The Leather Factory Inc

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UNITED STATES BANKRUPTCY COURT
CENTRAL DISTRICT OF CALIFORNIA
SAN FERNANDO VALLEY DIVISION
In re:
The Leather Factory Inc
Debtor(s).
Case No.: 1:05-bk-18708-GM
Chapter 7
MEMORANDUM OF OPINION
DENYING MOTION TO DISALLOW CLAIM
NUMBER 211-1 OF VARLOW
ENTERPRISES AND CLAIM NUMBER
60 OF CREDITOR HARRY ROSS
INDUSTRIES AND DENYING SANCTIONS
Date: June 19, 2012
Time: 10:00 a.m.
Courtroom: 303
On October 12, 2005, the Leather Factory filed its chapter 11 petition. At the
time that it filed, the Leather Factory was a vertically integrated company that
manufactured and sold custom leather furniture built in its Montebello, California factory
and sold in its twelve retail stores located throughout California. The schedules showed
$22,000+ in secured claims, $269,000+ in unsecured priority claims, and $4.6+ million
in unsecured claims (of which about $2 million was owed to non-insiders). The assets
(all personal property) were valued at $2.3 million.
A creditors’ committee was appointed and the debtor was immediately subject to
a series of motions for relief from stay by the landlords. It rejected some leases as early
as December 2005 and continued to operate as a debtor-in-possession until its case
was converted to chapter 7 on March 9, 2007. David Seror was appointed as the
trustee and he continued to oversee a series of avoidance power actions as well as
carry out the other duties required of the trustee.
FILED & ENTERED
JUL 09 2012
CLERK U.S. BANKRUPTCY COURT
Central District of California
BY DEPUTY CLERK	gasparia
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As of February 2012, the trustee had $236,000 in cash. He anticipated that the
chapter 7 costs of administration would be about $74,000. After reviewing the
administrative claims, he determined that the case was administratively insolvent and
that the chapter 11 administrative claimants would be paid only about 13.5% of their
claims. The trustee accordingly sought disgorgement from chapter 11 professionals
who had previously received interim payments in excess of 13.5% of their allowed
administrative claims. One of the firms from which disgorgement is sought is the
Friedman Law Group, P.C. (“Friedman”), chapter 11 counsel to the debtor.
The trustee concluded that, other than some duplicates, the chapter 11
administrative claims appeared to be legitimate and that he would not be filing
objections. However, the trustee did not oppose Friedman filing objections to claims,
since Friedman is an interested party who is trying to reduce the amount of the required
disgorgement.
In January 2012, Friedman filed a series of objections to the chapter 11
administrative claims of the former landlords, on a variety of grounds. All except two of
these objections have been resolved, and the facts of these two remaining claims –
those of Harry Ross Industries (“HRI”) and Andrew Varlow dba Varlow Enterprise
(“Varlow”) – are substantially similar. These last two objections focus on whether rent
for the period immediately after the petition date until the first post-petition lease
payment came due (“stub rent”) is a pre-petition unsecured claim or an administrative
claim, whether the security deposit must be applied toward the landlord’s unsecured
claim or its administrative one, and whether the landlord is entitled to its attorneys’ fees
and the amount of those fees. The landlords have responded to Friedman’s objections
and also sought sanctions.
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.
STUB RENT
The bankruptcy was filed on October 12, 2005 and the next rent payment under
the leases was due on or after November 1, 2005. Neither HRI nor Varlow had been
paid the October rent prior to bankruptcy. The issue is whether the unpaid rent for the
post-petition portion of October 2005 is a pre-petition obligation or whether it is entitled
to an administrative priority. Bankruptcy Code §365(d)(3) requires the trustee to
perform all lease obligations “arising” post-petition and grants such obligations
administrative claim status, but there is a split between Circuit Courts of Appeals over
whether leasehold obligations “arise” under §365(d)(3) when they are due (in this case
on October 1, making them pre-petition) or when they accrue (in this case, over the
month of October, making rent from October 12-31 post-petition and entitled to
administrative status).
This split between circuit courts is over a single sentence in 11 U.S.C.
§365(d)(3), which states that the "trustee shall timely perform all the obligations of the
debtor, except those specified in §365(b)(2), arising from and after the order for relief
under any unexpired lease of nonresidential real property, until such lease is assumed
or rejected." 1 Prior to the amendment of the Bankruptcy Code adding this section,
although landlords were entitled to post-petition rent, etc. as an administrative expense,
the burden was on the landlord to seek collection rather than on the debtor to make the
payments. Payments could be delayed at the discretion of the bankruptcy judge and
could be less than the contract amount. While it is universally agreed that §365(d)(3)
was intended to alleviate the landlord’s burden and risk regarding post-petition lease
1 All statutory citations are to 11 United States Code, unless otherwise noted.
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payments by shifting it to the trustee or debtor-in-possession,2 the Third and Seventh
Circuits (and a number of lower courts) have disagreed on the standard for whether a
lease obligation “arises” post petition. This split follows an ongoing debate as to
whether the language of §365(d)(3) is ambiguous or not.
A number of courts, led by the Third Circuit, have found the language of
§365(d)(3) to be unambiguous and to compel the result that obligations must be paid at
the time they are due under the lease. Concluding that the obligation "arises under a
lease for the purposes of §365(d)(3) when the legally enforceable duty to perform arises
under the lease," the Third Circuit reluctantly adopted the billing approach rather than
the pre-Code proration approach. Centerpoint Props. v. Montgomery Ward Holding
Corp. (In re Montgomery Ward Holding Corp.), 268 F.3d 205, 211 (3d Cir. 2001); see
also, e.g., Burival v. Creditor Comm. (In re Burival), 406 B.R. 548, 553 (B.A.P. 8th Cir.
2009)(rent); In re Krystal Co., 194 B.R. 161, 163-64 (Bankr. E.D. Tenn. 1996)(property
tax obligations).
On the other hand, those courts who find §365(d)(3) to be ambiguous look to the
issues of equity and of bankruptcy policy and generally apply the “accrual” method to
the question of when rent and tax obligations arise post-petition. See, e.g., Heathcon
Holdings v. Dunn Indus. (In re Dunn Indus.), 320 B.R. 86, 89-90 (Bankr. D. Md. 2005);
(property tax obligations); In re Travel 2000, Inc., 264 B.R. 444 (Bankr. W.D. Mich.
2001)(rent). In the context of a tax obligation that had already accrued but which the
debtor was not obligated to pay to the landlord until it was actually billed, the Seventh
Circuit held that the
2 For ease, the term “trustee” is used throughout this opinion even though duties of a trustee are placed on a debtor-
in-possession. § 1107(a).
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'billing date' approach is a possible reading of section 365(d)(3), but it is neither
inevitable nor sensible. It is true that Handy Andy's obligation to National to pay
(or reimburse National for paying) the real estate taxes did not crystallize until the
rental due date after the taxes were paid. But since death and taxes are
inevitable and Handy Andy's obligation under the lease to pay the taxes was
clear, that obligation could realistically be said to have arisen piecemeal every
day of 1994 and to have become fixed irrevocably when, the last day of the year
having come and gone, the lease was still in force. . . .
. . . .
. . . Handy Andy’s debt to National for 1994 and earlier 1995 taxes relates
entirely to an earlier period, and is thus no different from its debts to trade
creditors for supplies that it bought in 1994 but never paid for. . . .
In re Handy Andy Home Improvement Ctrs., 144 F.3d 1125, 1127 (7th Cir. 1998). The
court found the accrual approach more sensible than the billing date approach because
it tracks the purpose of the Bankruptcy Code by giving post-petition creditors a high
priority so as to keep the debtor operating for as long as possible. Id.
Timing is crucial and increases the complexity of this interpretation issue. In
Handy Andy the estate was benefitted under the accrual method because it classified
the landlord's claim for taxes as pre-petition, even though it was contractually billed to
the debtor post-petition. The facts of this case would work in an exactly opposite
manner: the estate would benefit under the billing date method since the entire October
rent payment would be classified as pre-petition.
At the back-end of the §365(d)(3) period, Courts of Appeals have used a more
uniform approach: they have denied the trustee’s request to prorate rent that comes
due immediately before the rejection, but actually covers a period beyond the rejection.
The courts find no ambiguity in the language of §365(d)(3) on this point. Although this
rule provides a windfall to the landlord at the expense of other creditors, the statute is
clear and the control of the date of rejection is in the hands of the trustee, not of the
landlord. For example, in HA-LO Industries v. CenterPoint Properties Trust, 342 F.3d
794 (7th Cir. 2003), the rent was due on November 1 and the rejection took place on
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November 2. The Seventh Circuit required the debtor to pay its November rent in full
and distinguished its Handy Andy opinion by limiting Handy Andy to non-rent "sunk
costs" that relate to a time before the bankruptcy case, as opposed to rent arising wholly
post-petition, which is the consumption of a resource during the administration of the
case.
The Sixth Circuit reached the same result on similar facts in Koenig Sporting
Goods, Inc. v. Morse Road Co. (In re Koenig Sporting Goods, Inc), 203 F.3d 986 (6th
Cir. 2000)(rejection on second day of month, rent due on first). Citing legislative history,
the court noted that the purpose of §365(d) was to "'to relieve the burden placed on
nonresidential real property landlords (or 'landlords') during the period between a
tenant's bankruptcy petition and assumption or rejection of a lease.'" Id. at 989. The
Koenig court found that the debtor or trustee was in control of the landlord's right to
payment of the December rent since it could have rejected the lease two days earlier
and would not have been obligated to pay for December. Thus equity as well as the
statute favored the landlord.
Because the courts are split on the issue of stub rent, I specifically asked for
Ninth Circuit authority, which Friedman failed to provide. The only case in the Ninth
Circuit that Friedman cites, In re Designer Doors, Inc., 389 B.R. 832 (Bankr. Ariz. 2008),
does not deal specifically with stub-rent. Designer Doors notes that there is not yet a
preferred approach in the Ninth Circuit for determining which lease obligations should
be treated as administrative priorities, but gives a well-reasoned analysis on why the
court should only give administrative priority status to payments or performance due
after the petition is filed.
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The only Ninth Circuit appellate opinion anywhere near on point is TreeSource
Indus. v. Midway Engineered Wood Prods. (In re TreeSource Indus.), 363 F.3d 994 (9th
Cir. 2004), which discusses a situation where the obligation did not arise until the lease
was terminated. However the court noted that for tax and rent obligations "the relevant
time to determine whether the obligation is pre- or post-petition is when the obligations
accrue and not necessarily when performance must take place. . . ." Id. at 998.
Although this statement is dicta (and thus ignored by Designer Doors), I believe that it
must be considered in issues of back-end obligations at the end of the lease or on
rejection, though not necessarily in dealing with stub rent.
In re Picturesque, L.L.C., 2006 Bankr. LEXIS 3689 (Bankr. D. Ariz. Dec. 22,
2006), never mentions TreeSource, which preceded it by two years, but notes the circuit
split between the Seventh Circuit and the Third Circuit and follows the slight majority of
cases that accept the proration (as opposed to the billing) theory for stub rent.
While I agree that there is little or no ambiguity in §365(d)(2) on the rejection end
of the lease and that, as a matter of equity, the date of rejection is solely in the hands of
the debtor and the debtor should have realized the implications of the date chosen, I do
not think the language of §365(d)(3) or the equities are so clear on stub rent at the front
end. Accordingly, it is appropriate to look to the legislative intent. Congress intended to
shift the burden from the landlords for the debtor's use of their property. To allow "stub
rent" to be considered as a pre-petition unsecured claim gives a windfall to the debtor
and its administrative creditors at the expense of the landlord, who has no ability at that
time to evict because of the automatic stay. I find that the rent for the days after the
filing of the petition until the next lease payment is due are an administrative claim
under §365(d)(3) in a prorated amount of a full monthly lease payment, in accord with
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TreeSource and that slight majority of courts following the accrual rule. To rule
otherwise would reward the estate to the detriment of the landlord, which was not the
intent of Congress.
Landlords also argue that the use of the premises during the "stub" period would
be an administrative claim under §503(b), even if §365(d)(3) does not clearly make it so
(since §365(d)(3) only deals with the requirement of the trustee to act and does not
categorize the claim). In re Sportsman's Warehouse, Inc., 436 B.R. 308 (Bankr. D. Del.
2009); see also In re Goody's Family Clothing Inc., 610 F.3d 812 (3d Cir. 2010) (“We
hold that §365(d)(3) does not supplant § 503(b) and the Landlords are entitled to "stub
rent" as an administrative expense.”). While this is a very sensible argument, it flies in
the face of Cukierman v. Uecker (In re Cukierman), 265 F.3d 846 (9th Cir. 2001)(citing
Towers v. Chickering & Gregory (In re Pacific-Atlantic Trading Co,), 27 F.3d 401 (9th
Cir. 1994)):
We have held that claims arising under §365(d)(3) are entitled to administrative
priority even when they may exceed the reasonable value of the debtor's actual
use of the property. See Pacific-Atlantic, 27 F.3d at 405. We did so because the
"notwithstanding section 503(b)(1)" proviso exempts the amount of lease
obligations that a trustee must timely pay under §365(d)(3) from §503(b)(1)'s
limitation of administrative expenses to the fair value of the debtor's use of the
property. Id. When the trustee fails to pay an obligation, the amount accorded
administrative priority is similarly not subject to the §503(b)(1) limitation. Id. We
reasoned that to hold otherwise would reward trustees for failing to perform lease
obligations, a result entirely at odds with §365(d)(3)'s purpose of ensuring prompt
payment for landlords. Id.
Cukierman, 265 F.3d at 850. Even though post-petition lease claims seem to fall under
the definition of an administrative claim in §503(b), these claims are granted priority
under §365(d)(3) and it is questionable whether a post-petition use of the premises can
qualify under §503(b) if it is disqualified under §365(d)(3). But since I find that the
landlords are entitled to their stub rent as an administrative priority under §365(d)(3), I
need not analyze the §503(b) issue at this time.
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SECURITY DEPOSIT
Friedman argues that HRI’s security deposit should be applied against HRI’s
administrative claim for post-petition rent, rather than the unsecured claims for pre-
petition arrearages and lease rejection pursuant to Bankruptcy Code §502(b)(6).
(Varlow had applied its security deposit prior to the petition date and thus the issue is
moot since it already reduced the pre-petition claim and the security deposit never
became property of the estate.) HRI does not dispute that the security deposit can
reduce the amount of its claims, but argues that it is the pre-petition arrearages or
rejection claims that are affected, not the administrative claim.
The application of the security deposit is governed by the terms of the lease.
The applicable provision, paragraph 5 of the HRI lease, provides that the security
deposit may be applied by the landlord if the lessee fails to pay rent, or otherwise
defaults under the lease.3 There is no requirement that it be applied at all, although at
the termination or expiration of the lease it must be either applied or returned to the
lessee. The security deposit is not in trust and is property of the estate, but is clearly
meant to be used to protect the landlord against a default.
Without the bankruptcy, there would be no issue since there would be a single
claim for default under the lease. But the bankruptcy actually creates three separate
categories of claims (a general unsecured claim for pre-petition arrearages, a general
unsecured claim for rejection damages under §502(b)(6), and an administrative claim
for post-petition damages). The lease does not deal with how to apply the security
deposit in case of a bankruptcy filing by the tenant. Without direction from the lease,
the Court considers applicable law.
3 Legible copies of this portion of the lease has been filed as Exhibit 1 to Amended Claim #60-2 (HRI).
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Section 502(b)(6) Cases
Most cases decided under Bankruptcy Code §502(b)(6) are not directly relevant
to the question at hand. A number of cases have applied security deposits to reduce
§502(b)(6) rejection damages, but they start from the premise that the security deposit
will be applied against rejection damages. The issue in those cases is whether the
deposit should be applied against the rejection claim (i) prior to limiting the claim under
the §502(b)(6) cap or (ii) after the rejection claim is capped, having the effect of
reducing the statutory rejection claim. They have not explicitly considered the rights of
the landlord to apply the deposit to the rejection damages claim (or other pre-petition
claims) as opposed to applying it to an administrative claim for post-petition rent.
Oldden v. Toronto, 143 F.2d 916 (2d Cir. 1944), a pre-Code case, is the model
for the post-Code holdings. It considers whether a security deposit should be deducted
from the total claim or from the “allowable” claim for damages due to the post-petition
rejection of the lease (calculated under then 11 U.S.C. §63, sub. A(9), which limits the
claim for future rents). Oldden holds that the landlord must apply the security deposit to
the “allowable claim” as capped by §63, as it would be unfair to give the landlord the
large rejection claim without taking into consideration and applying the security deposit
to it.
Legislative history indicates that Congress intended to uphold Oldden when it
enacted §502(b)(6). The House and Senate Reports read in relevant part:
The history of this provision is set out at length in Oldden v. Tonto Realty Co. . . .
It is 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. The damages a landlord
may assert from termination of a lease are limited to the rent reserved for the
greater of one year or ten percent of the remaining lease term, not to exceed
three years . . . . This subsection does not apply to limit administrative expense
claims for use of the leased premises to which the landlord is otherwise entitled.
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This paragraph will not overrule Oldden, or the proposition for which it has
been read to stand: To the extent that a landlord has a security deposit in excess
of his claim allowed under this paragraph, the excess comes into the estate. . . .
As under Oldden, he will not be permitted to offset his actual damages against
his security deposit and then claim for the balance under this paragraph. Rather,
his security deposit will be applied in satisfaction of the claim that is allowed
under this paragraph.
H. Rep. No. 95-595, 95th Cong., 1st Sess. 353-54 (1977); S. Rep. No. 95-989, 95th
Cong., 2d Sess. 63-64 (1978).
Post-Code cases have generally followed Oldden: when applying security
deposits to rejection damages claims, they have done so after the §502(b)(6) cap has
been applied, essentially reducing the amount of statutory damages under §502(b)(6).
See, e.g., AMB Prop. v. Official Creditors Committee of AB Liquidating Corp. (In re AB
Liquidating Corp.), 416 F.3d 961 (9th Cir. 2005); In re All for a Dollar, 191 B.R. 262, 264
(Bankr. D. Mass. 1996)(quoting legislative history at length); Redback Networks, Inc. v.
Mayan Networks Corp. (In re Mayan Networks Corp.), 306 B.R. 295 (9th Cir. BAP 2004)
(deducting not only cash security deposits but also draws on letters of credit against the
statutory rejection claim, so long as the letter of credit draw had the effect of reducing
estate assets). In Mayan, although the landlord had filed an administrative priority claim
for over $50,000, neither the parties nor the court dealt with the possibility that the
security deposit should be credited toward that portion of the claim.
The second paragraph of the legislative history quoted above arguably extends
the meaning of Oldden beyond both its original holding and the holdings of this line of
cases: not only how security deposits should be applied against §502(b)(6) rejection
claim, but also that security deposits should be applied against §502(b)(6) rejection
claims.
Section 365(d)(3) Cases
Several cases under Bankruptcy Code §365(d)(3) offer more guidance and
explicitly consider whether a security deposit should be applied against administrative
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claims for post-petition rent under §365(d)(3) or against pre-petition claims (whether
pre-petition arrearages or rejection claims). These cases have uniformly held that the
security deposits should be applied against the general unsecured claims (whether for
pre-petition arrearages or statutory rejection damages).
In re PYXSYS Corp., 288 B.R. 309 (Bankr. D. Mass. 2003) deals with a trustee
who wished to setoff the security deposit against both an administrative claim for post-
petition rent under §365(d)(3) and use and occupancy charges under §503(b). After
determining the amount of the administrative claim, the court held that it was clearly
Congress’s intent that the security deposit be applied to the pre-petition arrearages and
lease rejection damages and not to post-petition claims. Id. at 319. The PYXSYS court
read the second paragraph of §502(b)(6)’s legislative history quoted above as authority
not only for applying the security deposit against the capped amount of the rejection
claim, but also for applying the security deposit against the §502(b)(6) rejection
damages in the first place (and not against administrative claims). Id. at 319. See also
In re All for a Dollar, 191 B.R. at 264 (“[T]he legislative history of §502(b)(6) signals
Congress' intention not to reduce the statutory cap by postpetition rentals and not to
categorize security deposits and postpetition rentals together.”).
In re Far West Corp., 120 B.R. 551 (Bankr. E.D. Cal. 1990) was similar to this
case before the Court because the landlord was seeking post-petition rents, interest and
attorneys’ fees as an administrative claim and it concerned the proper application of a
security deposit paid to the landlord at the initiation of the lease over ten years before
the bankruptcy. In that case the parties agreed that generally a security deposit could
not be applied against a post-petition administrative rent claim, but should be applied
against any pre-petition, unsecured claim of the landlord. But the debtor argued that the
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deposit was really payment of the last two months of rent under the lease and thus
should be offset against the landlord’s post-petition claims. The court reviewed the
lease and determined that the security deposit was to be applied to the last two lease
payments only if the debtor was not in default under the lease. Since there were
substantial pre-petition defaults, the option to use the security deposit for the last two
lease payments had lapsed and so it was to be applied to the outstanding pre-petition
rent payments. Id. at 553.
Finally, Pereira v. Rich Taubman Assocs. (In re KP Fashion Co.), 2011 U.S. Dist.
LEXIS 96466 (S.D.N.Y. Aug. 26, 2011) concerned a security deposit in the form of a
standby letter of credit. It is factually confusing since it seems that the landlord drew on
the letter of credit (possibly prior to the bankruptcy) and applied it to its pre-petition debt.
The trustee apparently sought to recharacterize this draw so that it would be applied to
the administrative claim. The court, citing to PYXSYS and Far West, held that it was
proper for the landlord to apply this letter of credit draw/security deposit to the pre-
petition claim, rather than the administrative claim.
Setoff Cases
A different line of cases has analyzed the rights of debtors to setoff security
deposits against landlords’ administrative claims. These cases have concluded that the
pre-petition security deposits and post-petition administrative claims lack mutuality of
obligation and cannot be set off. They generally assume or conclude that the security
deposit can be set off against pre-petition arrearage claims and rejection damages,
consistent with Colliers. 5 Collier on Bankruptcy ¶ 553.03 [3][c][iii] (“[A] landlord may
offset a security deposit against a claim for pre-petition rent . . . .”).
In re Genuity Inc., 323 B.R. 79 (Bankr. S.D.N.Y. 2005) involved security deposits
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under a variety of telecommunications contracts. As the court succinctly stated: “At
issue is whether the Debtors are entitled to use the Pre-Petition Deposits to offset their
post-petition cure obligations. In a word, the answer is no.” Id. at 83. The court noted
that the debtor and debtor in possession are separate and distinct entities, so that there
is no mutuality of obligation between the pre-petition security deposits and the post-
petition cure obligations. The court also felt it would be unfair for the debtor to apply the
deposits to the cure obligations rather than the arrearages; the purpose of the deposits
was to safeguard parties contracting with the debtor against the effect of just such
defaults. The court clearly intended that its decision would enable the
telecommunications providers to apply the deposits against debtors’ pre-petition
arrearages.
In In re Telligenix Corp., 436 B.R. 211 (Bankr. M.D. Fla. 2010) the court denied
the debtor’s motion to apply its post-petition rent obligations under a commercial real
estate lease against the security deposit. The court stated that, as both the security
deposit and the rejection damages are pre-petition claims, “bankruptcy courts routinely
allow a landlord to offset rejection damages claims against security deposit funds.” Id.
at 213. The court “stop[ped] short of holding that post-petition administrative priority
claims can never be set off against pre-petition debts owed to the debtor.” Id. at 215
(emphasis in the original). But the court did not find any of the “narrow circumstances”
that might justify such a setoff in the instant case and allowed the landlord to setoff the
security deposit against the rejection damages.
The court in In re Go Fig, Inc., 2009 Bankr. LEXIS 533 (Bankr. E.D. Mo. Feb. 5,
2009) held that a Chapter 7 trustee could not use recoupment to apply the security
deposit against the landlord’s §365(d)(3) administrative claim. The court distinguished
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the pre-petition debtor and post-petition debtor as different legal entities, such that the
administrative claim and the security deposit arose out of different transactions. The
court also cited policy considerations: applying the deposit against administrative claims
would effectively strip the landlord of the higher priority treatment that enables debtors
to obtain post-petition services. Although recoupment was at issue, the very same
analysis could be applied to setoff.
Finally, in In re Aspen Data Graphics, 109 B.R. 677 (Bankr. E.D. Pa. 1990) in the
context of whether setoff was avoidable under Bankruptcy Code §547 and §553, the
court stated that “a landlord may setoff the amount of a security deposit under a lease
against a pre-petition claim for rent and damages owed to the landlord, as these are
mutual, pre-petition obligations.” Id. at 683 (emphasis in original).
Conclusion as to the Application of the Security Deposit
Precedent under both §365(d)(3) and §553 overwhelmingly holds that pre-
petition security deposits may be applied against pre-petition claims, whether
arrearages or rejection damages, rather than administrative claims. These holdings are
consistent with the legal principle of mutuality of obligation being required for setoff and
the legal distinction between pre-petition and post-petition obligations and legal entities.
They are also consistent with the purpose of §365(d)(3) and fundamental fairness. The
Bankruptcy Code protects the landlord by requiring the trustee to pay the landlord for
use of the premises post-petition until the lease is rejected. Allowing the trustee to use
the premises to benefit the estate and then pay for that use, not with the cash
contemplated by §365(d)(3) but with the security deposit designed to protect the
landlord against defaults, both strips the landlord of the protections of §365(d)(3) and
unfairly benefits the estate at the expense of the landlord. (This conclusion is also
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consistent with case law interpreting the legislative history of §502(b)(6) as requiring
application of security deposits to rejection claims.) Accordingly, this Court rules that
HRI’s security deposit should be applied against its pre-petition claims, both arrearage
and rejection damages, not its administrative claims.
HRI argues that even if the security deposit was applied to debtor’s obligations
under §365(d)(3), that draw down on the security deposit triggers debtor’s lease
obligation to refresh the security deposit, which would be an administrative claim under
the logic of Cukierman (that the debtor must fulfill all lease obligations under §365(d)(3)
and all such obligations become administrative claims). Hence, applying the security
deposit against HRI’s §365(d)(3) administrative claim, would simply create a new
administrative claim (to refresh the deposit) in the same amount. Because I am ruling in
favor of HRI by concluding that the deposit should be applied against HRI’s pre-petition
arrearages and rejection claim, I will not devote further attention to this argument.
ATTORNEY’S FEES
HRI is not claiming attorneys' fees as part of its administrative claim. In his
original response to the objection, Varlow asserted a request for attorneys’ fees for
defending this objection to his claim. Since then he has revised his request, limiting it to
the fees and costs incurred in defending the motion to reject the lease. Varlow is
entitled to attorneys’ fees from the date of the petition to the time of surrender, but not
after that. Cukierman makes it clear that under §365(d)(3), the court is to follow the
lease and not use the measure of reasonableness, etc. unless that is part of the lease.
Paragraph 31 of the Varlow lease does require that the fees be reasonable and that
they will be allowed to the prevailing party on any action to enforce the terms of the
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lease, whether such action or proceeding is pursued to judgment. The landlord is also
entitled to fees and costs incurred in preparing notices of default, whether or not a legal
action is taken.4
Varlow asserts that the amount actually incurred through to the defense of the
Motion to Reject the Lease was $1,225 for Mr. Goodman and $3,165.25 for Ms. Nelson.
No back-up documentation has been given.5 The docket reveals that Varlow filed a
limited opposition and objection to the motion to reject the lease, based on a lack of
notice and timing, and demanded a hearing.6 The content of that opposition shows that
there were multiple contacts and attempts to contact debtor and its counsel in the period
leading up to the rejection and that the lease was in pre-petition and post-petition
default. Replies to the opposition were filed and a short hearing was held on February
8, 2006. The court granted the motion to reject, but deemed this to be effective on
January 8, 2006 (rather than on December 1, 2005, as requested in the motion). Thus
Varlow was the prevailing party. Although there is no breakdown, the total fees and
costs requested appear to be reasonable for the amount of work that was done. And
these are entitled to an administrative priority. In re Multiple Allied Servs., 2010 Bankr.
LEXIS 3895 (Bankr. N.D. Cal. Oct. 15, 2010).
SANCTIONS
Although I am not happy about the failure of Friedman to just admit that there is
little or no authority for its statement that many courts in the Ninth Circuit use the billing
date approach, this is not a frivolous motion, but rather it deals with an unclear area of
law, as can be seen by my long analysis. Sanctions are denied.
4 A legible copy of this portion of the lease has been filed as doc. #406.
5 Doc. #385.
6 Doc. #46.
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CONCLUSION
HRI’s administrative claim is $70,558, its claim for pre-petition arrearages is
$115,174 and its rejection claim under 11 USC §502(b)(6) is $245,343. The security
deposit is $24,000 and is to be applied to the pre-petition arrearage claim, reducing it to
$91,174.
Varlow’s administrative claim is $45,236.85. This is calculated by apportioning
the month of January 2006 between an administrative claim (though January 8, 2006)
and a rejection claim for the balance of the month. As stated above, Varlow appears to
be entitled to an administrative claim for the rent for the full month of January 2006, but
that has not been requested.7 The Varlow unsecured claim of $98,108.64 is not
affected by this ruling.
###
7 Doc. #385.
United States Bankruptcy Judge
DATED: July 9, 2012
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NOTICE OF ENTERED ORDER AND SERVICE LIST
Notice is given by the court that a judgment or order entitled (specify): )_ MEMORANDUM OF
OPINION REGARDING DENYING MOTION TO DISALLOW CLAIM NUMBER 211-1
OF VARLOW ENTERPRISES AND CLAIM NUMBER 60 OF CREDITOR HARRY
ROSS INDUSTRIES AND DENYING SANCTIONS ______________________
was entered on the date indicated as AEntered@ on the first page of this judgment or order and will be
served in the manner stated below:
1. SERVED BY THE COURT VIA NOTICE OF ELECTRONIC FILING (NEF) B Pursuant to controlling
General Orders and LBRs, the foregoing document was served on the following persons by the court via
NEF and hyperlink to the judgment or order. As of (date)________________, the following persons are
currently on the Electronic Mail Notice List for this bankruptcy case or adversary proceeding to receive
NEF transmission at the email addresses stated below.
Gregory Abrams Email: jbothell@askfinancial.com
Jerome Friedman Email: jfriedman@jbflawfirm.com
David Seror Email: kpscion@ebg-law.com
Sheila Nelson Email: shedoesbklaw@aol.com
Michael Greger Email: mgreger@allenmatkins.com
Richard Dinets Email: rdinets@allenmatkins.com
Service information continued on attached page
2. SERVED BY THE COURT VIA UNITED STATES MAIL: A copy of this notice and a true copy of this
judgment or order was sent by United States mail, first class, postage prepaid, to the following persons
and/or entities at the addresses indicated below:
The Leather Factory Inc.
c/o Larry Katz
5776 Lindero Canyon Road
Westlake Village, CA 91362
Service information continued on attached page
3. TO BE SERVED BY THE LODGING PARTY: Within 72 hours after receipt of a copy of this judgment
or order which bears an AEntered@ stamp, the party lodging the judgment or order will serve a complete
copy bearing an AEntered@ stamp by United States mail, overnight mail, facsimile transmission or email
and file a proof of service of the entered order on the following persons and/or entities at the addresses,
facsimile transmission numbers, and/or email addresses stated below:
Service information continued on attached page
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