El Toro Materials v. Saddleback Valley ( 2007 )

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
In re: EL TORO MATERIALS 
COMPANY, INC.,
Debtor,
No. 05-56164
SADDLEBACK VALLEY COMMUNITY BAP Nos.
CHURCH,  CC-04-01287-PaBK
Appellant, CC-04-01300-PaBK
v. OPINION
EL TORO MATERIALS COMPANY,
INC.,
Appellee.

Appeal from the Ninth Circuit
Bankruptcy Appellate Panel
Klein, Brandt and Pappas, Bankruptcy Judges, Presiding
Argued and Submitted
June 7, 2007—Pasadena, California
Filed October 1, 2007
Before: Daniel M. Friedman,* Alex Kozinski and
Ronald M. Gould, Circuit Judges.
Opinion by Judge Kozinski
*The Honorable Daniel M. Friedman, Senior United States Circuit
Judge for the Federal Circuit, sitting by designation.
13365
IN RE: EL TORO MATERIALS CO. 13367
COUNSEL
Robert C. Braun, Penelope Parmes and Roger F. Friedman,
Rutan & Tucker, LLP, Costa Mesa, California, for the appel-
lant.
Ronald K. Van Wert, Robert K. Van Wert P.C., Costa Mesa,
California, and William Malcom, Malcom & Cisneros, Irvine,
California, for the appellee.
OPINION
KOZINSKI, Circuit Judge:
Bankruptcy presents a unique challenge: How should a
paucity of resources be allocated to cover a multiplicity of
claims? Distributing money to satisfy claims is, in most cases,
a zero-sum game: Every dollar given to one creditor is a dol-
lar unavailable to satisfy the debt owed to others. For Paul to
be paid in full, Peter must be short-changed. Congress sought
to balance the interests of competing creditors through an
extensive set of rules organizing, prioritizing and structuring
claims against the estate. E.g., 11 U.S.C. § 507(a) (prioritizing
claims); id. § 502(e)(1) (disallowing claims for reimburse-
ment or contribution); id. § 502(b)(1)-(5), (7)-(9) (limiting or
disallowing various claims).
13368 IN RE: EL TORO MATERIALS CO.
The bankruptcy estate of mining company El Toro Materi-
als hopes to use one of these rules—a cap on damages “result-
ing from the termination of a lease of real property,” id.
§ 502(b)(6)—to limit its liability for allegedly leaving one
million tons of its wet clay “goo,” mining equipment and
other materials on Saddleback Community Church’s property
after rejecting its lease.1 Saddleback brought an adversary
proceeding against El Toro claiming $23 million in damages
for the alleged cost of removing the mess, under theories of
waste, nuisance, trespass and breach of contract. The bank-
ruptcy court, on a motion for partial summary judgment,
found that Saddleback’s recovery would not be limited by the
section 502(b)(6) cap. On certified cross-appeal the Bank-
ruptcy Appellate Panel (BAP) reversed, holding that any dam-
ages would be capped. Saddleback appeals.
* * *
Claims made by landlords against their bankrupt tenants for
lost rent have always been treated differently than other unse-
cured claims. Prior to 1934, landlords could not recover at all
for the loss of rental income they suffered when a bankrupt
tenant rejected a long-term lease agreement; future lease pay-
ments were considered contingent and thus not provable debts
in bankruptcy. See Manhattan Props., Inc. v. Irving Trust Co.,
291 U.S. 320, 332-36, 338 (1934).
The Great Depression created pressure to reform the sys-
tem: A wave of bankruptcies left many landlords with broken
long-term leases, buildings sitting empty and no way to
recover from the estates of their former tenants. See Oldden
v. Tonto Realty Corp., 143 F.2d 916, 919-920 (2d Cir. 1944).
On the one hand, allowing landlords to make a claim for lost
rental income would reduce the harm done to them by a ten-
1
The parties entered into a stipulation that the lease would be rejected
under 11 U.S.C. § 365(a) (allowing bankrupt tenants to reject the remain-
ing term of leases).
IN RE: EL TORO MATERIALS CO. 13369
ant’s breach of a long-term lease, especially in a down market
when it was difficult or impossible to re-lease the premises.
On the other hand, “extravagant claims for . . . unearned rent”
could quickly deplete the estate, to the detriment of other
creditors. See In re Best Prods. Co., 229 B.R. 673, 676
(Bankr. E.D. Va. 1998). The solution was a compromise in
the Bankruptcy Act of 1934 allowing a claim against the
bankruptcy estate for back rent to the date of abandonment,
plus damages no greater than one year of future rent. See Old-
den, 143 F.2d at 920-21.
[1] Congress dramatically overhauled bankruptcy law when
it passed the Bankruptcy Reform Act of 1978. However, sec-
tion 502(b)(6) of the 1978 Act was intended to carry forward
existing law allowing limited damages for lost rental income.
S. Rep. No. 95-989, at 63 (1978) as reprinted in 1978
U.S.C.C.A.N. 5787, 5849 (the cap on damages is “derived
from current law”). Only the method of calculating the cap
was changed. Under the current Act, the cap limits damages
“resulting from the termination of a lease of real property” to
“the greater of one year, or 15 percent, not to exceed three
years, of the remaining term of such lease.” 11 U.S.C.
§ 502(b)(6). The damages cap was “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 unse-
cured creditors from recovering a dividend from the estate.”
S. Rep. No. 95-989, at 63.
[2] The structure of the cap—measured as a fraction of the
remaining term—suggests that damages other than those
based on a loss of future rental income are not subject to the
cap. It makes sense to cap damages for lost rental income
based on the amount of expected rent: Landlords may have
the ability to mitigate their damages by re-leasing or selling
the premises, but will suffer injury in proportion to the value
of their lost rent in the meantime. In contrast, collateral dam-
ages are likely to bear only a weak correlation to the amount
of rent: A tenant may cause a lot of damage to a premises
13370 IN RE: EL TORO MATERIALS CO.
leased cheaply, or cause little damage to premises underlying
an expensive leasehold.2
[3] One major purpose of bankruptcy law is to allow credi-
tors to receive an aliquot share of the estate to settle their
debts. Metering these collateral damages by the amount of the
rent would be inconsistent with the goal of providing compen-
sation to each creditor in proportion with what it is owed.
Landlords in future cases may have significant claims for both
lost rental income and for breach of other provisions of the
lease. To limit their recovery for collateral damages only to
a portion of their lost rent would leave landlords in a materi-
ally worse position than other creditors. In contrast, capping
rent claims but allowing uncapped claims for collateral dam-
age to the rented premises will follow congressional intent by
preventing a potentially overwhelming claim for lost rent
from draining the estate,3 while putting landlords on equal
footing with other creditors for their collateral claims.
[4] The statutory language supports this interpretation. The
cap applies to damages “resulting from” the rejection of the
lease. 11 U.S.C. § 502(b)(6). Saddleback’s claims for waste,
nuisance and trespass do not result from the rejection of the
lease—they result from the pile of dirt allegedly left on the
property. Rejection of the lease may or may not have trig-
gered Saddleback’s ability to sue for the alleged damages.4
But the harm to Saddleback’s property existed whether or not
the lease was rejected. A simple test reveals whether the dam-
ages result from the rejection of the lease: Assuming all other
2
Here, El Toro is alleged to have caused $23 million of damage to a
property that it leased for only $28,000 per month.
3
The structure of the cap suggests congressional concern about damages
from long-term leases spanning many years: The cap maxes out at 15%
of 20 years, or 3 years’ rent. A claim for lost rent for a full 20 years would
in many cases overwhelm any other claims against the estate.
4
We need not, and do not, decide whether Saddleback could have
brought its claims before the lease terminated.
IN RE: EL TORO MATERIALS CO. 13371
conditions remain constant, would the landlord have the same
claim against the tenant if the tenant were to assume the lease
rather than rejecting it? Here, Saddleback would still have the
same claim it brings today had El Toro accepted the lease and
committed to finish its term: The pile of dirt would still be
allegedly trespassing on Saddleback’s land and Saddleback
still would have the same basis for its theories of nuisance,
waste and breach of contract. The million-ton heap of dirt was
not put there by the rejection of the lease—it was put there by
the actions and inactions of El Toro in preparing to turn over
the site.5
Interpreting the section 502(b)(6) cap to include damage
collateral to the lease would also create a perverse incentive
for tenants to reject their lease in bankruptcy instead of run-
ning it out: Rejecting the lease would allow the tenant to cap
its liability for any collateral damage to the premises and thus
reduce its overall liability, even if staying on the property
would otherwise be desirable and preserve the operating value
of the business. Bankrupt tenants—especially those who have
damaged the property and thus may face liability upon expira-
tion of the lease—would pack up their wares6 and reject other-
wise desirable leases in order to gain the benefit of capping
unrelated damages. This would both reduce the operating
value of the business and deny recovery to a creditor—a lose-
lose situation counter to bankruptcy policy. An incentive to
sacrifice efficiency in order to exploit a loophole in the
liability-capping provisions would be plainly counter to con-
gressional intent to maximize the value of the estate to credi-
tors.
5
Our ruling is consistent with K-4, Inc. v. Midway Engineered Wood
Prods., Inc. (In re Treesource Indus., Inc.), 363 F.3d 994 (9th Cir. 2004).
There, we determined the priority of a claim for failure to remove materi-
als from the premises, id. at 995, whereas today we decide whether similar
claims are capped by the section 502(b)(6) limitation. Prioritization of the
claim is a separate issue from determining the amount of the claim that
will be permitted.
6
Or fail to pack them up at all, as is alleged here.
13372 IN RE: EL TORO MATERIALS CO.
Further, extending the cap to cover any collateral damage
to the premises would allow a post-petition but pre-rejection
tenant to cause any amount of damage to the premises—either
negligently or intentionally—without fear of liability beyond
the cap. If the tenant’s debt to the landlord already exceeded
the cap then there would be no deterrence against even the
most flagrant acts in violation of the lease, possibly even to
the point of the tenant burning down the property in a fit of
pique. Absent clear statutory language supporting such an
absurd result, we cannot suppose that Congress intended it.
[5] The BAP reached a contrary conclusion because it con-
sidered itself bound by its precedent in Kuske v. McSheridan
(In re McSheridan), 184 B.R. 91 (B.A.P. 9th Cir. 1995), and
therefore held that Saddleback’s recovery against El Toro
would be capped under section 502(b)(6).7 To the extent that
McSheridan holds section 502(b)(6) to be a limit on tort
claims other than those based on lost rent, rent-like payments
or other damages directly arising from a tenant’s failure to
complete a lease term, it is overruled.8
7
Two of the three judges on the appellate panel filed concurring opin-
ions in which they expressed reservations about McSheridan, going as far
as to foreshadow that “it may be doubted that [McSheridan] . . . would
survive scrutiny by the court of appeals.” El Toro Materials Co. v. Saddle-
back Valley Cmty. Church (In re El Toro Materials Co.), No. CC-04-
01287, slip op. at 31 (B.A.P. 9th Cir. July 8, 2005) (Klein, J., concurring
in result). When the panel believes that one of its precedents is wrongly
decided or otherwise deserves reconsideration, the goal of judicial effi-
ciency may be best served by allowing the BAP itself to overrule its own
precedent. The BAP, promulgating its rules under supervision of the Ninth
Circuit Judicial Council, has not yet implemented a rule creating an en
banc procedure. Cf. Textile Mills Sec. Corp. v. Comm’r of Internal Reve-
nue, 314 U.S. 326, 335 (1941) (statutory authorization for three-judge pan-
els in the courts of appeals did not preclude the Third Circuit from
instituting the “more effective” procedure of hearing select cases en banc).
As this case suggests, the time may be ripe for the BAP to consider insti-
tuting such a procedure.
8
McSheridan also holds that damages flowing from the failure of a party
that has rejected a lease to perform future routine repairs or pay utility
bills are capped. 184 B.R. at 95, 102. As the tort claims at issue here are
not based on a failure to perform routine maintenance, we do not address
the propriety of that holding.
IN RE: EL TORO MATERIALS CO. 13373
Saddleback’s argument that section 502(b)(6) does not cap
its claim for damages is properly raised before us; Saddleback
did not waive the argument by failing to question the breadth
of the section 502(b)(6) cap in its cross-appeal from the bank-
ruptcy court to the BAP, as the ruling of the bankruptcy court
on this issue was entirely favorable to Saddleback. Saddle-
back had no reason to challenge a favorable decision.
We remand for a determination on the merits of Saddle-
back’s claim.
REVERSED and REMANDED.