plan.7 For example, in In re Wright,8 the debtor was in the trucking business. The confirmed Chapter 13 plan assumed the lease of a trailer. Fortunes changed, and four months after confirmation, the debtor modified the plan to abandon the trailer. The resulting lease rejection generated a huge administrative expense:

Under § 365(g)(1), damages resulting from rejection of such a lease (absent a previous assumption) are construed as arising immediately before the date of the filing of the petition. Accordingly, the damages are treated as a general unsecured claim under § 502(g). Section 365(g)(2) applies to claims for damages arising from a debtor’s rejection of a lease that was previously assumed. This provision states that where an assumed lease is later rejected, the resulting damages are construed as arising postpetition at the time of such breach. . . . [P]ostpetition damages resulting from the breach of a previously assumed lease are entitled to priority as an administrative expense.9

 

1  11 U.S.C. § 365(g)(1).

 

2  11 U.S.C. § 502(g).

 

3  In re Hughes, 98 B.R. 963 (Bankr. E.D. Mo. 1989).

 

4  See In re Clements, 185 B.R. 895 (Bankr. M.D. Fla. 1995) (Landlord’s claim against the debtor/guarantor is limited by § 502(b)(6) to the monthly rent plus expenses, attorneys’ fees and insurance, totaling $239,569.48.); Kuske v. McSheridan (In re McSheridan), 184 B.R. 91 (B.A.P. 9th Cir. 1995) (Upon rejection of a lease guaranteed by a Chapter 13 debtor, the “rent reserved” for purposes of § 502(b)(6)(A) includes items paid by the tenant under the lease in addition to the monthly rental payment.); In re Fulton, 148 B.R. 838 (Bankr. S.D. Tex. 1992) (Section 502(b)(6) limits the amount of damages to which a lessor is entitled, notwithstanding a final prepetition state court judgment. Section 502(b)(6) is a limitation on the allowance of the prepetition claim that was liquidated by the state court, and the amount of the lessor’s claim, including attorneys’ fees, is limited by the cap in § 502(b)(6).). See also In re Smith, 249 B.R. 328 (Bankr. S.D. Ga. 2000) (Applying § 502(b)(6), prepetition abandonment of leased commercial space was not effective to surrender the property; but, landlord’s claim is reduced from $152,059.85 to $95,798.39 because late charges, interest, attorneys’ fees and other items are excluded from the cap allowable under § 502(b)(6)(B).); In re Walker, 190 B.R. 362 (Bankr. E.D. Mo. 1995) (On the debtors’ objection to claim, commercial landlord is entitled to interest, attorney’s fees and costs and unpaid rent, totaling nearly $75,000. Also, $17,000 of the landlord’s claim is secured by the debtors’ business property.).

 

5  In re Paskorz, 284 B.R. 429 (Bankr. W.D. Pa. 2002). Accord In re Schnitz, 293 B.R. 7 (Bankr. W.D. Mo. 2003) (Unpaid pre-rejection rent of business property is an administrative expense in a Chapter 13 case that debtor can pay through the plan together with other priority claims.).

 

6  See Milstead v. Tele Media Broadcasting, Inc. (In re Milstead), 197 B.R. 33, 35–37 (Bankr. E.D. Va. 1996) (Debtor/landlord’s rejection of lease was effective upon confirmation; tenant had option to treat the lease as terminated and is entitled to damages for the costs of relocating. “[B]ecause the debtor never filed a motion to reject the lease, rejection did not take place until debtor’s chapter 13 plan was confirmed. . . . Under § 365(g)(1), rejection of an unexpired lease by a debtor constitutes a breach. . . . [T]he nondebtor party to the lease becomes the holder of an unsecured prepetition claim. . . . Under § 365(h)(2), a debtor lessor remains liable for any damages caused by the nonperformance of any obligation of the debtor under the lease. . . . Defendant was within its rights to treat the lease as terminated and vacate the premises. . . . [D]efendant incurred costs in the stipulated amount of $17,443.50.”).

 

7  See also § 173.1 [ Debtor Must Cure Defaults and Assure Future Performance ] § 102.2  Debtor Must Cure Defaults and Assure Future Performance.

 

8  256 B.R. 858 (Bankr. W.D.N.C. 2001).

 

9  256 B.R. at 859–60. Accord In re Masek, 301 B.R. 336 (Bankr. D. Neb. 2003) (Chapter 13 debtors are warned that the balance of lease payments becomes an administrative priority claim if the debtor first assumes and then rejects an executory contract.).