• In re Mervyn's Holdings, LLC, et al., Case No. 08-11586 (KG); WM Inland Adjacent LLC v. Mervyn's LLC, Adv. Proc. No. 09-50920 (KG) (January 8, 2013)
  • March 12, 2013
  • Law Firm: Morris James LLP - Wilmington Office
  • Claims arising from indemnification provision in non-residential commercial lease, including requirement to keep property free of mechanics’ liens, that was rejected post-petition, are entitled to administrative priority pursuant to section 365(d)(3) of the Bankruptcy Code.

    On January 8, 2008, debtors Mervyn’s Holdings, LLC, Mervyn’s LLC (“Mervyn’s”) and Mervyn’s Brands, LLC (collectively, the “Debtors”) executed a lease (the “Lease”) on a commercial property in San Bernardino, California (the “Premises”) owned by WM Inlands Adjacent LLC (“WM Inland”) and a construction agreement relating to prospective property improvements to the Premises, included as Exhibit C to the Lease (the “Construction Agreement”). Mervyn’s entered into an agreement with a general contractor Fisher Development Inc. (“Fisher”) to improve and renovate the Premises. The Lease and Construction Agreement required Mervyn’s to indemnify WM Inland for various liabilities occurring prior to, during and after the term of the Lease. These indemnification duties included a duty to keep the premises free of mechanics’ liens and pay WM Inland as additional rent all amounts and changes due under the Lease, including attorneys’ fees (the “Indemnification Obligations”).

    On July 29, 2008 (the”Petition Date”), Mervyn’s filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. As of the Petition Date, Fisher, the general contractor, who had only received only partial payment for its work, stopped all work on the Premises. The general contractor then filed two mechanics’ liens against the rental property for an approximate total of $5.5 million. Fisher filed suit against WM Inland on October 8, 2008 to foreclose on the two liens. Debtors rejected the Lease effective November 21, 2008.

    WM Inland filed two claims in Debtors’ bankruptcy comprising of: (1) a general unsecured claim for rejection damages and an administrative postpetition claim seeking indemnity for the pending litigation with Fisher; and (2) a claim for mechanics’ liens, rent, property taxes and attorneys’ fees. Debtors objected to the WM Inland claims on the grounds that the claims were overstated and/or misclassified. WM Inland eventually settled the litigation with Fisher for $1.7 million and WM Inland then asserted an administrative expense for the amount of its settlement.

    The Court treated WM Inland’s claims as administrative expenses because the obligation to indemnify arose postpetition. WM Inland argued that its indemnification claim was an administrative expense pursuant to section 365(d)(3) of the Bankruptcy Code. Under section 365(d)(3), the debtor in possession must continue to perform postpetition obligations under the unexpired lease, until such lease is assumed or rejected. Debtors argued that the Indemnification Obligations were general unsecured claims because the obligation either arose from the rejection of the Lease 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 that occurred prior to the Petition Date. The Court disagreed.

    The Court held that Debtors’ obligation to indemnify WM Inland arose from the postpetition filing of the mechanics’ liens against the Premises and therefore, pursuant to section 365(d)(3), was a claim entitled to administrative status. Once the general contractor recorded the mechanics’ liens (in September 2008) and WM Inland was sued by the general contractor, the terms of the Lease dictated that Mervyn’s was obligated to indemnify WM Inland. Although the conduct giving rise to the Indemnification Obligations Claim arose prepetition, the associated Indemnification Obligations claims arose after the Petition Date in July 2008 and before the effective date of the Lease’s rejection in November 2008, entitling it to administrative priority under section 365(d)(3). The Court relied upon the Third Circuit’s holding in Centerpoint Properties v. Montgomery Ward Holding Corp., (In re Montgomery Ward, LLC), 268 F.3d 205 (3d Cir. 2001) that, for purposes of section 365(d)(3) an obligation arises when the legally enforceable duty to perform arises under the lease. Therefore, the Court held that, although the conduct giving rise to the claim for indemnification 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.

    Finally, the Court rejected Debtors’ argument that the indemnification claims were not entitled to administrative priority even if they arose postpetition because WM Inland could not meet its burden under section 503(b)(1) of the Bankruptcy Code in that WM Inland failed to show that the expense is an “actual, necessary cost and expense of preserving the estate” because section 365(d)(3) of the Code requires the Debtors to perform all obligations under the Lease “notwithstanding section 503(b)(1) of this title.” The Court concluded that this phrase operates as a carve-out exempting these expenses from the “usual burdens and procedures”. In re Goody’s Family Clothing, Inc., 401 B.R. 656, 667 (D.Del. 2009). According to the Court, because the Indemnification Obligations claim stemmed from post-petition obligations under section 365(d)(3), section 503(b)(1) was inapplicable.