Contributed by Jessica Diab

Section 365 of the Bankruptcy Code has made several stand-out appearances on the Weil Bankruptcy Blog. Today, section 365 takes the stage again, as we discuss the recent decision in In re Mervyn’s Holdings, LLC, in which the United States Bankruptcy Court for the District of Delaware held that a claim arising from an indemnification provision, in a non-residential commercial lease, which was rejected post-petition, was entitled to administrative priority pursuant to section 365(d)(3) of the Bankruptcy Code. 
In January 2008, Mervyn’s LLC, a West Coast discount department store chain, executed a lease on a commercial property in San Bernardino, California owned by WM Inland Adjacent LLC.  Shortly after executing the lease, Mervyn’s realized that it could not open its doors to the residents of San Bernardino without sprucing up the rental property.  To that end, Mervyn’s entered into an agreement with a general contractor to improve and renovate the rental property.  Under both the lease and the construction agreement, Mervyn’s was required to indemnify WM Inland for various liabilities occurring prior to, during, and after the term of the lease.  In particular, both agreements required Mervyn’s to indemnify WM Inland for any liens filed against the rental property.
Despite significant improvements to the rental property, Mervyn’s never opened its doors to the public.  On July 29, 2008, Mervyn’s filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code attributing the precipitous decline in its profitability and liquidity to external economic factors.  Upon hearing the news of the Mervyn’s bankruptcy filing, the general contractor, who had only been partially paid for the building improvements, recorded two mechanics’ liens against the rental property for an approximate total of $5.5 million.  Subsequently, on October 8, 2008, the general contractor filed suit against WM Inland to foreclose on the two liens, and on November 21, 2008, Mervyn’s rejected the lease.  During the early months of 2009, WM Inland filed two claims in the Mervyn’s chapter 11 case comprising of: (1) a general unsecured claim for rejection damages and an administrative postpetition claim seeking indemnity for the pending litigation with the general contractor; and (2) a claim for mechanics’ liens, rent and property taxes and attorney’s fees.  WM Inland and the general contractor eventually entered into a settlement agreement with WM Inland paying the general contractor $1.7 million.  WM Inland then asserted an administrative expense for the amount of its settlement outlay.
The Dispute
WM Inland argued that its indemnification claim was an administrative expense pursuant to section 365(d)(3) of the Bankruptcy Code.  Section 365(d)(3) of the Bankruptcy Code deals with the “gap period” between the petition date and the date on which the court approves a debtor’s assumption or rejection of a non-residential real property lease.  Pursuant to section 365(d)(3), the trustee or the debtor in possession must continue to perform postpetition obligations under the unexpired lease, until such lease is either assumed or rejected.  Failing to do so, entitles the non-debtor party to a postpetition administrative claim.  This landlord friendly provision ameliorates the financial burden borne by commercial landlords pending the decision of the debtor to assume or reject a lease.
According to WM Inland, Mervyn’s obligation to indemnify WM Inland for the liens filed against the rental property arose either in September 2008, when the liens were recorded or in October 2008, when the general contractor sued WM Inland to foreclose on the mechanics’ liens.  In any event, WM Inland contended that the indemnification obligation arose postpetition and pre-rejection of the lease and therefore, entitled WM Inland to an administrative claim pursuant to section 365(d)(3) of the Bankruptcy Code.
Mervyn’s objected to the claim, arguing that the indemnification obligation was a general unsecured claim.  In support of this assertion, Mervyn’s stated that WM Inland’s indemnification obligation either arose from the rejection of the lease and therefore, pursuant to section 502(g) of the Bankruptcy Code, was to be treated as a prepetition unsecured claim, or in the alternative, was a prepetition unsecured claim because it arose from the execution of the lease and construction agreement and derived from the property improvements, all of which occurred prepetition.
The parties filed cross-motions for summary judgment.  The issue before the court was whether the claim for indemnification was an obligation that arose postpetition and prior to the rejection of the lease, entitling WM Inland to an administrative claim under section 365(d)(3) of the Bankruptcy Code, or whether the obligation arose prepetition, entitling WM Inland to a general unsecured claim.
The court held that Mervyn’s obligation to indemnify WM Inland arose from the filing of the mechanics’ liens against the premises and therefore, pursuant to section 365(d)(3), was a claim entitled to administrative status.
The court dismissed both of Mervyn’s theories as to when the “obligation” arose.  First, the court found that Mervyn’s assertion that the damages stemmed from the rejection of the lease, was simply incorrect.  The liability to indemnify WM Inland would have existed whether or not the lease was rejected because, pursuant to the terms of the lease, the obligation arose as soon as the general contractor filed the mechanics’ liens against the premises.  The court spent more time discussing Mervyn’s second theory, which alleged that because the conduct giving rise to the indemnification claim was the property improvements, an act which occurred prepetition, the indemnification claim was a general unsecured prepetition claim.  This rationale stemmed from a Third Circuit decision, where the court considered the point at which a claim ought to arise.  The Third Circuit held that a claim will arise when the conduct giving rise to the injury occurs rather than when the injury manifests.  Relying on the Third Circuit’s holding, Mervyn’s argued that the conduct giving rise to WM Inland’s injury (that is, the filing of the liens and the lawsuit) was the prepetition act of entering into the contract to have the rental property renovated and therefore, the indemnification claim arose prepetition.  In rejecting Mervyn’s second theory, the court did not explicitly endorse or overturn the decision in In re Grossman’s, Inc. but held that the Third Circuit’s analysis in In re Grossman’s Inc. did not apply to section 365(d)(3) and was therefore distinguishable on this basis.  Rather, in the case of section 365(d)(3), the relevant time is when the “obligation” arose and not when the “claim” arose.  According to the court, a “claim” is an “unmatured right to payment” whereas; an “obligation” is “something one is legally required to perform.”
Instead, the court adopted the Third Circuit’s holding in Montgomery Ward, that a landlord’s claim for reimbursement for real estate taxes attributable to a period prepetition, but due postpetition was entitled to administrative status because, under the terms of the non-residential lease, the debtor was required to reimburse the lessor for the taxes as they became due.  In Montgomery Ward, the Third Circuit held that, for the purposes of section 365(d)(3) an obligation arises when the legally enforceable duty to perform arises under the lease.  Even though the taxes were attributable to a prepetition period, the debtor was not obligated to reimburse the landlord until they were due, which occurred postpetition.  Thus, the landlord’s claim for reimbursement was an administrative postpetition claim.
Applying the holding in Montgomery Ward to the case at hand, the court held that, although the conduct giving rise to the claim for indemnity (entering into the lease and the construction agreement and making the property improvements) arose prepetition, the obligation to indemnify WM Inland did not arise until the general contractor recorded the liens and sued WM Inland, which occurred postpetition.  Thus, WM Inland’s claim for indemnification was an administrative postpetition claim under section 365(d)(3).
A Last Kick at the Can…
In a final attempt to characterize the indemnification obligation as a general unsecured claim, Mervyn’s argued that, even if the indemnity claims arose postpetition, they should not be granted administrative priority because WM Inland could not meet its burden under section 503(b)(1) of the Bankruptcy Code.  Section 503(b)(1) imposes an additional hurdle for claimants seeking to have their claim treated as an administrative expense by requiring proof that the expense is an “actual, necessary cost and expense of preserving the estate….”  This standard is met where (1) the expense arose from a postpetition transaction and (2) the transaction has substantially benefitted the estate.  Mervyn’s argued that because there was no postpetition transaction between the parties, the requirements under section 503(b)(1) were not met.  Focusing on the language of section 365(d)(3),  which requires the debtor to perform all obligations under the lease “notwithstanding section 503(b)(1),” the court held that claims under section 365(d)(3) are exempt from the “usual burdens and procedures” governing administrative claims and do not need to satisfy the requirements set forth in section 503(b)(1) in order to be treated as administrative postpetition claims.
Take Away
A debtor has the right to assume or reject executory contracts and unexpired leases to which the debtor is a party.  This decision serves as a reminder that, where a debtor delays its decision to either assume or reject a real property lease, real consequences to the debtor’s estate may ensue, as obligations arising from the petition date through the date of assumption or rejection will likely be treated as an administrative claim.