Introduction
Despite the parties’ best intentions at the beginning of a commercial lease, landlords will inevitably encounter tenants in financial distress. Ultimately, some tenants will seek protection in bankruptcy, whether to restructure their ventures or wind down operations in an orderly process.
Bankruptcy affords a commercial tenant significant rights and protections but also imposes financial obligations and deadlines for lease-related business decisions. Likewise, a tenant’s bankruptcy significantly restricts a landlord’s ability to pursue its rights and remedies under the lease and applicable law. This article provides an overview of the bankruptcy process related to leases, explains the parties’ rights and obligations, and offers suggestions regarding how landlords can minimize their entanglement in bankruptcy proceedings and the accompanying delays and costs.
Bankruptcy Basics
When a corporate entity files for bankruptcy, it typically files either a Chapter 7 or Chapter 11 case.
In a Chapter 7 bankruptcy, the entity elects to liquidate its business, meaning that the bankruptcy court will appoint a Chapter 7 trustee to gather the entity’s assets, liquidate them, and pay creditors according to each creditor’s priority under state law as modified by the Bankruptcy Code. Importantly, in Chapter 7, the tenant loses control of the business, which will ultimately cease to exist as a going concern.
In contrast, in a Chapter 11 bankruptcy, the business plans to reorganize its finances and debts under the supervision of the bankruptcy court. Normally, the business intends to emerge from bankruptcy or sell its assets as a going concern and continue to operate under existing management as debtor-in-possession during its bankruptcy proceeding. Thus, a Chapter 11 bankruptcy provides the business “breathing room” to halt creditor activities and repay its creditors over time.
What Happens When a Tenant Files Bankruptcy: The Automatic Stay
Once a commercial tenant files a bankruptcy petition, an “automatic stay” immediately goes into effect. The automatic stay prohibits the tenant’s creditors — including its landlord — from taking any action to enforce its rights against the tenant or the tenant’s property (known as the “property of the estate”) without the bankruptcy court’s approval, including actions to collect the tenant’s pre-petition debts. A landlord may not send a demand or default letter to the tenant, file an eviction action to remove the tenant from the leased premises, or sue a tenant outside of the bankruptcy court for unpaid rent. What constitutes “property of the estate” is broadly construed and includes all legal and equitable rights of the tenant. The tenant’s bankruptcy filing protects both the tenant’s contractual rights under the lease and the tenant’s possessory interest in the leased premises. Significantly, any creditor that knowingly violates the automatic stay can face severe financial consequences, including paying the tenant’s attorneys’ fees or potentially punitive damages.
Many landlords mistakenly assume that lease provisions stating that a tenant’s bankruptcy automatically constitutes an event of default entitle them to pursue their rights. However, such lease provisions — known as ipso facto provisions — are not enforceable in bankruptcy.
If a Landlord Cannot Evict or Sue a Bankrupt Tenant, What Can a Landlord Do?
Bankruptcy provides for an orderly assembly of the debtor’s (i.e., the tenant’s) assets for distribution and/or repayment in liquidation or through a Chapter 11 plan. To seek repayment of amounts owed, the debtor’s creditors can file a “proof of claim” in the bankruptcy court. This proof of claim notifies the bankruptcy court, tenant, and other interested parties of the amount the creditors claim they are owed.
Notably, although the automatic stay takes effect immediately upon the tenant’s bankruptcy filing, that automatic stay does not apply to any lease guarantors. Therefore — if the guarantors have not also filed their own bankruptcy — a tenant’s bankruptcy filing does not prevent the landlord from suing a guarantor for past due rent or other amounts owed.
What Obligations Does the Tenant Have?
Fortunately for landlords, a tenant’s bankruptcy filing does not release a tenant from most of its contractual obligations. In the commercial lease context, if a tenant wishes to remain in possession of the premises, it must timely pay all rent accruing after the filing of the bankruptcy petition in full and on time. Also, depending on the jurisdiction, and assuming the tenant does not file for bankruptcy on the first day of the month, the tenant may also be required to pay “stub rent” (i.e., the prorated rent for the rest of the month during which the tenant files its bankruptcy petition) with the full rent due on the first due date following the bankruptcy filing.
Frequently, a bankrupt tenant will shirk its statutory obligations to pay post-petition rent as it comes due. Therefore, it is critical that landlords monitor a tenant’s bankruptcy case to ensure that a tenant pays all amounts accruing after the bankruptcy filing on a timely basis and not let those amounts escalate. However, a landlord may only demand payment of amounts that accrue after the tenant files bankruptcy (known as “administrative expenses” or “post-petition debts”). This concept sounds simple, but, in the context of a commercial lease, that is not always the case. For example, prior-year triple net reconciliation amounts due after the bankruptcy filing will likely be considered “pre-petition debts” if they accrued before the bankruptcy filing.
If the tenant fails to timely pay post-petition debts, a landlord may seek relief from the automatic stay or ask the bankruptcy court to compel the tenant to reject or assume the lease on a more expedited basis or to terminate the lease and evict the tenant. Importantly, a landlord must seek the bankruptcy court’s permission to pursue its remedies if a tenant defaults on its post-petition obligations. The fact that the tenant fails to pay post-petition rent does not, standing alone, authorize the landlord to pursue its remedies. This process – seeking relief from the automatic stay – typically takes 30 to 60 days, depending on the relief sought and the bankruptcy court’s schedule and protocols.
What Options Does a Tenant Have in Bankruptcy?
Generally, a tenant has three options with respect to a commercial lease:
- Reject the lease;
- Assume the lease; or
- Assume and assign the lease.
In a Chapter 11 bankruptcy, a tenant has 120 days to file a motion to assume or assume and assign the lease. This period may be extended for 90 days “for cause,” which bankruptcy courts grant liberally. If the tenant fails to assume the lease within this period, the lease is deemed rejected. Further, a tenant may assume or assume and assign the lease as part of a Chapter 11 plan. In a Chapter 7 bankruptcy, the trustee must elect to reject or assume and assign the lease within 60 days. If it fails to do so, the lease will be deemed automatically rejected.
A tenant rejects its lease if it no longer wishes to or cannot afford to occupy the leased premises. Rejection is tantamount to termination of the lease, and the landlord is left with a “rejection damage” claim for the damages caused by the tenant’s repudiation of the lease. However, a landlord’s claim for rejection damages is, by operation of law, considered a pre-petition claim (which is of lower priority than a claim for pre-rejection, post-petition rent), and is capped at the greater of:
- One year’s worth of rent; or
- 15% of rent for the remaining lease term not to exceed two years of rent.
Rejection damage claims are also subject to mitigation of rent defenses where applicable.
Alternatively, a tenant may elect to “assume” the lease, effectively notifying the bankruptcy court and the landlord that it wishes to remain in possession of, and operate its business in, the premises. To assume the lease, the tenant must:
- Promptly cure all monetary defaults and all curable non-monetary defaults in full;
- Compensate the landlord for any other monetary losses the landlord has suffered (this may include attorneys’ fees); and
- Provide the landlord with “adequate assurances of future performance” (i.e., demonstrate that it is reasonably likely that the tenant can satisfy its lease obligations prospectively).
Notably, bankruptcy courts vary dramatically in how they define what constitutes a “prompt” cure. Typically, most bankruptcy courts require a cure to take place within two years. However, the requirements within the timeline can vary — some necessitate an immediate cure upon assumption, and others allow the cure to take place over that entire period.
Lastly, the tenant may “assume and assign” the lease notwithstanding a lease provision restricting assignment, which is similar to the assumption option but involving a third party who “steps into the tenant’s shoes” as an assignee and satisfies the tenant’s obligations going forward (after all pre-petition debts are paid in full). Normally, a tenant is only likely to assume and assign the lease if it had been paying market rent or below-market rent before the bankruptcy filing. Tenants are often unsuccessful in finding a willing assignee if the tenant was paying above-market rent. In those circumstances, the tenant and the potential assignee may use the landlord’s fear of lease rejection (i.e., losing the tenant and being saddled with a capped claim with a low priority and little, if any, recovery) as leverage to entice the landlord to agree to concessions, including reduced rent, rent abatement, and modifications of other key provisions, making the lease more attractive to the proposed assignee.
What Can Landlords Do to Avoid or Minimize a Bankruptcy Entanglement?
If a tenant in default has threatened to file bankruptcy — or if a landlord has grounds to believe that a tenant in default might do so — the lease may afford several options. Most commercial leases provide three primary remedies following default (and any applicable notice-and-cure period):
- Termination of the lease;
- Termination of the tenant’s right of possession to the premises without terminating the lease; and
- A lawsuit for damages without seeking possession of the premises.
If a landlord terminates the lease, it will forgo all future rents and obligations following the termination date (or, if later, the date of surrender). The tenant remains liable for all amounts due under the lease through the date of termination. If the tenant refuses to vacate the premises notwithstanding termination, the landlord must pursue eviction.
If a landlord terminates the tenant’s right of possession without terminating the lease, the tenant’s obligations will continue to accrue, even though the tenant will lose possession of the premises. Thus, a landlord may pursue both amounts owed prior to the date on which it terminates the tenant’s right of possession and future rents that accrue. However, if the tenant refuses to surrender possession of the premises, the landlord must still pursue eviction. This option may be attractive when the lease involves a creditworthy tenant and/or guarantor.
If a landlord files a lawsuit for the sole purpose of recovering damages, no eviction is necessary because the landlord is not seeking to recover possession.
In each case, if a tenant files bankruptcy, the automatic stay halts all legal proceedings. However, the long-term effects of the bankruptcy filing differ depending on the remedy the landlord has elected.
Where a landlord has either terminated the tenant’s right of possession without terminating the lease or filed a lawsuit for damages without seeking possession, the automatic stay prohibits the landlord from continuing the legal proceedings. Instead, the landlord must seek to recover damages (and recover possession of the premises if the landlord has terminated the tenant’s right of possession) under the direction of the bankruptcy court. And, again, the tenant may reject, assume, or assume and assign the lease — and in Chapter 11 could have as many as 210 days to make its election.
Conversely, if the landlord terminates the lease before the tenant files bankruptcy, the tenant’s contractual leasehold interest does not become an asset of the debtor’s estate. Consequently, the tenant has no right to reject, assume, or assume and assign the lease. If the tenant has not vacated the premises before filing bankruptcy, the landlord must still obtain relief from the bankruptcy court to pursue eviction, but its ability to do so will be less restricted and less time-consuming (usually less than 30 days) than if the landlord has only sought to terminate the tenant’s right of possession.
Where a tenant is in default beyond any applicable notice and cure period and its bankruptcy filing is imminent, a landlord should strongly consider terminating the lease, especially if it has no desire for the tenant (or its assignee) to remain in possession long-term (typically where the lease is below market and a higher rent is obtainable or the landlord is confident it can relet the premises quickly with minimal or limited tenant improvements). Again, although it will forgo recovery of future rents, the landlord will prevent the lease from becoming property of the estate and the prospect that the tenant will be able to assume the lease or assign it to a replacement tenant over whom the landlord has no meaningful right of refusal. In short, by terminating the lease before the tenant files bankruptcy, the landlord limits its entanglement in the bankruptcy process and minimizes the associated costs and delay.
Conclusion
By design, bankruptcy provides a commercial tenant with significant protections. Its creditors — including its landlord — must immediately halt efforts to recover damages and will be constrained by the automatic stay. Lease provisions dictating that a bankruptcy filing constitutes an event of default or that the lease may only be assigned to a third party with the landlord’s consent are expressly unenforceable. However, with those protections come obligations for the tenant, as it must pay post-petition rent in full and on time and comply with its other obligations under the lease. Further, the tenant has somewhat limited time to elect whether it will reject, assume, or assume and assign its lease. If a tenant has threatened to file bankruptcy — or if there are grounds to believe that it may do so — the landlord must understand its own rights and obligations, as well as the economics of the lease. With the assistance of experienced counsel, landlords can avoid or minimize entanglement in the bankruptcy proceedings and maximize their long-term flexibility and recoveries with respect to the leased premises.
