Guest Post By David G. Dragich, founder of The Dragich Law Firm
There has been a surge of corporate bankruptcy filings in 2020, and many more are on the way. Even before the COVID-19 pandemic, there was an uptick in cases, and the recent economic downturn has exacerbated financial difficulties for many companies, particularly among those in the retail sector. As a result, commercial landlords are being forced to deal with more tenants in, or on the brink of, chapter 11 bankruptcy.
Unlike in a chapter 7 bankruptcy, a business continues to operate in chapter 11 until it emerges as a reorganized entity, sells its assets, or liquidates because there is no viable path to a reorganization or sale. Accordingly, all is not necessarily lost for a landlord when a tenant files for bankruptcy, but a landlord must be informed and vigilant in order to understand its rights, exercise its remedies, and recover as much as possible under a lease agreement with a bankrupt tenant.
In this article, the following five key issues are addressed:
- What is the effect of a tenant’s bankruptcy on a lease?
- What are a tenant’s obligations with respect to lease payments during bankruptcy?
- What is the “automatic stay” and what impact does it have on a landlord’s ability to enforce its lease remedies?
- What are a landlord’s rights when a tenant seeks to assign a lease to a third party?
- Is a landlord entitled to damages when a tenant rejects a lease?
What is the effect of a tenant’s bankruptcy on a lease?
When a tenant files for chapter 11 bankruptcy, it has three options with respect to an unexpired lease: (1) it can assume the lease and continue to perform its obligations, (2) it can reject the lease, which means the lease is essentially terminated and the tenant must vacate the property, or (3) it can assume and assign the lease to a third party.
A debtor/tenant has 120 days to reject or assume (and, in some cases, assign) an unexpired lease, although a tenant may request an extension of time beyond the 120-day period. A landlord may object to such a request, as appropriate. Generally speaking, courts defer to the “business judgment” of a debtor when it comes to decisions to reject or assume a lease.
What are a tenant’s obligations with respect to lease payments during bankruptcy?
The Bankruptcy Code requires that a tenant must perform its obligations under a lease while in bankruptcy. Accordingly, rent that is due during the pendency of the bankruptcy must be paid in accordance with the lease. Post-bankruptcy filing lease payments are considered “administrative claims,” which means that such payments are entitled to a higher priority than many other bankruptcy claims and must be paid in full. To the extent that a tenant is not staying current on post-petition lease payments, a landlord may request that the bankruptcy court order the tenant to fulfill its obligations.
What is the “automatic stay” and what impact does it have on a landlord’s ability to enforce its lease remedies?
Once a party files for bankruptcy, an “automatic stay” is imposed that prohibits a landlord, or any other creditor, from commencing or continuing any proceeding against the debtor which could have been commenced prior to the bankruptcy. To put it plainly, a landlord cannot, for example, attempt to evict a tenant for non-payment of rent during the pre-bankruptcy period once the tenant files a bankruptcy petition. It’s also important to keep in mind that post-petition performance obligations are mutual—a landlord who is not performing its obligations under a lease agreement after a bankruptcy has been filed can be found to have violated the automatic stay.
If a landlord is found to be in violation of the automatic stay, damages, including attorney’s fees, may be assessed. Accordingly, a landlord should carefully consider whether any actions taken against the tenant or its property may arguably violate the automatic stay. Landlords should aggressively pursue their rights and remedies in bankruptcy, but when in doubt as to whether certain actions may implicate the automatic stay, it’s a good idea to seek relief from the automatic stay before taking action.
What are a landlord’s rights when a tenant seeks to assign a lease to a third party?
A debtor who assumes a lease may also be able to assign it to a third party. A tenant’s right to assign a lease in bankruptcy overrides any anti-assignment provision in the lease. However, in order to assign a lease, all defaults under the lease, which accrued before or during the bankruptcy, must be cured, and the assignee must provide adequate assurance of future performance. The landlord may also require a deposit or other form of security from the assignee equal to what it would have initially required from a similar tenant at the time it entered into the lease.
Is a landlord entitled to damages when a tenant rejects a lease?
As previously discussed, a debtor may reject (terminate) a lease, and in approving a request to reject a lease bankruptcy courts defer to the business judgment of the debtor. A debtor may decide to reject a lease for many reasons, such as that the lease calls for above-market rent or the debtor is exiting certain markets as part of a reorganization. In the large retail bankruptcies, one of the primary considerations for debtors is determining how to strategically use the power to reject leases in order to shrink retail footprints and reduce fixed costs.
If a tenant rejects a lease, the landlord is entitled to a lease “rejection damage” claim. A rejection damage claim applies to future rent that would have been due but for rejection. Such a claim is treated as a pre-petition unsecured claim, and is capped at the greater of one year’s rent or the rent for 15 percent, not to exceed three years, of the remaining term of the lease. A landlord must file a separate claim for either (or both) unpaid rent for the period before the bankruptcy (a pre-peition unsecured claim) or unpaid rent during the bankruptcy period (an administrative claim).
Conclusion
As the old saying goes, the best offense is a good defense, so while tenant bankruptcies are an inevitable risk of doing business for landlords—particularly in the current environment—there are proactive steps landlords can take to protect themselves. One is to require security deposits from tenants, which can enable a landlord to have a secured claim to the extent of the security deposit in a tenant’s bankruptcy. Another common tactic is to require a letter of credit or guarantee of the lease by a third party, both of which may, generally, allow a landlord to obtain recovery for defaults without implicating the automatic stay. For example, a landlord may draw down on a letter of credit or pursue collection from a third-party guarantor. These tactics, and others, are important considerations that landlords should be thinking about when negotiating lease agreements in order to mitigate risks in the event of a tenant bankruptcy.
