What Commercial Landlords Can Expect When a Tenant Files for Bankruptcy
Every year – pandemic or no pandemic – countless businesses shutter their doors and seek bankruptcy protection. Many, if not most, of these businesses lease their premises, meaning commercial landlords across the country face the difficulties that result from severely diminished cash flow and unoccupied spaces.
As such, commercial landlords need to understand their rights, limitations, and options when a tenant closes up shop and files for bankruptcy during the term of a current lease. Acting quickly and strategically can help lessors mitigate losses and position themselves for positive outcomes. Conversely, taking steps that violate the automatic stay or otherwise run afoul of the Bankruptcy Code’s provisions governing commercial leases could make a difficult situation even more challenging.
Bankruptcy Code Section 365: Assume, Reject, or Assign?
Section 365 of the Bankruptcy Code addresses the treatment of commercial leases in bankruptcy proceedings. Since a commercial landlord’s hands are tied and remedies limited, at least initially, by the automatic stay, the ball starts in the tenant’s court.
After filing its bankruptcy petition, a tenant generally has 120 days to choose between three options regarding their existing lease:
- Assume the lease.
- Reject the lease.
- Assume and assign the lease.
For cause, the bankruptcy court can extend the 120-day deadline for assuming/rejecting/assigning the lease for an additional 90 days without the landlord’s consent. However, the landlord will need to agree to any requests for a further extension.
During this time, the debtor tenant must meet its obligations under the lease, including payment of rent, with post-petition rent obligations entitled to priority as an administrative claim. The bankruptcy court can temporarily defer the tenant’s rent obligations for a maximum of 60 days after the bankruptcy petition is filed. Importantly, the landlord must also meet its lease obligations during this time or risk violating the automatic stay.
If the tenant neither assumes nor rejects a lease within the applicable period, the lease is deemed rejected, and the tenant will be required to immediately vacate the leased premises.
Assumption of the Lease
If the tenant decides to assume their lease, they essentially agree to continue the lease and satisfy their tenancy obligations going forward. A tenant assuming the lease must cure any defaults, compensate the landlord for “any actual pecuniary loss” resulting from the debtor’s breach, and “provide adequate assurance of future performance.”
Rejection of the Lease
A debtor that does not want to retain its lease can reject it. This essentially acts as a breach of the lease requiring the tenant to vacate the rented space. Upon rejection, the landlord can assert a “rejection damage” claim, which will be treated as a prepetition unsecured claim—sharing pro rata with other general unsecured creditors. However, unlike other rejection damage claims, the landlord’s rejection damage claims are capped by §502(b)(6) to one year’s rent or 15 percent of the rent for the remaining term of the lease up to three years, whichever is greater.
Assumption and Assignment of the Lease
Despite any anti-assignment provisions in the lease and notwithstanding any objection by the landlord, the tenant debtor can choose to assume the lease and assign it to a third party. To do so, the debtor (and third-party assignee) must cure any defaults and adequately assure future performance by the assignee. The Code allows a landlord to request and require a deposit or other security from the assignee equal to what it would have initially required from a similar tenant when it entered into the lease.
Additional Protections for Lessors of Shopping Centers
The Bankruptcy Code provides special protections for shopping center landlords where the tenant chooses to assume or assign the lease. Specifically, Section 365(b) requires debtors and assignees to provide all of the following as part of their “adequate assurance of future performance” of their lease obligations:
- Assurance that the reorganized tenant (or assignee) will have at least the same ability to pay rent as the initial tenant at the start of the lease.
- Assurance that any “percentage rent” due will not decline substantially.
- Assurance that the assumption or assignment of the lease will be subject to the requirements in the lease regarding radius, location, use, or exclusivity and will not breach any such provision contained in any other lease, financing agreement, or master agreement relating to the shopping center.
- Assurance that assumption or assignment of the lease will not disrupt any tenant mix or balance in the shopping center.
Failure to provide such assurances can support a landlord’s objection to any assumption or assignment of the lease.
Planning for Insolvency in the Lease Terms
The very real threat of tenant insolvency and bankruptcy and the financial fallout that results are why many commercial landlords ask for a personal guarantee as part of their lease agreements. So long as the guarantor has not filed for bankruptcy, the automatic stay in the tenant’s bankruptcy proceeding should not preclude the landlord from pursuing its remedies under the guaranty. Additionally, any claims against a guarantor are not subject to the caps on rejection damage contained in Code Section 502(b)(6).
Similarly, a letter of credit can also provide such security if a tenant bankruptcy occurs. Since a letter of credit is not property of the debtor’s bankruptcy estate, a landlord may draw down on the letter without regard to the automatic stay.
Any commercial lessor concerned about a tenant’s potential insolvency or pending bankruptcy should consult with experienced bankruptcy counsel to ensure their interests are protected.