Bankruptcy and Real Estate Lease
Impact of Bankruptcy on a Real Estate Lease
A bankruptcy filing by either a lessor or a lessee has the potential of severely disrupting the rights and obligations of the parties under that lease. This observation is neither surprising nor shocking, but bankruptcy's impact on a commercial lease relationship can be disconcerting and potentially very frustrating to a party or an attorney not aware of the bankruptcy implications.
This outline is not designed to be the definitive dissertation on this issue. Instead, it is intended to provide a framework so that an individual will have a general understanding of how bankruptcy impacts on a lease relationship while simultaneously highlighting for that individual pertinent and material code sections.
Though this outline will alert you to general issues and suggest certain strategies, it is not recommended that an individual or non-bankruptcy attorney delve into this area of the law, at least for the first time, without the assistance of a lawyer who normally practices in Bankruptcy Court.
The Impact of the Bankruptcy Abuse Prevention and Consumer Protection Act (the "Reform Act")
With very few exceptions, the recent changes in the law were enacted to discourage both individuals and companies from filing for bankruptcy protection, and this proposition pertains to a tenant seeking bankruptcy protection as well. Since the Bankruptcy Code was modified because of a perception that bankruptcies were being filed unnecessarily and were abusive, the reduction of debtors' rights under the Reform Act was to be expected.
Probably the best-known and most notorious change in the Bankruptcy Code is found under 11 U.S.C. §365(d)(4), which is the section addressing when a debtor must assume or reject a lease upon filing for bankruptcy protection. Under the old law, a debtor must have decided whether to assume or reject an unexpired lease on business property within sixty (60) days after the bankruptcy filing. The Court could extend the sixty (60) day period "for cause," and no limit existed on the number or length of extensions that the Court could grant Debtors, particularly in retail cases involving numerous leases, received periodic extensions from the Bankruptcy Court, often continuing until Plan Confirmation. The Reform Act changes the initial period for a debtor/lessee to determine whether to assume or reject an unexpired lease on non-residential real property to one hundred twenty (120) days, but the period can be extended by ninety (90) days only once without the consent of the lessor. This is a significant change in leverage favoring real property lessors since it requires debtors to decide relatively quickly which leases to assume or reject, thereby threatening the viability of retail restructurings.
Attached, as Appendix 1, is the pertinent section of 11 U.S.C. §365, as modified. This change is so significant that no one at this juncture is comfortable predicting the ultimate impact it may have on companies filing for bankruptcy with multiple locations. Debtors will now have to conduct an expeditious analysis of whether to assume leases, which could very well impact on when certain companies seek bankruptcy protection. Actually, in certain instances, businesses may delay seeking bankruptcy or not file at all knowing that it may not be in a position to reach a decision on whether to assume or reject leases within the time period mandated under the new law.
In certain instances, the tenant's rights to protection by the automatic stay of 11 U.S.C. §362 may be limited under the new law, but that discussion will be reserved for Section C of this outline.
How a Bankruptcy of a Tenant Can Affect a Lease
This outline will delve into more detail as to the specific ways a tenant's bankruptcy filing can affect a lease, but some general observations will be delineated now as a preview to those sections.
The vast majority of this outline will focus on what happens when a tenant files for reorganization, either under Chapter 11 or 13. Little attention will be paid to Chapter 7 filings because, since the debtor is not seeking reorganization under Chapter 7, even though the automatic stay will normally be invoked by the bankruptcy filing, the non-filing party to the commercial lease should be entitled to prompt stay relief as a matter of law. Stay relief will be granted if, 1) the debtor is an individual and was a multiple filer, or 2) by motion for cause, or 3) automatically if the trustee has not assumed the lease within one hundred twenty (120) days of the bankruptcy filing. However, as a practical matter, since Chapter 7 trustees want to minimize administrative claims, and the rent that accrues prior to assumption or rejection of a commercial lease is entitled administrative priority, most Chapter 7 trustees will immediately move to reject valueless leases.
If a tenant is in default under a lease, the tenant's bankruptcy filing prevents the landlord from taking any further action against the tenant without Bankruptcy Court permission. The exception is if the tenant's rights have been terminated under applicable state law either by a proper lockout or the entry of a forcible entry and detainer judgment. In those cases, the Bankruptcy Code provides that the landlord is entitled to possession though even after locking out a tenant or obtaining a judgment in such instances, some cautious landlords still seek stay relief just to be safe.
Another often overlooked impact of a tenant's bankruptcy filing involves the landlord's lien rights. Because a landlord's lien is a statutory right, a bankruptcy trustee or debtor in possession has the right to set aside that lien for the benefit of creditors generally. This can be disastrous to a landlord, which is owed large amounts of money in unpaid rent and was hoping to recoup those losses by means of the enforcement of its landlord's lien. The landlord will find itself being treated as a general unsecured creditor as to pre-petition rent once the bankruptcy trustee or the debtor in possession exercises its avoidance rights.
Now let's talk about the specifics of bankruptcy and commercial leases.
Effect of the Automatic Stay
In the preceding section, the general rule regarding the automatic stay was overviewed. When a tenant files for bankruptcy protection, the landlord must stop all action except if, under state law, the tenant no longer has any possession rights. And, even in that situation, landlords will oftentimes seek stay relief just to be safe.
When a lessee files for bankruptcy protection, the landlord should cease all action and quickly review the lessee's bankruptcy filing and ascertain as quickly as possible the debtor's intentions. First of all, the debtor has to continue paying rent post-petition. Though the Code provides that in certain instances the debtor can request an extension of time to perform post-petition, lessees need to assume that such consent will rarely be granted, and the debtor should be financially able to immediately start paying rent. If the lessee does not, then the landlord should immediately seek stay relief. The bankruptcy law provides that the debtor must perform its post-petition obligation to pay rent and failure to do so constitutes grounds for stay relief. If the debtor does not assume or reject the lease within one hundred twenty (120) days of the bankruptcy filing, and does not otherwise obtain an extension, then the debtor must immediately surrender the premises to the landlord. Once again, as in the case of leases terminated pre-petition, whether the landlord needs stay relief at that junction depends upon how aggressive the landlord wants to be. Most landlords will still seek stay relief in that case since if a landlord does not and it is then determined that the landlord did not have the right to seize the premises, it will be liable for potentially staggering amounts for violation of the automatic stay.
Finally, even though commercial leases are most commonplace in business cases, it is important to understand that in situations in which individuals who have previously filed bankruptcy seek Bankruptcy Court protection, the Reform Act may limit the applicability of the stay. Specifically, the protection of the automatic stay is lost sixty (60) days after the filing of a second bankruptcy case within one year unless an extension is granted, and the debtor may not be entitled to the protection of the automatic stay at all if it has filed two or more cases within one year of the most recent filing. See 11 U.S.C. §362(c)(3) and (4) Appendix 2.
Requirements for the Assumption of Leases
If a debtor/lessee wants to assume a lease, besides paying post-petition rent on a timely basis, it must cure its pre-petition default within a reasonable time and provide the landlord with assurance of future performance. What constitutes a reasonable time is normally within the sole discretion of the bankruptcy judge, although the court will allow a debtor wide latitude if the debtor can show that it is paying post-petition rent and the landlord is not prejudiced by having to wait for the cure payments.
Being able to demonstrate reasonable assurance of future performance is a little more challenging, but if the debtor timely pays post-petition rent and shows it is making progress in its reorganization efforts, the Bankruptcy Courts will be disinclined to prevent a debtor lessee from assuming a lease.
However, as previously explained, the days of lessees being able to extend the assumption deadline for many many months and even years are over, and debtors will now have to make that decision relatively quickly, even in complicated cases. Presumably, because the time to decide is now so short, judges may actually become more tolerant and grant lessees even more latitude in assuming leases since debtors will oftentimes have to make such decisions much more quickly than under previous law.
Rejection of the Lease and Limitations on Damages Resulting From Rejection of Unexpired Lease
In many bankruptcy cases, a company specifically files for bankruptcy protection to rid itself of troublesome and/or expensive leases. Two relatively famous Arizona cases, the America West and Circle K filings, were, at least in part, prompted by those companies' need to dispose of financially draining lease obligations. And, in both situations, once those leases were shed, the debtors were able to reorganize.
11 U.S.C. §502(b)(6) provides that in such situations, the landlord shall have a claim for 1 year's rent or 15% of the amounts remaining due under the lease (not to exceed three (3) years), whichever is greater. See Appendix 3. This, of course, assumes that the landlord cannot otherwise mitigate its damages. Though in certain instances, the amounts that are consequently owed by the debtor can be substantial, the claims are general unsecured claims and not entitled to priority. Without a bankruptcy filing, if the debtor defaults under those same leases, it presumably would face substantial judgments and seizure of its assets, which could disrupt or destroy the debtor's business operations.
A change in the law imposed by the Reform Act provides that if the debtor assumes a lease and then defaults, then the landlord is entitled to an administrative claim for up to two (2) years of lease payments. 11 U.S.C. §503(b)(7). See Appendix 4. The landlord's claim in this situation is very powerful and potentially devastating to the debtor because the debtor will not be able to confirm its plan without payment of administrative claims in full. Because the assumption of a lease by a tenant effectually converts what may be an innocuous unsecured claim into an all powerful administrative claim, debtors have to be very careful in deciding which leases to assume. Moreover, under the Reform Act, that decision has to be made quickly.
Negotiating with a Financially Troubled Landlord
Now let's spend a few moments considering what concerns a tenant should have if it suspects that its landlord may be contemplating bankruptcy.
Though the Code provides that a tenant is entitled to the benefits of the lease if its landlord files for bankruptcy protection and the lease is rejected by the landlord, if the lease has not commenced at the time of the bankruptcy filing, the tenant is simply entitled to a damage claim. This can place a tenant in a very awkward position, especially if it was contemplating taking possession of the premises just to discover that its landlord has filed for bankruptcy protection. And, even if the lease has commenced, the tenant may now find itself dealing with a landlord which has difficulty performing under the lease.
As a practical matter, the lessee needs to be sensitive to the possibility that the landlord may not be able to timely make its mortgage payments. This can be extremely perilous for a tenant since a foreclosure of the lessor's interest could wipe out the leasehold interest as well. The lessee could find itself out on the streets even after signing a long-term lease with a lessor which has lost its interest in the building.
To avoid that unpleasant result, the lessee could approach the lienholder on the building and have the lienholder agree that the lessee's interest will not be impacted by any subsequent foreclosure. This approach is actually practical in situations in which the lessor's financial difficulties are well known and the lessor consents to a prospective lessee communicating with the leinholder.
A lessee in that situation also wants to be careful not to commit large sums of money for the lease in case the lessor defaults. The lessee would not want to pay a large deposit or invest a substantial amount of money in tenant improvements unless, once again, a lender on the property agrees to otherwise honor that financial commitment. Or, the lessee could require that the lessor place any money into a segregated trust account for the benefit of the lessee. Though there is no guarantee that the lessor may not try to circumvent any such arrangement, taking such steps will at least maximize the chances that the lessee's monies could be returned upon the lessor filing for bankruptcy or being foreclosed. Regardless of what precautions may be taken, a lessee contemplating entering into a landlord/tenant relationship with a financially troubled lessor should hesitate to do so unless the lessor fully cooperates and the lender participates in the process.
What about the situation in which the landlord experiences financial difficulties in the middle of the lessee's lease term? In that case, the lessee would want the lessor to grant permission for the lessee to contact the lender for the reasons just outlined. If the lessor refuses, then the lessee could be placed in a perilous situation. Unfortunately, besides taking steps to be prepared for the possibility of the owner being foreclosed upon or not being able to perform timely because of a bankruptcy filing, the lessee may simply be in a vulnerable position. Presumably, the lease negotiated by the lessee does not grant the lessee any protections in instances in which the lessor may be suffering financially and therefore the lessee's recourse is limited.
Though the lessee's options may be few, the lessee needs to make sure in such a situation that it does not increase its potential vulnerability. For example, the lessee would not want to pre-pay rent even if provided with incentives by the lessor to do so nor would the lessee want to increase its potential commitment to the leasehold space, unless the lender consents to such an arrangement and agrees to honor the lessee's leasehold rights.
If because of financial problems, the landlord's ability to perform becomes impaired, the lessee may want to consider withholding a portion of the lease payment as a setoff for the landlord's impaired performance. However, doing so can be extremely risky because the lease may not allow such conduct and the lessee may find itself being locked out or subject to eviction proceedings because of an unauthorized setoff of lease payments.
In summary, if a struggling landlord is dealing in good faith, there are steps a lessee can take to minimize its exposure, but if a landlord is trying to exploit the situation, the lessee could find itself literally "stuck between a rock and a hard place."
Tenant Remedies Against a Bankrupt Landlord
11 U.S.C. §365(h)(1)(A),(B),(C), and (D) spell out the tenant's rights in a situation in which the landlord rejects the tenant's lease. See Appendix 5. The Reform Act has not altered these rights. If the lease has commenced, then the lessee may remain as a tenant, but possesses certain setoff rights and statutory protections. Basically, the Bankruptcy Code maintains the status quo for the lessee but also grants it certain rights that presumably are not granted to the lessee under the operative lease. However, as already explained, the lessee's main concern may be with its lessor's lender since a foreclosure can wipe out the lessee's lease notwithstanding the Bankruptcy Code or any understanding or agreement between the lessor and the lessee.
Bankruptcy Considerations During Lease Drafting
The Bankruptcy Code specifically renders unenforceable boilerplate provisions in commercial leases which provide that the lessee's rights as a tenant are cancelable or unenforceable upon the filing of the bankruptcy by the lessee. Nevertheless, there are certain steps a lessor can take to protect itself from a lessee's bankruptcy filing. And, there are certain precautions that a lessee can take even when dealing with what appears to be a financially solvent lessor.
A lessor would want to collect a large enough deposit to ensure that it has protection upon the filing of a bankruptcy by a lessee. It also wants a fair amount of flexibility as to what to do with that money in case it needs it for its reorganization efforts. A lessee should seek the exact opposite because the more money it has on account in the event its lessor files for bankruptcy, the more it has at stake.
Lessors obviously want to obtain guarantees from lessees. Lessees may want to request guarantees as well regarding the lessor's performance. Though the latter is very unusual, at the very least, the lessee wants to strike the common provision in leases that the lessor's liability under the lease is limited to the net value of the property. It goes without saying that if the lessor seeks bankruptcy protection, there is no net value for the lessee to access.
The lessee may want to negotiate language in the lease which allows it certain setoff rights or even the ability to terminate the lease if the lessor is suffering financially. Most leases are drafted by landlords and can include draconian provisions which require the lessee to traverse Herculean obstacles before it can exercise setoff rights under the lease. Try to include language which allows the lessee at least some recourse once the lessee has notice of the lessor's financial troubles.
Finally, in some instances, a lessor can even have a lessee post a performance bond. From the lessor's perspective, I cannot think of a more powerful tool since the lessor would be able to seek recourse against an independent bond upon the lessee's default and even if the lessee seeks bankruptcy protection.
Negotiating a Successful Workout
Normally, this issue arises when the landlord knows that its lessee is suffering but does not want to force the lessee into bankruptcy. Though sometimes the situation is reversed and the lessee is trying to work out an understanding with a landlord which is on the verge of bankruptcy, that scenario is relatively rare and discussed in earlier sections.
First of all, the lessor needs to be intimately familiar with the bankruptcy concepts of preferences and fraudulent transfers. These concepts are crucial in any workout because the lessor may demand additional security from its tenant to protect its position as part of a workout. For example, the lessor may request that the lessee grants it a security interest in business assets. Doing so is an effective tool to protect the landlord, but if the lessee then files for bankruptcy within ninety (90) days of the granting of that lien, the debtor in possession or a bankruptcy trustee can probably avoid that lien as being preferential. This does not mean that you should not take this step anyway since an avoidable lien is probably better than no lien at all, but a landlord should not otherwise prejudice itself and dig itself deeper into a hole just because it has been granted a lien on the lessee's assets.
A grant of additional security under the circumstances is not always preferential. If the lessor is granting concessions or considerations to a lessee simultaneously to the granting of the lien, then it can be argued that the contemporaneous exchange of value negates the preference problem. If this is attempted, then it is crucial to include specific language in an agreement delineating the exchange and consideration and reciting that the lessee received quantifiable value in return for granting the lessor the secured position.
As recommended earlier, the lessor should approach the lessee about providing 3rd party guarantees or even request additional deposits. Many times a lessee seeking to avoid bankruptcy will cooperate with a lessor in such circumstances.
The lessor needs to also conduct an in-depth analysis of whether it truly is better off if the lease is terminated. Many times, for a variety of different reasons, the lessor improves its situation by not working out a settlement with the lessee. In that case, though always risky, a lessor may even consider locking out a tenant since a proper lockout should terminate the lessee's leasehold rights under Arizona law whereas the filing of a forcible entry and detainer complaint does not. However, the landlord should always remember that, in most cases, the chance of being paid by forcing a tenant into bankruptcy are not good. Therefore, a landlord should not force the issue in this manner unless it is willing to absorb the cost of losing the tenant and probably not receiving any payment.
If all of this sounds complicated, it is. If all of this sounds precarious for the unwary or unsophisticated, you are correct. Even sophisticated bankruptcy attorneys find the myriad of rules and case law very daunting, and neophytes should be very cautious when entering the bankruptcy arena, either as a landlord's or a tenant's advocate.
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