The Bankruptcy Code creates a series of priorities that dictate the order in which claims are paid. Needless to say, obtaining the highest priority status is an important objective for any creditor. Administrative claims (generally consisting of those arising post-petition) are given a senior priority status and are typically among the first paid. (See 11 U.S.C. § 507.)

In fact, administrative claims must be paid in full as part of any plan of reorganization. As a result, precedent recognizing an additional category of administrative claims is always notable. In a recent case of first impression, the U.S. Bankruptcy Court for the District of Delaware held that a claim arising from an indemnification obligation contained within a rejected nonresidential commercial lease was entitled to administrative status pursuant to 11 U.S.C. § 365(d)(3). (See WM Inland Adjacent v. Mervyn’s (In re Mervyn’s Holdings), No. 08-11586 (KG), Adv. Pro. No. 09-50920 (KG), 2013 Bankr. LEXIS 67 (Bankr. D. Del. Jan. 8, 2013).)

In Mervyn’s Holdings, the debtors and the landlord executed a lease for nonresidential commercial property and a construction agreement, both containing provisions requiring one of the debtor entities, Mervyn’s, to indemnify the landlord for varying liabilities arising prior to, during and after the lease ended; including a duty to keep the premises free of mechanic’s liens and to pay all amounts, charges and attorney fees due under the lease. Subsequent to entering into the lease, Mervyn’s signed an agreement with a third-party contractor, Fisher Development Inc., for building improvements to the leased premises. The debtors filed under Chapter 11 while construction was under way.

The debtors’ bankruptcy filing caused Fisher to record two mechanic’s liens in rapid succession against the premises and to file a state action against the landlord. The landlord answered Fisher’s complaint and cross-claimed against Mervyn’s, asserting its indemnity rights. The landlord’s cross-claim was removed to the bankruptcy court as an adversary proceeding. The landlord ultimately settled with Fisher. Subsequently, the debtors rejected the lease.

The landlord filed two proofs of claim, which included an unsecured claim and an administrative post-petition priority claim. Specifically, the landlord sought administrative priority treatment pursuant to Section 365(d)(3) for claims arising from debtors’ indemnity obligations for amounts the landlord paid to Fisher via the settlement (the indemnity claim). Section 365(d)(3) provides in pertinent part, that: “The trustee shall timely perform all the obligations of the debtor, except those specified in Section 365(b)(2), arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is … rejected.”

Debtors objected to each of the landlord’s claims as overstated and/or misclassified; specifically, asserting that the indemnity claim was a pre-petition general unsecured claim under 11 U.S.C. § 502(g). The parties each moved for summary judgment on the issue of priority pursuant to Federal Rule of Civil Procedure 56(a), which is made applicable to adversary proceedings via Federal Rule of Bankruptcy Procedure 7056.

The landlord argued that pursuant to the language of the lease, the indemnity claim “arose post-petition and prior to rejection” of the lease and was, therefore, entitled to administrative priority pursuant to Section 365(d)(3). Specifically, the landlord contended that the indemnity claim obligation arose either when Fisher’s liens were recorded or when Fisher sued the landlord, which in either case occurred post-petition but prior to rejection. Moreover, the landlord relied upon U.S. Court of Appeals for the Third Circuit precedent holding that Section 365(d)(3) mandates administrative status, in the context of nonresidential unexpired leases, for “all obligations that arise after an order for relief is entered and before the lease is rejected.” (See Centerpoint Properties v. Montgomery Ward Holding, 268 F.3d 205, 209-211 (3d Cir. 2001).) The Montgomery Ward opinion also established that a court must look to the terms of the lease to determine the nature of obligations and when said obligations “arise” (i.e., become legally binding).

The debtors presented several counterarguments. First, the debtors asserted that the indemnity claim arose from rejection of the lease and was, therefore, a pre-petition unsecured claim pursuant to 11 U.S.C. § 502(g) (providing that lease-rejection claims are pre-petition unsecured claims). The court disagreed, finding that “the damages arose from the filing of mechanic’s liens against the premises.” The debtors alternatively contended that the indemnity claim arose pre-petition because the indemnity claim arose from Fisher’s property improvements. However, relying on Montgomery Ward, the court disagreed, reasoning that the terms of the parties’ lease controlled, which dictated that although the conduct (the property improvements) giving rise to the indemnity claims occurred pre-petition, the actual obligation to indemnify under the lease was triggered at the time the mechanic’s liens were filed, which was post-petition and before lease-rejection. Consequently, the court found that the indemnity claim was entitled to administrative priority under Section 365(d)(3).

Attempting to avoid the holding of Montgomery Ward, the debtors further argued: (1) that the indemnity claim was unmatured and not triggered until after the lease was rejected when Fisher and the landlord agreed to settle for an amount certain; (2) that Montgomery Ward could not be applied because there were no prior cases applying the opinion to a lease indemnification claim; and (3) precedent existed finding that indemnification obligations in executory contracts qualify as pre-petition unsecured claims. (See, e.g., In re Summit Metals, 379 B.R. 40 (Bankr. D. Del. 2007).) Regarding the first point, the court again disagreed with the debtors pursuant to Montgomery Ward and Section 365(d)(3), finding that an administrative “obligation” within the meaning of Section 365(d)(3) arises when the lease renders the obligation legally binding, which under the circumstances was when the mechanic’s liens were filed. Moreover, as to the second point, the court reasoned that Montgomery Ward was “not inapplicable merely because this question has not yet been posed. The issue is one of first impression, and the court is both guided and constrained” by Montgomery Ward. As to the third point, the court distinguished the cited cases as “not helpful” because “none involved nonresidential real property” or Section 365(d)(3).

The court silenced the debtors’ remaining statutory argument by concluding that the landlord’s administrative claim under Section 365(d)(3) was not subject to the two-part administrative expense test in Section 503(b)(1) because Section 365(d)(3) “creates a new and different obligation — one that does not necessarily rest on the administrative expense concept.” The court also rejected the debtors’ argument that exempting administrative claims under Section 365(d)(3) from the requirements of Section 503(b)(1) was bad policy, reasoning that the court’s holding “fits squarely” into Third Circuit precedent and statutory law. Finally, the court declined to find that the landlord would receive a windfall by obtaining the renovated premises without any payment or setoff, concluding that debtors did not fulfill their obligations under the lease.

Mervyn’s Holdings represents a sensible application of statutory text and judicial precedent. However, it is sure to make debtors, who are parties to executory contracts, uneasy. This decision suggests that although the elements of a claim may exist before bankruptcy, if the obligation to pay does not arise until after bankruptcy is filed, exposure for administrative claim liability is a potential risk. Since administrative claims must be paid in full as part of confirmation, this decision could make it harder for some debtors to emerge under a plan. Additionally, the decision to assume or reject a contract may need to be accelerated under certain circumstances. Commercial landlords and their counsel, in particular, should take note. •

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice in national bankruptcy and reorganization matters. He routinely lectures to various creditor groups concerning general bankruptcy issues, including preferences, reclamation, the role of creditors committees and related issues.

 Erik L. Coccia is an associate in the firm’s Philadelphia office and concentrates his practice in national bankruptcy and reorganization matters.