US Bankruptcy Court rules on lease classification for skilled nursing and long-term care facilities

The US Bankruptcy Court for the Western District of Pennsylvania issued a memorandum opinion on November 15, 2024, holding that a real property lease for a skilled nursing, long-term care, and rehabilitation facility should be classified as “residential,” and thus not subject to the more landlord-friendly treatment of a “nonresidential” real property lease in chapter 11 bankruptcy cases. In re Guardian Elder Care at Johnstown, LLC d/b/a Richland Healthcare and Rehabilitation Center, et al., Case No. 24-70299 [Dkt. No. 893] (Bankr. W.D. Pa. 2024).

In so doing, the court:

1. Authorized debtors to not pay monthly post-petition rents under section 365(d)(3) of the Bankruptcy Code, and
2. Allowed landlords to request any such rent at a fair market rate as administrative expenses under section 503(b) of the Bankruptcy Code, payable at the end of the bankruptcy cases.

Background

Guardian Elder Care at Johnstown, LLC, doing business as Richland Healthcare and Rehabilitation Center, and certain of its affiliates (collectively, the Debtors) provide skilled nursing, long-term care, and rehabilitation services to patients residing at its facilities in Pennsylvania. The Debtors leased the facilities in which they provide services under a lease agreement (Lease) with a consortium of landlords under a real estate investment trust (collectively, the Landlords). By its plain terms, the Lease stated that the primary intended use of the premises was for facilities where patients resided and received care. At all relevant times, the Debtors maintained operations at the facilities, which housed 1,143 resident beds and 950 patients who actually resided at the facilities.

Chapter 11 filing and Bridge Financing

On July 29, 2024, the Debtors filed for chapter 11 protection with the goal of selling or transitioning their business. To finance their cases, the Debtors sought court authority to use cash collateral and borrow proposed debtor-in-possession financing intended to serve as working capital throughout the cases (Bridge Financing). The Landlords objected to the Bridge Financing on the grounds that it did not provide for the immediate payment of post-petition rent and other obligations under the Lease as required by section 365(d)(3) of the Bankruptcy Code.

Debtors’ argument for residential property classification

The Debtors countered that the Landlords would only be entitled to such protection if the Lease involved “nonresidential property.” However, the Debtors’ asserted that the Lease involved “residential property,” because the facilities housed patients as residents. As a result, the Debtors argued that section 365(d)(3) did not apply, and the Landlords were not entitled to seek immediate payment of rent. The Debtors also argued that any potential entitlement to payment would be limited to a right to seek reasonable occupancy charges as administrative expenses under section 503(b) of the Bankruptcy Code. Moreover, they argued that because such payments constituted administrative expenses, then the Debtors could defer payment of all rent and other charges under the Lease until confirmation of a chapter 11 plan.

The court’s decision on Bridge Financing

The court indicated that it would approve the Bridge Financing, but it would consider the substantive arguments regarding the classification of the Lease through a contested matter. The Landlords then filed a motion to compel payment of rent, which the Debtors and the official committee of unsecured creditors opposed.

Section 365(d)(3) and the distinction between “nonresidential” and “residential” real property leases

Section 365(d)(3) of the Bankruptcy Code requires a debtor-in-possession to timely perform post-petition obligations with respect to leases of “nonresidential real property.” The term “nonresidential” is not defined in section 365(d)(3), or anywhere else in the Bankruptcy Code. As a result, courts have identified a gap in the statute, requiring an analysis of whether a property is nonresidential (and thus subject to section 365(d)(3)’s requirements) or residential (and thus falls outside the scope of section 365(d)(3)).

That distinction impacts the rights and leverage of landlords in a chapter 11 case. For example, if a court characterizes a real property lease as nonresidential under section 365(d)(3), then the debtor-lessee must:

1. Timely perform post-petition rent obligations at the contract rate, and
2. Assume or reject such lease within 120 days of the petition date (subject to potential extensions for a total of 210 days) (Lease Assumption/Rejection Deadline).

If a debtor fails to timely perform under a nonresidential lease, the landlord has the right to move the court for an order compelling the debtor to assume or reject its lease before the expiration of the Lease Assumption/Rejection Deadline. The damages arising from the rejection of a nonresidential real property lease will be subject to a cap on damages pursuant to section 502(b)(6).

On the other hand, if a court characterizes a real property lease as residential, that lease will fall outside the scope of section 365(d)(3). As a consequence, the debtor-tenant:

1. Is not required to immediately pay post-petition rent at the contract rate, and instead would be obligated to pay rent as an administrative claim at the end of the bankruptcy case (at a fair rental rate), and
2. Must only assume or reject the lease at any time before confirmation of a plan (which could be a date beyond the Lease Assumption/Rejection Deadline.

However, like with a nonresidential real property lease, the damages arising from the rejection of a nonresidential real property lease will be subject to a cap on damages pursuant to section 502(b)(6).

The property test and the economic test

To address the gap in the statute, courts frequently analyze whether property is nonresidential by applying either the “property test” or the “economic test.” Compare In re PNW Healthcare Holdings, LLC, 617 B.R. 354 (Bankr. W.D. Wash. 2020) (applying the property test) to In re Passage Midland Meadows Operations, LLC, 578 B.R. 367 (Bankr. S.D. W. Va. 2017) (applying the economic test).

Most courts apply the property test, which examines the character of the property itself, and conclude that if people reside on such property, then the lease should be classified as residential. Conversely, the courts the apply the economic test consider the contractual intent behind the lease to determine whether the parties intended the lease for commercial or non-commercial purposes.

If the court finds that the lease constitutes a commercial lease, where the debtor is in the business of generating income, then the lease would be treated as nonresidential.

The court’s decision

Ultimately, the court found the property test more persuasive because it focused on the actual use of the premises, and thus provided “a more congruent fit with the plain language of the statute.” The court reasoned that “the substance of the arrangement” (occupancy by patients who reside on the property for healthcare services) was residential in nature.

Significantly, the court observed that the presence of the patients was critical to the entire purpose of the Lease. And, although patients may not be formal tenants, they “occup[y] the space as residents in every meaningful sense.”

By holding that the Lease was residential, the court joined numerous other bankruptcy courts holding that leases involving patient-centered care facilities should be classified as residential. See In re Care Givers, Inc., 113 B.R. 263 (Bankr. N.D. Tex. 1989); In re PNW Healthcare Holdings, LLC, 617 B.R. at 354, In re Independence Village, Inc., 52 B.R. 715 (Bankr. E.D. Mich. 1985), and In re Texas Health Enters., Inc., 255 B.R. 181 (Bankr. E.D. Tex. 2000).

Issues with the property test and the economic test

Significantly, however, the court highlighted that neither the property test nor the economic test provides a satisfactory framework in all cases. The economic test ignores the actual use of the property by overlooking the fact that patient care facilities serve as a place of residence for patients. Conversely, the property test often overlooks the “unique fusion” of commercial purpose and personal residency that can arise in patient care facilities.

Applying a new “totality of the circumstances” test

As a result, the court proposed employing a “totality of the circumstances test” to evaluate whether a real property lease should be treated as residential or nonresidential. According to the court, a totality of the circumstances test would allow courts to evaluate the nuances of mixed-use property leases – such as leases for healthcare facilities that house residents – along with the property’s purpose, use, and intent. Ideally, under that test, no single factor would be dispositive. Instead, courts could evaluate the specific facts and practical realities of each case.

Thus, the court relied on a totality of the circumstances test and focused on the residential nature of the facility subject to the Lease. In particular, the court observed that:

1. The primary use of the facilities was “clearly residential,” because approximately 950 residents relied on the facilities for around-the-clock care. As a result, the facilities functioned more similarly to homes, rather than commercial enterprises
2. The Lease required the use of the properties as skilled nursing facilities or primary care homes, which strongly implied a purpose rooted in a residence. In addition, the Lease explicitly contemplated a residential purpose, describing the facilities as “primary care homes” and referencing “resident” occupancy
3. Patient occupancy is residential because individuals reside in the facilities for extended stays with a “home-like environment”
4. The entire business relationship between the Debtors and the Landlords depended on maintaining resident occupancy and healthcare services, and
5. While the economic aspects of the Lease contemplated revenue generation, that factor alone did not override the fundamental residential use of the property.

Moreover, the court applied the plain meaning of the term “nonresidential,” and found that it did not comport with the residential nature of the Debtors’ facilities. Further, because the term “nonresidential” modified “real property” in section 365(d)(3), the court held that any analysis under the text of the statute must prioritize the use and character of the property itself, rather than the Lease’s commercial aspects.

Lastly, the court noted that the 1984 amendments to the Bankruptcy Code, which introduced the residential and nonresidential distinctions, were primarily designed to prevent undue hardship on nonresidential landlords, such as shopping mall and retail landlords. The court reasoned that the absence of any mention of skilled nursing facilities or personal care homes was significant, because Congress could have defined the term “nonresidential” to include mixed-use properties in light of the other changes that Congress had employed at the time. Since Congress did not do so, the court declined to “rewrite the statute” in this instance.

The court also emphasized that residential care facilities serve some of society’s most at-risk individuals and that disruptions in residency for these patients would have serious consequences for public health. By contrast, and as noted above, nonresidential leases are subject to more robust protections in favor of landlords.

Key takeaways

Although the court ultimately determined that the Lease was residential, and the strictures of section 365(d)(3) did not apply, the court allowed the Landlords to seek allowed administrative expenses for reasonable occupancy charges under section 503 of the Bankruptcy Code.

The court also noted that the Landlords could take other action, such as seeking adequate protection or relief from the automatic stay, if they faced significant financial hardship due to the Debtors’ continued use of the premises.

The court highlighted that the administrative expense option would provide the Debtors with flexibility to allocate financial resources strategically, craft a feasible plan, and prioritize patient care, staffing, and regulatory compliance, while also balancing the interests of the Landlords.

For more information

If you have any questions about this ruling or any restructuring-related matter, please reach out to the authors, Robert Klyman and Nicole McLemore, or your usual DLA Piper contact.