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Lessee Remains Liable to Lessor Following Failed Mitigation

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In Giant Eagle, Inc. v. Phar-Mor, Inc., 2008 WL 2078787 (6th Cir. 2008) the United States Court of Appeals for the Sixth Circuit held that the lower courts erred in their determination that once a lessor mitigates its damages by entering into a substitute lease, the lessor cannot claim damages from the original lessee for the period covered by the new lease if the substitute lessee subsequently defaults.

In this case, the original lessee and lessor were parties to a long-term lease for warehouse equipment. One year after the lessee’s Chapter 11 filing, the lessee rejected the lease under § 365(a) of the bankruptcy code. The lessor attempted to mitigate its damages by entering into a new lease, but that lessee also filed for bankruptcy. The lessor then sought damages from the original lessee. The original lessee objected, arguing that it was excused from liability as of the date the lessor entered into the subsequent lease, because that lease could have fully mitigated its damages. The Bankruptcy Court agreed with the original lessee, as did the District Court. The Circuit Court reversed and instead found for the lessor.

The Case

Phar-Mor, Inc. (“Phar-Mor”) formerly operated a chain of drugstores. On May 1, 1995, Phar-Mor signed a 13-year lease to rent certain warehouse equipment from Giant Eagle, Inc. (“Giant Eagle”). Monthly payments were $44,496.45 and the lease was set to terminate on Sept. 1, 2008. On Sept. 21, 2001, Phar-Mor filed a bankruptcy petition, but continued to use and pay partial rent for the equipment until July 17, 2002. On July 18, 2002, the Bankruptcy Court entered an order authorizing the sale of substantially all of Phar-Mor’s assets. Subsequently, on Sept. 20, 2002, Phar-Mor rejected its lease with Giant Eagle. The latter filed two types of claims in the Phar-Mor bankruptcy, a claim for administrative rent for the period between the filing and rejection, and a general unsecured claim arising out of Phar-Mor’s rejection.

Attempting to mitigate its damages, on Oct. 31, 2002, Giant Eagle signed a substitute lease with Snyder Drugstores, Inc. (“Snyder”). Snyder later filed for bankruptcy on Sept. 11, 2003 and rejected its lease with Giant Eagle on Nov. 30, 2003. After Snyder rejected the lease, Giant Eagle was unable to re-lease the equipment. To further mitigate its damages, Giant Eagle filed claims in the Snyder bankruptcy. It recovered from Snyder administrative expenses for rent due prior to the date of rejection, and 6% of its claim for rent due after the date of rejection, which was the distribution to unsecured creditors provided in Snyder’s reorganization plan. Thereafter, Phar-Mor objected to Giant Eagle’s claim for administrative expense payments in the Phar-Mor case on the basis that Phar-Mor did not benefit from the use of the equipment from the date of the sale order ( July 18, 2002) until rejection (Sept. 20, 2002). It also objected to post-petition damages on the basis that the Snyder lease fully mitigated Giant Eagle’s damages. The Bankruptcy Court and District Court disallowed Giant Eagle’s claim for future-rent damages, reasoning that the substitute lease with Snyder, if fulfilled, would have mitigated the claimed damages.

Giant Eagle appealed the District Court’s decision to the Sixth Circuit Court of Appeals. The Circuit Court looked to Pennsylvania law to calculate Giant Eagle’s damages for future rent arising from Phar-Mor’s rejection of the lease. Section 365(a) of the bankruptcy code provides that a bankruptcy trustee may reject an unexpired lease and § 365(g) gives the lessor an unsecured claim as if the lease had been breached immediately before the bankruptcy petition was filed. However, the trustee can still object to the amount of the lessor’s claim, and the bankruptcy code does not address how to calculate the claim. Section 502(b)(1) provides that the court shall determine the amount of such claim as of the date of filing, and shall allow such claim “in such amount, except to the extent that such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law.” Thus to properly quantify the lessor’s claim, courts must look to state law. In this case, the lease contained a choice of law provision designating Pennsylvania law as controlling.

Pennsylvania Law

Pennsylvania has adopted Article 2A of the UCC, which provides that upon a lessee’s breach, a lessor may exercise remedies provided for under the UCC and under the lease. Pennsylvania law provides four alternatives for calculating damages:

  1. dispose of the goods and recover damages (§ 2A-527);
  2. retain the goods and recover damages (§2A-528);
  3. recover rent (§2A 529); or
  4. exercise any other rights or pursue other remedies provided in the lease contract (§2A-523).

Here, the lease contained a liquidated damages provision that calculated damages as the present value of future rent based on a 7% discount rate. It also contained a provision requiring Giant Eagle to mitigate damages in the case of a breach, but further provided that Phar-Mor would continue to be liable for reasonable damages arising from the breach. Similarly, Pennsylvania law would otherwise provide that the lessor is entitled to be put in the same position it would have been had the lessee fully performed.

Before applying Pennsylvania law, the Circuit Court examined whether the duty to mitigate conflicts with the bankruptcy code. Following an analysis of applicable case law, the court in concluding that the bankruptcy code did not intend to allow a lessor to recover for the amount of rent due under the lease and also have the property available for re-rental, held that a lessor can only claim actual damages, which are subject to the state law duty to mitigate. With respect to the duty to mitigate, however, it should be noted that lessee may not be able to rely on the court’s determination that there is a blanket duty to mitigate damages in Pennsylvania. Here, the court cited Paskorz v. JMK Realty, 284 B.R. 429 (Bankr. W.D.Pa. 2002) in concluding that Pennsylvania law imposes a duty upon a lessor to mitigate damages. Paskorz relied on a 1988 decision from the Bankruptcy Court of the Eastern District of Pennsylvania, which anticipated that the Pennsylvania Supreme Court would require mitigation of damages. It is important to note that in Stonehedge Square Limited Partnership v. Movie Merchants, Inc., 685 A.2d 1019 (Pa. Super 1996), the Pennsylvania Superior Court held that a commercial landlord had no duty to mitigate damages upon a tenant’s breach of a shopping center lease. The Stonehedge court acknowledged in its opinion that there have been several lower court decisions imposing a duty to mitigate, however, provided that “regarding this anomaly” an issue as complex as the duty to mitigate damages in a commercial lease setting is not desirable for lower courts to anticipate, and absent a contrary decision from the Pennsylvania Supreme Court, a landlord has no duty to mitigate damages. Here, because the lease contained a provision requiring mitigation of damages, presumably the court’s calculation of damages would not change.

‘Benefit of the Bargain’

In the case at hand, the court determined that the proper approach to establishing damages is first to calculate the “benefit of the bargain” as of the date of filing, under § 502(b)(1), and then determine the “actual damages” based on Pennsylvania law by reducing damages by the amount mitigated. As of the date of Phar-Mor’s rejection, 71 monthly payments remained on the lease, the present value of which was $2,580,642.60. The Circuit Court calculated damages to be $1,454,780.90, the difference between the present value of the Phar-Mor lease at the time of the bankruptcy and the amounts received by Giant Eagle through mitigation.

The Bankruptcy Court had predicted that four “dire consequences” would result if it allowed Giant Eagle to collect damages from Phar-Mor following Snyder’s breach, each of which the Circuit Court dismissed in its opinion. The Bankruptcy Court proposed that allowing the subsequent breach of a mitigating lease to “revive” a debtor’s obligations under its original lease would:

  1. force the breaching lessee to “wait anxiously” for the duration of its rejected lease term to see if it would owe damages at some unknown time in the future;
  2. force the lessor to sue the original breaching lessee, even after mitigating, in order to protect itself from the possibility of a failed mitigating lease and the expiration of the statute of limitations;
  3. render the breaching lessee a guarantor of the subsequent mitigating lessee; and
  4. put the lessor in a better position than it would have been under the original lease, by allowing it to recover from both the original breaching lessee and subsequent breaching lessee.

The Circuit Court’s Decision

The Circuit Court reviewed and dismissed each of the foregoing proposals, first noting “notwithstanding the fact that this ‘revival’ perspective is entirely backwards — and requires the assumption, without basis, that the original lessee’s obligations were terminated or extinguished, none of these proposed calamitous consequences is even legitimate, let alone persuasive.” First, the Bankruptcy Court’s proposal that such a holding would force a breaching lessee to “wait anxiously” to see if it owed damages at some point in the future would be an argument for shortening the statute of limitations, and thus an issue for the legislature, not for the court. Second, the Bankruptcy Court’s argument that granting a lessor’s claim under these circumstances would force the lessor to sue the original breaching lessee to protect itself from the expiration of the statute of limitations would again be an argument for the legislature, not the court.

Third, the Circuit Court stated that the Bankruptcy Court’s argument that granting the lessor’s claim would render the original breaching lessee a guarantor of the subsequent mitigating lessee was “just incorrect’ because once Phar-Mor rejected the lease, it became liable for the damages resulting from the breach. Giant Eagle’s attempt to mitigate did not render Phar-Mor any less liable, it simply reduced the amount of damages Phar-Mor would have to pay. Fourth, the Circuit Court disagreed that granting Giant Eagle’s claim would put Giant Eagle in a better position than it would have been under the original lease, because a lessor cannot recover any more than the amount of its damages, regardless of how many parties it seeks recovery from. Finally, the Circuit Court responded to several of Phar-Mor’s arguments, particularly its contention that Giant Eagle should “suffer the consequences of [its] mitigation efforts with Snyder.” The Circuit Court answered, “Let us be very clear: there is no proposition in law or in equity that an injured party who attempts to mitigate the damage that results from another party’s misconduct must ‘suffer the consequences’ of its attempting to mitigate.”

It should be noted that the application of this decision may be limited by its unique facts. In many instances, the original bankruptcy case will be long over before a lessor may see a subsequent lessee default. This decision also poses some practical problems in a fast-track case, demonstrated by the following scenario: The lessor files a claim for anticipated damages and then enters into a new lease. The debtor or liquidating trustee thereafter objects to the lessor's original claim on mitigation grounds and the court allows the claim at an estimated reduced amount based on the mitigation expectancy. Distributions are made under a liquidating trust and thereafter the subsequent lessee defaults. At this point in time, there is a burden on the lessor to seek to have its claim reconsidered and there is a risk of substantial prejudice to the liquidating trust because funds already have been distributed. While the lessor may seek to rely on this decision, the courts may limit its applicability to a situation where no prejudice can be shown to the estate.

Importantly though, the Circuit Court’s decision in this case also demonstrates the requirement of filing a proof of claim in an original lessor’s bankruptcy case upon breach, because a lessee’s obligation to a lessor continues for the duration of the lease term. As the Circuit Court noted, the Bankruptcy Court’s notion that the second breach “revived” the original lessee’s obligation under the lease was inaccurate, because a subsequent contract would not relieve the original lessee of its obligations absent a novation. No evidence was presented to demonstrate that the new lease here was intended to discharge all existing obligations. Thus, it seems that this case would encourage lessees to assist in finding a strong substitute lessee, to avoid or at least minimize any resulting liability for damages in the future.

Reprinted with permission from the September 2008 edition of the ALM© 2008 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.