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A Landlord’s Primer on Navigating a Tenant’s Bankruptcy

May 27, 2020

As the COVID-19 pandemic continues to shake the retail industry, certain retailers and other businesses dependent upon in-person customers will increasingly find themselves unable to pay their rent.  In some situations, a landlord may be able to work with such tenants for a long-term solution that allows the tenants’ businesses to survive.  But, in other situations, lease accommodations will simply not be enough and tenants will be forced to seek bankruptcy protection or otherwise liquidate their businesses out of court.

Set forth below are a handful of high-level considerations for landlords of distressed or defaulting commercial tenants.

Bankruptcy Stay

Once a tenant files for a bankruptcy, the Bankruptcy Code imposes an “automatic stay,” which, among other things, prevents a landlord from commencing an eviction action, continuing with a filed eviction action, or collecting unpaid rent outside of the bankruptcy claims process.  Unfortunately, even when a landlord acts quickly upon a tenant’s default, a tenant will typically be successful in timing a bankruptcy filing to prevent eviction if the property is needed to continue operations, or if its lease constitutes a material asset of the business. 

A landlord’s knowing violation of the automatic stay may result in damages and sanctions.  As a result, if a landlord is responding to tenants’ failure to pay rent, it should take care in the type of communication sent to a tenant that has filed for bankruptcy.

Ispo Facto Clauses

Leases often contain clauses that provide that the lease terminates upon a bankruptcy filing or insolvency.  These clauses, referred to as ispo facto clauses, are not enforceable in bankruptcy, except in very limited circumstances.  Thus, a tenant’s bankruptcy filing will generally not give a landlord the right to terminate the lease, even if the language of the lease provides otherwise.  

Pre and Post-Bankruptcy Obligations: Stub Rent

Under the Bankruptcy Code, a debtor is generally prohibited from paying amounts due and owing that arose prior to the bankruptcy (the amounts are referred to as “pre-petition” obligations).  Those pre-petition obligations instead are treated as claims in the bankruptcy case and the recovery on those claims is determined by a plan of reorganization.  Typically, unsecured pre-petition obligations are paid on a discount to face value.  In contrast, a debtor must pay obligations incurred after the bankruptcy case has been filed (referred to as “post-petition” obligations) in full. 

However, there is a split among the courts as to when rental and tax reimbursement obligations are deemed to arise.  One school of thought, referred to as the “billing date approach”, treats obligations as arising when a legally enforceable duty arises under the lease.   The other school of thought, referred to as the “accrual approach,” treats obligations as arising when there is a right to payment. Followers of this latter approach will prorate post-petition rent, regardless of the payment due date under the lease.

For example, if rent is due in advance of the first day of each month under a lease, and the tenant skips the payment for a month and files for bankruptcy on the 2nd day of the skipped month, then under the billing approach, assuming that the lease allows for notice and cure periods in the event of tenant’s monetary default, the entire month’s rent is a prepetition claim even though the tenant occupied the premises nearly the entire month in bankruptcy. 

Rejection or Assumption of a Lease

In bankruptcy, a tenant has the opportunity to assume or reject an unexpired lease. If the debtor/tenant assumes the lease (or assumes and assigns the lease), the debtor (or assignee) must cure all outstanding defaults, including payment in full of prepetition rent, and provide the landlord with adequate assurance of future performance. To protect landlords from uncertainty, a debtor tenant must elect to assume a lease within 120 days following the bankruptcy filing, or such tenant loses the right to so assume the lease.  That period can be extended for an additional 90 days for cause, and such an extension is routinely granted by bankruptcy courts if the debtor tenant is showing progress in its reorganization.  Moreover, in at least two recent bankruptcy cases, the courts have extended the seven-month assumption period given the impact of COVID-19 and the resulting inability of the debtors in those cases to evaluate their going-forward footprint.  We expect the courts to continue to show sympathy to similarly situated tenants, and for additional risks to be shifted to landlords.

The lease is deemed rejected if not assumed in the applicable period set by the bankruptcy court.  A landlord’s claim for damages upon rejection is treated as a general unsecured claim capped pursuant to the Bankruptcy Code. However, even if the lease is rejected, rental obligations due from the bankruptcy filing to the rejection date are treated as post-petition administrative claims and must be paid in full. 

Shopping Center Landlord Protections

The Bankruptcy Code provides some additional protection to shopping center owners.  While anti-assignment clauses and restrictions are typically invalidated in bankruptcy, a debtor tenant can only assign its interest in a shopping center lease if the restrictive use clauses and tenant mix and balance within the shopping center are maintained.  This protects the landlord and the other, non-debtor tenants alike.  In addition, the landlord must have assurance that any percentage rent will not decline substantially, and the lease will continue to be subject to all requirements in the lease, including use and exclusivity requirements.

Abandonment of Personal Property

Bankruptcy courts often authorize a debtor to abandon personal property when it rejects a lease and vacates the leased premises, regardless of what requirements are set forth in the lease for surrender of the premises.  The costs of removing any such property may become part of the landlord’s lease rejection damages claim.

Alternatives to Formal Bankruptcy

In certain circumstances, a defaulting tenant may not file a formal bankruptcy proceeding, but instead may pursue a distressed sale, allow its lenders to foreclose, initiate an assignment for the benefit of creditors, become subject to a receivership, or otherwise simply cease operations and walk away from a judgment-proof entity.  The enforcement of the existing lease and landlord considerations vary across these alternatives and jurisdictions in which they are implemented.

Ironically, as the stay home orders are lifted and the economy begins to open again, we expect an increase in formal bankruptcy filings as the courts reopen and stakeholders are able to more accurately evaluate their financial prospects.  Proactive and diligent action by landlords in reviewing their existing lease terms, and understanding their tenants’ financial positions and the potential impact of  bankruptcy filings are vital to ensuring maximum leverage and mitigating what could be very substantial losses for commercial landlords.

Please contact Erin Broderick, Kristen Boike, or one of the other attorneys in Honigman’s Real Estate Department or Restructuring and Insolvency Group for further information or guidance.