Courts generally agree that if an obligation arises during the option period, the debtor is required to pay it in full in a “timely” manner, but if the obligation is deemed to arise pre-petition or post-rejection,¹ it is treated as a general unsecured claim. Whether a given claim arises during the option period is therefore critical to whether the landlord will be paid in full or left struggling for a small portion of its original claim with other unsecured creditors. This article addresses the narrow question of when courts deem various lease obligations to arise under Code §365(d)(3).

What Constitutes an Option Period Obligation?
Most bankruptcy courts have adopted one of two approaches to determine what constitutes an option period obligation – the “billing date” and the “accrual” approaches. Under the “billing date” approach, the debtor is responsible for post-petition payment of all lease obligations that are billed post-petition, as provided by the express terms of the lease, regardless of the time period to which the obligation actually relates. The “accrual” approach, in contrast, makes the debtor responsible for obligations that accrue post-petition, regardless of when the debtor is obligated to pay for them under the terms of the lease.²

Billing-date Approach
Under the billing-date approach, landlords do not receive post-petition payment of “stub rent” – basic rent covering the period from the petition date through the end of the petition month – because the billing date was pre-petition. Thus, if the rent is due on the first of the month, a debtor that elects to file on the second of the month may eliminate a full month’s rent obligations as a post-petition or administrative expense. See, e.g., In re CCI Wireless, LLC, 279 B.R. 590 (Bankr. D. Colo. 2002); In re ½ Off Card Shop, Inc., No. 00-48425-WS, 2001 WL 1822419 at *3 (Bankr. E.D. Mich. Mar. 7, 2001) (§365(d)(3) does not say obligations “existing as of” the order for relief).

Landlords in billing-date jurisdictions may, however, get a benefit upon lease rejection because the debtor must pay full rent for the rejection month, regardless of what day of the month the lease is actually rejected. The Sixth and Seventh Circuits have each considered cases where the debtor rejected the lease on the second day of the month. The landlords sought rent for the entire rejection month, while the debtor argued that it should only be required to pay rent for the first two days. Persuaded in part by the fact that the debtor controls the day on which a lease is rejected, the courts both held that §365(d)(3) required the debtor to pay the full month’s rent, even though it covered a period of time after the lease was rejected. In re Ha-Lo Indus., Inc., 342 F.3d 794 (7th Cir. 2003); In re Koenig Sporting Goods, 203 F.2d 986 (6th Cir. 2000).

Delaware courts apply the billing-date approach, but permit stub rent to be recovered as an administrative claim for actual benefit to the estate under Code § 503(b)(1) rather than an obligation under Code §365(d)(3). In re ZB Co., Inc., 302 B.R. 316 (Bankr. D. Del. 2003) (Rosenthal, J.); In re HQ Global Holdings, Inc., et al., 282 B.R. 169, 174 (Bankr. D. Del. 2002) (Walrath, J.); cf., In re Valley Media, Inc., 290 B.R. 73 (Bankr. D. Del. 2003) (Walsh, J.)(taxes). This compromise view has also been employed in other billing date courts to ameliorate the landlord’s burden of the debtor’s post-petition occupation of the leasehold. See In re UAL Corp., 291 B.R. 121 (Bankr. N.D. Ill. 2003).

The billing approach requires debtors to pay taxes that are billed under the lease during the option period, regardless of the time period covered by the actual tax. See, e.g., In re Montgomery Ward Holding Corp., 268 F.3d 205, 209 (3rd Cir. 2001) (proration not expressly provided for in the lease is prohibited); In re Krystal Co., 194 B.R. 161, 162 (Bankr. E.D. Tenn. 1996). Because real estate taxes are usually paid in arrears, the debtor is held responsible for payment of any taxes that are billed to it post-petition pursuant to the terms of the lease, even if the taxes themselves relate to a period long prior to the petition date.

The billing-date approach has been applied to a variety of other charges assessed under commercial leases. See, e.g., Urban Retail Properties v. Loews Cineplex Entertainment Corp., No. 01 Civ. 8946(RWS), 2002 WL 535479 at *6-7 (S.D.N.Y. Apr. 9, 2002) (pre-petition construction charges that came due under the lease during the option period, as well as attorneys’ fees and interest); In re DeCicco of Montvale, Inc., 239 B.R. 475 (Bankr. D. N.J. 1999) (taxes and common-area maintenance).

Billing-date courts defend this approach as arising from a literal interpretation of §365(d)(3). However, the billing-date method has been criticized as unfairly permitting the debtor to manipulate the Code at the landlords’ expense (contrary to Congress’s intent) because the debtor controls both the petition and rejection dates, and as providing a windfall to landlords for their pre-petition tax claims. See Montgomery Ward, 268 F.3d at 213 (Mansman, J., dissenting); In re McCrory Corp., 210 B.R. 934, 940 (S.D.N.Y. 1997).

Accrual Approach
Under the accrual approach, landlords receive pro rata monthly rent for the entire option period. In these jurisdictions, the date that the debtor actually files or rejects the lease is irrelevant, as the debtor will only be required to pay rent and taxes in full for actual post-petition usage. See In re Cukierman, 265 F.3d 846 (9th Cir. 2001) (all obligations under the terms of the lease, including charges unrelated to use of the premises); In re Handy Andy Home Improvement Centers, Inc., 144 F.3d 1125 (7th Cir. 1998) (taxes); In re Pacific-Atlantic Trading Co., 27 F.3d 401 (9th Cir. 1994) (rent); In re Travel 2000, 264 B.R. 444, 448-49 (Bankr. W.D. Mich. 2001)(construing Koenig narrowly to its facts to exclude application to stub rent); In re Best Prods. Co., 206 B.R. 404 (Bankr. E.D. Va. 1997); McCrory, 210 B.R. at 939-40 (taxes).

The accrual approach is cited as being consistent with case law established prior to the enactment of §365(d)(3) by compensating landlords for the time that they have to do business with the debtor post-petition, regardless of the billing date. Handy Andy, 144 F.3d at 1127-29 (referring to practice under Code §503(b)(1)). Opponents suggest that the accrual method eviscerates the terms of the lease, particularly as to the payment of real estate taxes, by disregarding the parties’ arms’ length negotiations as to when such payments will be due.

Breakpoint Approach for Percentage Rent
For leases with percentage rent clauses requiring payment of additional rent (e.g., 2 percent of the debtor’s gross annual sales in excess of $1.2 million), courts may treat the debtor’s option period obligations for percentage rent in the same manner as base rent or taxes, consistent with the billing date or accrual approach. Recognizing that percentage rent does not accrue at a steady rate over the lease term, some courts employ a third “breakpoint” approach to such charges. The breakpoint is the date on which the debtor achieves sales sufficient to trigger the percentage rent obligation. Under this approach, if the breakpoint occurs after the petition date, the debtor must pay all of the percentage rent in full because it is all deemed to have accrued post-petition. If the breakpoint is reached pre-petition, the debtor need only pay percentage rent that actually arose from post-petition sales as an option period obligation. See In re Kmart Corp., 286 B.R. 345 (Bankr. N.D. Ill. 2002); In re Petrie Retail, Inc., 233 B.R. 256 (S.D.N.Y. 1999); In re Revco D.S., Inc., 111 B.R. 626 (Bankr. N.D. Ohio 1989).

Conclusion
The treatment of lease charges under Code §365(d)(3) continues to be litigated actively across the country. Depending on the charge at issue, some courts have adopted differing approaches to whether lease obligations are entitled to post-petition payment. For example, in the Seventh Circuit, rent is paid according to the billing date method, but real estate taxes are paid using an accrual methodology. Compare Ha-Lo Indus., 342 F.3d at 794 (rent paid by billing date) with Handy Andy, 144 F.3d at 1125 (taxes prorated). Landlords should consult with local bankruptcy counsel in the jurisdiction where their debtor’s case is pending for updates on the approach adopted both in that jurisdiction and by the specific judge who is handling the case. In most cases, experienced bankruptcy counsel may make a difference as to what payments the landlord will receive and when.

* Ms. Treger is a partner in the Creditors Rights and Bankruptcy practice group of Gardner Carton & Douglas LLP.