By: Donald L Swanson
Every now and then, a bankruptcy ruling elicits an “Oh, no!” response from just about everyone.
And then, subsequent case law starts rejecting and/or chipping-away at that “On, no!” ruling.
We have such an “Oh, no!” situation going on right now on a Subchapter V debt-limit issue.
New Rejecting/Chipping-Away Opinion
The new rejecting and chipping-away opinion is In re Zhang Medical P.C., Case No. 23-10678, SDNY Bankruptcy Court (decided November 20, 2023; Doc. 205).
The issue is Debtor’s debt-limit eligibility for Subchapter V.
A creditor argues against Zhang’s Subchapter V eligibility because future payments on Debtor’s real estate lease total $60 million—which amount exceeds Subchapter V’s $7.5 million total-debt eligibility cap.
Creditor cites to a recent “Oh, no!” ruling that requires inclusion of all future rent payments in the Subchapter V debt-limit calculation. That opinion is In re Macedon Consulting, Inc., 652 B.R. 480 (Bankr. E.D. Va. 2023):
- In re Macedon holds that all future lease liability “must be considered noncontingent and liquidated,” which puts the Macedon debtor “above the debt limits for subchapter V.”
Rejecting the “Oh, no!” Ruling
The SDNY Bankruptcy Court, in In re Zhang, rejects the In re Macedon ruling.
The central proposition of In re Zhang (on future lease payments and Subchapter V eligibility) is this:
- A debtor’s future payment obligations under executory contracts and unexpired leases should rarely, if ever, be included in the Subchapter V debt limit calculation.
The “Oh, No!” Ruling Cited
The objecting creditor, in In re Zhang, asks the SDNY Court to follow In re Macedon Consulting and hold that, in determining Subchapter V eligibility, debtor’s future rent payments must be be included in the debt-limit calculation.
The Macedon Consulting debtor was a software developer that, like the Zhang Debtor, falls on hard times and, as a result of the COVID-19 pandemic, needs less office space than it previously leased.
Unlike the In re Zhang Debtor, Macedon Consulting moves on the petition date to reject its unexpired office leases.
Macedon Consulting’s two landlords ask the court to revoke the debtor’s Subchapter V designation because its future rent under the leases exceeds $14 million.
The Macedon Consulting court holds that debtor’s future rent obligations are noncontingent on the petition day, because debtor’s liability for all rent over the term of the leases “arose pre-petition, on the dates the Leases were fully executed.”
The “Oh, No!” Ruling Rejected
The In re Zhang opinion rejects the In re Macedon Consulting ruling like this:
- if the Macedon Consulting ruling were followed, it would greatly restrict subchapter V eligibility; and
- that’s because many debtors otherwise eligible for Subchapter V are parties to long-term leases or contracts, with future payment obligations well in excess of $7.5 million—
- In Zhang, for example, Debtor’s future rent payments exceed $60 million.
The In re Zhang opinion explains further that the Macedon Consulting decision overlooks the distinctive nature of a debtor’s obligations under executory contracts and unexpired leases. Such obligations differ in key respects from other obligations, including:
- the U.S. Supreme Court observes that an executory contract “represents both an asset (the debtor’s right to the performance) and a liability (the debtor’s own obligations to perform)”;
- that means a debtor’s obligations under an executory contract or unexpired lease are part and parcel of a reciprocal agreement that involves benefits as well as burdens—
- in many instances, the benefits exceed the burdens, making the contract or lease a net asset, rather than a net liability, for the debtor;
- because some executory contracts or unexpired leases on balance are beneficial and others are detrimental to the estate, the Bankruptcy Code gives the debtor the option either to assume or to reject each such contract or lease;
- if debtor assumes a contract or lease, its obligations going forward are treated on an administrative expense basis, entitled to the highest priority; but
- if debtor rejects, the counterparty’s future performance obligations are excused, and the counterparty is given a “rejection damages” claim against the debtor—which is a pre-petition breach of contract claim, payable at the same cents on the dollar as other unsecured claims; and
- for rejected leases, the debtor’s liability is further limited by the statutory cap provided by Bankruptcy Code § 502(b)(6) [Fn. 1].
Implications of Lease Assumption/Rejection
Implications follow from a debtor’s right to accept or reject.
First, an assumed executory contract or unexpired lease is not properly considered a “debt” for subchapter V’s eligibility. That’s because:
- a debtor may not assume a contract or lease unless it reasonably determines assumption is in the estate’s best interest—i.e., that the contract or lease is a net asset; and
- to consider the assumed obligations in isolation and treat them as debts would ignore that the contract as a whole is an asset, not a liability.
Second, until the debtor elects either to assume or to reject an executory contract or unexpired lease, the amount and nature of its obligations under that contract or lease are contingent and unliquidated:
- if debtor assumes, it will be responsible to pay all contractual obligations in hundred-cent dollars; but
- if debtor rejects, its obligations will be payable on a pre-petition basis, and the amount of those obligations will usually be much smaller—
- for contracts, the amount of damages caused by the debtor’s breach, and for leases, the capped amount set by Code § 502(b)(6).
Because the amount and nature of the debtor’s obligations, as well as whether these are even “debts,” depend on an uncertain future event (i.e., the debtor’s election to either assume or reject), the future payments are both contingent and unliquidated prior to that election.
Timing
The In re Zhang opinion mentions a distinction between a motion to reject an executory contract or unexpired lease filed, (i) as a first day motion (a rare occurrence), or (ii) later. And the In re Zhang opinion offers these observations:
- filing a rejection motion on the petition date might make the “noncontingent on the petition date” argument stronger; but
- a rejection motion, even if filed on the petition date, does not become effective until it is approved by the court.
Conclusion
When the In re Macedon Consulting ruling came down, there was a collective groan accompanied by “Oh, no!” exclamations throughout the bankruptcy world.
Hopefully, the In re Zhang opinion is the first of many legal opinions bringing the debt-limit law for Subchapter V eligibility back to a better place.
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Footnote 1. 11 U.S.C. § 502(b)(6) provides: (b) . . . if such objection to a claim is made, the court, after notice and a hearing, shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, 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, following the earlier of—(i) the date of the filing of the petition; and (ii) the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus (B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates.
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