Commercial Landlords And Bankruptcy

Oct. 1, 2009 - PRLog -- This release discusses the impact of a tenant's bankruptcy on the landlord and tenant relationship in the bankruptcy process. No commercial property manager or owner ever wants to hear "They filed Chapter 11". As landlords and property managers well know, a Chapter 11 filing may start an expensive and frustrating process during which the landlord tries to collect rent, while battling the debtor/tenant for control of the leasehold.

BANKRUPTCY CODE PROVISIONS GOVERNING UNEXPIRED COMMERCIAL LEASES

ASSUMPTION AND REJECTION. Section 365 is the principal Bankruptcy Code section governing the treatment of "executory contracts and unexpired leases" in all bankruptcy cases. Section 365 provides for tenants either to "assume" and thereby, keep the tenant's leasehold interest or "reject" it, thereby disaffirming, the tenant's interest in a lease. Once the tenant files for Chapter 7 or Chapter 11 relief, it has a 120-day period to either assume or reject its interest in such lease. During this period, the tenant must comply with all of its lease obligations, as discussed later in this Client Alert. If the tenant fails to timely assume or reject, at the end of the applicable time period the lease will be "deemed" rejected, and all of the consequences of rejection will apply.

Basically, "assumption" means business as usual, subject to certain conditions imposed by the Bankruptcy Code drafted to protect a landlord's interests. Among other things, assumption obligates a tenant to (a) cure existing monetary defaults, (b) pay damages to the landlord resulting from non-monetary defaults, (c) provide adequate assurance of future performance of the tenant's obligations under the lease, and (d) require the tenant to fully perform all of its obligations on a going forward basis as if there never was a bankruptcy case.

"Rejection" means the tenant is relieved from paying future rent and of its other ongoing obligations under a lease. Such a rejected lease is deemed to have been breached by the tenant immediately prior to the bankruptcy filing. "Rejection damage" claims are treated by the Bankruptcy Code as general unsecured claims, meaning such claims likely will be paid pennies on the dollar, rather than in full. Additionally, such claims are limited (the "cap") under the Bankruptcy Code, as follows: a rejection damage claim may not exceed the sum of (a) any amounts owed at the time of the bankruptcy filing, plus (b) the greater of (i) the rent due under the lease for one year, or (ii) 15% of the rent due under the lease for the remaining term, but not to exceed three years of the future rent reserved by the lease in question. Also, courts in many jurisdictions require a landlord to apply the amount of any security deposit or letter of credit proceeds to reduce the claim after first applying the cap. Therefore, for example, if security held by a landlord exceeds the amount of the capped claim, the landlord will be required to turn over any excess amount to the tenant. Also, the rejection damage claims are subject to other factors, including whether operating expenses can be included in the claim and whether payments to statutory lienholders can be recouped and offset against any security.

It is important not to miss a deadline for filing a proof of claim. In Chapter 11, the failure to timely file a proof of claim will result in the disallowance of the claim, and in Chapter 7, in the subordination of the claim to the claims of all creditors who have timely filed their proofs of claim.

In addition to assumption or rejection, the Bankruptcy Code provides that a tenant may assume and then assign its interest in a lease despite provisions restricting assignment; as such provisions are unenforceable under Section 365 of the Bankruptcy Code. Upon assignment, a tenant is released from future liability under the lease.

The Bankruptcy Code provides landlords with certain protections regarding any proposed assumption or assumption and assignment. First, the tenant must provide proof that a proposed assignee will have the ability to perform the tenant's obligations under the lease. Second, the tenant must cure, or provide proof it will cure, all monetary defaults and pay damages for non-monetary defaults as a prerequisite to the assumption and assignment. Third, shopping-center landlords are afforded additional protections including limitations on potential assignees.

THE AUTOMATIC STAY. Once a tenant files for bankruptcy relief, the landlord's right to evict the tenant or exercise other rights and remedies is prohibited, absent a grant of relief from the presiding court. Fundamentally, the automatic stay, found in Section 362 of the Bankruptcy Code, serves to prohibit all actions to collect from a tenant or to act against property of a tenant or its bankruptcy estate, without permission from the presiding bankruptcy judge. Generally, the stay will remain in effect to prevent a landlord from exercising rights and remedies, so long as the tenant continues to be the subject of a bankruptcy case and a lease has neither been rejected nor assigned to a third-party assignee.

UNENFORCEABLE LEASE PROVISIONS. Provisions placing restrictions on assignment of the lease are unenforceable under Section 365 of the Bankruptcy Code. Use clauses, continuous operation clauses, and the like have been held by bankruptcy courts to be unenforceable restrictions on assignment and have been written out of leases to permit a debtor/tenant to assign its interest to a third party. The Bankruptcy Code further restricts the ability of a landlord to take action by voiding ipso facto default provisions commonly found in commercial leases (i.e., default based on the tenant's insolvency, financial condition, bankruptcy, or the appointment of or taking possession by a bankruptcy trustee or custodian). Thus, a tenant's interest in an unexpired lease may not be terminated or modified after a bankruptcy filing, and any right or obligation under such lease may not be terminated or modified at any time after the commencement of a tenant's case, solely because of such events.

CONCLUSION

A tenant's bankruptcy sets into motion a complex chain of events that has far-reaching effects on a landlord's rights under its lease agreement with the tenant. The landlord should be aware of how a tenant's bankruptcy will affect its rights under its particular lease. Landlords with financially distressed or bankrupt tenants would be well advised to have an attorney assess what steps should be taken to protect the landlord's interest, both before and after the tenant files for bankruptcy protection.

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Sidney Turner LLC offers Chapter 11 Bankruptcy, Business Restructuring, and Debt Workouts to corporations, small businesses and startups across South Florida and New York.