Seventh Circuit Holds That Pre-petition Taxes Billed Post-petition Are Not Entitled to Priority Payment

Seventh Circuit Holds That Pre-petition Taxes Billed Post-petition Are Not Entitled to Priority Payment

Journal Issue: 
Column Name: 
Journal Article: 
In an important decision regarding the relative rights of landlords and their bankrupt tenants, the U.S. Court of Appeals for the Seventh Circuit became the first appellate court to address whether a debtor is obligated to reimburse its landlord in full for pre-petition real estate taxes that were billed to the debtor after the entry of the order for relief, but prior to the assumption or rejection of the lease, under §365(d)(3) of the Bankruptcy Code. Expressing its surprise that such an "important question of bankruptcy law...has never elicited an appellate opinion," the Seventh Circuit held in In re Handy Andy Home Improvement Centers Inc., 144 F.3d 1125 (7th Cir. 1998), that such obligations are not required to be paid in full merely because the billing date occurs after the entry of the order for relief, but instead must be prorated based on when the order for relief is entered so that only those taxes accruing after the entry of the order for relief are paid in full.

Handy Andy Home Improvement Centers rented commercial space from National Terminals Corp. in Cook County, Ill. The lease provided for Handy Andy to reimburse National for real estate taxes that accrued against National's property during the term of its lease with National. In practice, National paid its real estate tax bills after it received them from the taxing authorities and then billed Handy Andy for reimbursement of the amount of the taxes.

In Cook County, real estate taxes are assessed at the beginning of each year but are billed and paid for in two semi-annual installments, one year in arrears (35 ILCS 200/1-155, 200/21-30 and 200/20-210).

An involuntary chapter 11 petition was filed against Handy Andy by some of its creditors on October 12, 1995, at which time real estate taxes for the second half of 1994 and the first half of 1995 had been assessed against National's property but were not yet payable by Handy Andy to National. After the entry of the order for relief, National demanded that Handy Andy pay the 1994 and 1995 real estate taxes in full pursuant to §365(d)(3). Handy Andy refused on the basis that the taxes constituted general unsecured pre-petition debts that were not entitled to priority payment. National, therefore, sought an order from the bankruptcy court compelling Handy Andy to pay the 1994 and 1995 taxes.

Section 365(d)(3) of the Bankruptcy Code provides, in relevant part, 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 non-residential real property, until such lease is assumed or rejected, notwithstanding §503(b)(1) of this title...

11 U.S.C. §365(d)(3). National argued that the obligation to pay the 1994 and 1995 taxes arose entirely after the entry of the order for relief when the taxes were billed by National to Handy Andy under the lease; therefore, National was entitled to payment in full under §365(d)(3) of the Bankruptcy Code. Handy Andy and its unsecured creditors' committee took the position that the real estate taxes arose on a daily basis as they accrued to Handy Andy under its lease and, therefore, that the taxes should be prorated based on the date the order for relief was entered so that only taxes accruing after that date would be paid in full.

The Seventh Circuit's Handy Andy decision reinforces a growing majority of lower courts that have adopted the "proration approach" to real estate taxes...

The issue of statutory interpretation that confronted the Seventh Circuit in Handy Andy (i.e., when did Handy Andy's obligation to reimburse National for its real estate taxes arise?) is one that has sharply divided bankruptcy and district courts, but that had never been addressed by an appellate court before the Handy Andy decision. Compare, e.g., In re McCrory Corp., 210 B.R. 934 (S.D.N.Y. 1997); In re Child World Inc., 161 B.R. 571 (S.D.N.Y. 1993); In re Ernst Home Center Inc., 209 B.R. 955 (Bankr. W.D. Wash. 1997); In re Best Prods. Co., 206 B.R. 404 (Bankr. E.D. Va. 1997); and In re Victory Markets Inc., 196 B.R. 6 (Bankr. N.D.N.Y. 1996) (following the "pro ration approach") with, e.g., In re Krystal Co., 194 B.R. 161 (Bankr. E.D. Tenn. 1996); In re R.H. Macy & Co., 152 B.R. 869 (Bankr. S.D.N.Y. 1993) and In re F&M Distribs. Inc., 197 B.R. 829 (Bankr. E.D. Mich. 1995) (following the "billing date approach"). The majority of recent bankruptcy and district court decisions follow what is known as the "proration approach." After first determining that §365(d)(3) is ambiguous with respect to when an obligation arises, these courts find support for the proration of real estate taxes in the courts' practice of prorating such taxes prior to §365's amendment in 1984, the legislative history accompanying §365(d)(3) and the underlying policies of the Bankruptcy Code. Those courts that have adopted the minority "billing date approach" focus on the "plain meaning" of §365(d)(3), equating the time at which an obligation "arises" as the term that is used in §365(d)(3) with when it is "payable." The "billing date approach" decisions hold that the legislative history and pre-amendment practices of courts are irrelevant because the language of §365(d)(3) is unambiguous.

Although the Seventh Circuit acknowledged that the "billing date approach" advocated by National reflected a "possible reading of §365(d)(3)," after considering the purpose of and policies implicated by §365(d)(3), and the "real-world" context in which courts must interpret the statute, the court concluded that such a reading "is neither inevitable nor sensible." Handy Andy, 144 F.3d at 1127. Instead, the court found that:

...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.

Id. Therefore, the Seventh Circuit concluded that the lower courts had properly prorated the disputed taxes so that only those taxes that accrued after the order for relief was entered on November 1, 1995 were entitled to payment in full under §365(d)(3).< p>The court recognized that §365(d)(3) was enacted in 1984 to deal with the unfairness of treating landlords as administrative claimants. The Bankruptcy Code is designed to encourage parties to provide debtors with goods and services on an unsecured basis after the filing of a bankruptcy case by giving such parties priority over general unsecured creditors. 11 U.S.C. §§503(b)(1) and 507(a)(1); Child World, 161 B.R. at 574 citing Trustees of Amalgamated Ins. Fund v. McFarlin's Inc., 789 F.2d 98, 101 (2d Cir. 1986). However, the administrative expense claim of a party that provides such post-petition goods and services is subject to bankruptcy court review to determine whether the amount charged for such goods and services was reasonable. Child World, 161 B.R. at 574. Courts also have considerable discretion with respect to when such claims are paid, sometimes not allowing payment of such claims until confirmation of a plan of reorganization. Id. at 575.

Unlike vendors that can choose whether to extend post-petition unsecured credit to a debtor or to demand payment in advance, prior to the amendment of §365, landlords were essentially involuntary post-petition unsecured creditors that were compelled to provide a debtor with the use of the landlord's premises until the debtor decided whether to assume or reject the lease. See H.R. Rep. No. 882, 95th Cong., 2d Sess. 1984, reprinted in 1984 U.S.C.C.A.N. 576. Like other post-petition claimants, however, landlords were subject to §503(b)(1). As a result, landlords' rents for premises occupied by debtors were subject to downward adjustment by bankruptcy courts, based on whether such rates were reasonable and on delays in payment. See In re All For A Dollar Inc., 174 B.R. 358, 360 (Bankr. D. Mass. 1994) (citing cases prior to the 1984 amendments applying §503 to landlord claims); Child World, 161 B.R. at 574-75 (same).

When Congress passed the 1984 amendment to §365, it intended to eliminate the unfairness of treating landlords as involuntary administrative claimants by excepting landlords from the requirements of §503(b)(1), thereby putting landlords on an equal footing with other providers of post-petition goods and services that can demand cash in advance of the provision of such goods and services. In re Warehouse Club Inc., 184 B.R. 316, 317 (Bankr. N.D. Ill. 1995). But even creditors that provide post-petition goods and services cannot compel a debtor to pay its pre-petition debts to those creditors. Handy Andy, 144 F.3d at 1127-28. As the court explained in Warehouse Club, 184 B.R. at 317, real estate taxes that accrue pre-petition are:

sunk costs, not a current expense of allowing the debtor to remain in possession. If the debtor had rejected the lease before the bill came due, the landlord would not have less liability. The debtor's continued occupancy did not increase the landlord's burden for last year's taxes or make the landlord an involuntary creditor for those taxes.

The Seventh Circuit agreed that the disputed 1994 and 1995 real estate taxes were such pre-petition sunk costs for which National was no more entitled to a priority claim than any other provider of pre-petition goods or services. Handy Andy, 144 F.3d at 1127-28 ("There is no indication that Congress meant to go any further than to provide a landlord exception to §503(b)(1), and thus no indication that it meant to give landlords favored treatment for any class of pre-petition debts."); see McCrory, 210 B.R. at 940 ("The approach followed by the minority of courts would drastically alter the priority and distribution scheme under the Bankruptcy Code.") (emphasis added); In re Victory Mkts. Inc., 196 B.R. 6, 10 (Bankr. N.D.N.Y. 1996) (concluding that the pre-amendment practice of prorating real estate taxes "is commensurate with the overall purpose of the Code to afford a...debtor...[an] opportunity to reorganize while at the same time balancing the rights of all creditors seeking to recover on their claims").

The Seventh Circuit also proclaimed that statutory language, like §365(d)(3), must be interpreted in light of the "real-world" context to which it applies. The Seventh Circuit stated that the "billing date approach" advocated by National ignores the fact that Congress was only legislating with respect to the treatment of certain post-petition claims and that, if adopted, the "billing date approach" would lead to strategic behavior by landlords and tenants. Handy Andy, 144 F.3d at 1128. For instance, a debtor could avoid real estate tax reimbursement obligations by timing the filing of its bankruptcy case or its rejection of leases to ensure that the billing date fell before the debtor's bankruptcy case was filed or after the lease was rejected, thereby avoiding paying in full any portion of the real estate taxes that accrued during the debtor's occupancy. In re Ernst Home Center Inc., 209 B.R. 955, 964 (Bankr. W.D. Wash. 1997); National Terminals Corp. v. Handy Andy Home Improvement Centers Inc., 222 B.R. 149, 156 (N.D. Ill. 1997).

Likewise, a landlord might delay the transmission of a real estate tax reimbursement bill when a bankruptcy is imminent to improve the priority of the landlord's claim. The Seventh Circuit noted that had National promptly sent a reimbursement bill to Handy Andy after it received the 1994 tax bill from the taxing authorities, there would have been no dispute that National's reimbursement claim for those taxes would have been a general unsecured pre-petition claim. Handy Andy, 144 F.3d at 1128-29. The Seventh Circuit speculated that National may have delayed sending Handy Andy a bill for the 1994 taxes in an attempt to enhance its priority position. Id. at 1129. To discourage such behavior, the court adopted the proration approach, which is billing date neutral, and therefore does not encourage strategic behavior.

The breadth and ambiguity of the language of §365(d)(3) has resulted in a divisive body of case law. Perhaps because such issues are often settled, there have been few district court decisions and, until the Handy Andy decision, no appellate court decisions regarding the application of §365(d)(3) to real estate taxes. The Seventh Circuit's Handy Andy decision reinforces a growing majority of lower courts that have adopted the "proration approach" to real estate taxes and that are in harmony with the underlying policies of the Bankruptcy Code, the purpose of §365(d)(3), and the practice of bankruptcy courts before that provision was added.

Journal Date: 
Sunday, November 1, 1998