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Tenant bankruptcies are creating headaches for landlords. RadioShack. Brookstone. Toys R’ Us. Sears. With fifteen major retail bankruptcies filed last year in 2018, the toppled retail behemoth has almost become a cliché, and brands once courted by commercial landlords have become major sources of risk. With no sign of a slow-down, this article provides a refresher on your rights, as a commercial landlord, in commercial tenant bankruptcies.
Commercial Tenant Bankruptcies 101: THE BASICS
• Ipso facto clauses in a lease, which trigger default or acceleration upon the filing of a bankruptcy case, are generally unenforceable under the Bankruptcy Code. Thus, you cannot terminate a lease or stop performing your obligations under the lease on account of the bankruptcy filing.
• The filing of a bankruptcy case triggers the automatic stay, which requires all actions to enforce the lease, evict the tenant or collect a debt (including unpaid rent) to cease. Unless you have a judgment to possess the subject premises, or the lease has otherwise expired by its terms, you must not continue to pursue collection or enforcement activities.
• A commercial debtor may assume a lease and assign it to a third party, in most circumstances without your consent, even if the lease requires the consent of the landlord to assignment.
• A commercial debtor may reject a lease based on its business judgment, and you have very few (virtually no) grounds on which to object to a lease rejection.
Commercial Tenant Bankruptcies 201: WHEN WILL I GET PAID AND HOW MUCH?
The Bankruptcy Code requires bankrupt tenants to continue paying rent under the lease during the pendency of the case (post-petition rent). If a debtor does not assume a lease within 210 days of the commencement of the bankruptcy case, the lease is deemed rejected.
Depending on whether the lease is assumed or rejected and the financial health of the bankruptcy estate, rent that was unpaid as of the date of the filing (pre-petition rent) may be paid in full, in part or not at all. Tenants under assumed leases must cure all breaches under the lease, including to pay in full all unpaid pre-petition and post-petition rent and any damages incurred as a result of the breach of the lease. The cure amounts must be paid at the time the lease is assumed by the debtor or its assignee.
Landlords under rejected leases, on the other hand, are entitled to a claim against the bankruptcy estate, which, depending on the financial health of the debtor, may be paid in full, in part or not at all. While unpaid postpetition rent constitutes an administrative (or dollar-for-dollar) claim against the estate, all other pre petition rent and damages caused by the rejection of the lease constitute unsecured (often, cents-on-the-dollar) claims, and will be paid pro rata with other unsecured creditors. Further, while rejection damages include the amount of rent remaining in the life of its lease, damages are statutorily capped at the greater of one year of rent or the rent for 15% of the remaining term of the lease, not to exceed three (3) years. Landlords who successfully mitigate their damages and re-let the premises may not be entitled to any claim if the rent received under the new lease is greater than or equal to the rent under the existing lease. Payments on unsecured claims are typically paid, if at all, after the debtor has confirmed a plan of reorganization.
Commercial Tenant Bankruptcies 301: DO I HAVE TO ACCEPT A RENT REDUCTION?
Bankruptcy affords the debtor tenant a unique opportunity to re-negotiate its leases. On one hand, the Bankruptcy Code prohibits the debtor from cherry picking which provisions of a lease it wants to assume and which provisions it would like to reject; instead, the Code requires the debtor to assume or reject the lease in its entirety. On the other hand, many debtor tenants leverage the specter of potential rejection to obtain significant rent concessions from landlords. Rent reduction negotiations often begin in the pre-bankruptcy period and continue in the early days of the case, with landlords being told that failure to negotiate will result in certain rejection.
You do not have to negotiate with the debtor tenant or accept a rent reduction, though doing so may increase the possibility of the assumption of your lease. Debtor tenants are more likely to reject leases:
• Not essential to the continued operation of the business,
• With above-market rent,
• In areas saturated with other debtor locations, or
• With low-performing stores.
If your lease falls outside of these categories, then the debtor may assume the lease even without obtaining a rent (or other) concession.
Commercial Tenant Bankruptcies THE BIG PICTURE
As soon as a tenant shows signs of financial weakness, consider actively pursuing remedies under the lease, including termination or eviction proceedings. If the lease has expired or you have already obtained a judgment for possession when your tenant has filed for bankruptcy, tear up this article! (after confirming with your attorney that the lease is, in fact, properly terminated).
If the lease has not expired or terminated at the time of filing, be sure to engage bankruptcy counsel to review the proceedings and protect your interests in the case. Bankruptcy counsel will object to any insufficient cure amount, file a proof of claim for your damages and review any plan of reorganization to advise you of your
anticipated recoveries. Even though retail bankruptcies have become commonplace, sound counsel will ensure
that your rights are protected and help you get paid.
Finally, engage competent real estate professionals, who can provide an accurate assessment of current market
rent and assist in finding a replacement tenant to satisfy and requirement that you mitigate your damages
after rejection/termination of the lease.
The contents of this article are for informational purposes only and none of these materials is offered, nor should be construed, as legal advice or a legal opinion based on any specific facts or circumstances.
Let’s examine what you need to know about bankruptcy provisions in commercial leases. Each property is unique and every relationship has its own contours that will drive the path of commercial lease negotiations. While a lease cannot account for or predict every potential scenario in the course of a commercial landlord-tenant relationship, landlords can put themselves in a better position to weather a tenant bankruptcy by understanding the bankruptcy landscape, including which provisions will be enforced and which provisions will be ignored by bankruptcy courts.
Most landlords know that commercial bankruptcy cases generally take one of two forms: chapter 7 or chapter 11. In both types of cases, the automatic stay applies. In both types of cases, the commercial lease can be assumed, assigned or rejected within a finite period of time. A chapter 7 case is a liquidating case, while chapter 11 cases are typically reorganizations.
A tenant filing bankruptcy under chapter 7 will cease doing business. There, the court appoints a chapter 7 trustee to gather and liquidate assets and to distribute the proceeds to creditors. While the debtor tenant in a chapter 7 case is unlikely to continue the lease, the trustee may sell/assign a valuable lease to a third party. Negotiations in a chapter 7 case take place with the chapter 7 trustee, rather than with the debtor tenant.
On the other hand, a tenant filing a chapter 11 bankruptcy generally continues operations as a “debtor-in-possession.” The chapter 11 case typically culminates in a plan of reorganization, through which the debtor will outline its plans to fund payments to creditors, restructure debt and continue operations as the entity emerges from bankruptcy. Often, chapter 11 debtors seek to shed debt by rejecting above-market leases or leveraging the right to assume and reject leases by extracting rent concessions from landlords as a condition to lease assumption. Absent unusual circumstances, the court will not appoint a trustee, thus negotiations take place with the debtor tenant.
While a tenant bankruptcy filing shifts the balance of power to the tenant, defensively drafted leases may allow the landlord to retain some control and negotiating advantage after the filing of a bankruptcy.
7 Bankruptcy Provisions in Commercial Leases
(1) Tenant bankruptcy triggering lease termination
Bankruptcy provisions in commercial leases that would terminate a lease or modify other rights of a bankrupt party upon the filing of a bankruptcy petition are known as ipso facto clauses and are unenforceable under the Bankruptcy Code. Bottom line: Don’t waste your leverage trying to incorporate or keep an ipso facto provision in the lease.
(2) Waiver of the automatic stay.
The filing of a bankruptcy petition automatically triggers a stay of all activities to collect a debt, including efforts to obtain possession of property. To avoid the delay associated with the imposition of the stay, consider including a provision requiring the tenant to waive the protection of the automatic stay or a waiver of the right to contest a motion by the landlord for relief from the stay. The remedy, if enforced by a court, allows a landlord to obtain relief much sooner than it would otherwise be entitled, particularly because courts are reluctant to grant stay relief in the early days of a bankruptcy case. Bottom line: Whether this provision is worth fighting for depends on your jurisdiction. Not all courts will enforce a pre-petition waiver of the stay, and even if they will, the waiver will generally not be “self-executing”. The blessing of the court is needed. Therefore, to avoid the imposition of sanctions that accompany a violation of the stay (or the voiding of stay-violating activities), landlords with waivers in a lease should consult with counsel on filing the appropriate motion with the bankruptcy court before pursuing eviction or collection activities.
(3) Adequate Assurance Definition.
Under the Bankruptcy Code, in order for a bankrupt tenant to assume a lease, it must provide the landlord adequate assurance that it will meet its future lease obligations. The Bankruptcy Code does not define “adequate assurance”, but the parties can define the concept in the lease to narrow the issues in bankruptcy court litigation. Adequate assurance provisions often require the tenant provide assurances as to (i) the source of future rent, including that any assignee is similarly situated, financially, to the tenant at the time the lease was signed, (ii) the stability of the percentage rent, if applicable; and (iii) non-disruption to the tenant mix in the center or complex. Bottom line: A lease containing specific understandings of ambiguous bankruptcy concepts will carry greater weight with a court interpreting a tenant’s post-petition obligations to its landlord.
(4) Shopping Center Provisions.
While bankruptcy courts do not favor limitations or conditions on the assignability of a lease, shopping center leases receive special treatment and, as a result, shopping center landlords have greater leverage in post-petition assignment negotiations. Therefore, if a property can reasonably be considered a shopping center, including a provision indicating that the property is a shopping center may afford a landlord with additional leverage and protections. Any shopping center lease should require that any assignee of the lease in a bankruptcy adhere to exclusive use (or other use restrictions), co-tenancy and tenant mix requirements. Bottom line: Ensure that any
shopping center lease contains provisions that protect the future viability and maintain the integrity of the shopping center if a tenant lease is assumed and assigned in bankruptcy.
Cash may be king, but, generally, security deposits become property of the debtor’s estate once a bankruptcy petition is filed, limiting the setoff rights of a landlord and requiring motion practice in the bankruptcy court. A letter of credit, coupled with a lease provision allowing the landlord to draw upon it after default and without notice to the tenant, generally falls outside of “property of the estate” and therefore provides more ready access to cash to a landlord whose tenant has filed for bankruptcy. Bottom line: Securing the tenant’s obligations under the lease by collateral that falls outside the umbrella of “property of the estate” puts the landlord in a better position to recover costs when dealing with a tenant in bankruptcy.
A corporate parent or affiliate guaranty provides additional security for the tenant’s lease. Frequently, however, that guarantor often files bankruptcy at the same time as the tenant, and the landlord’s claim against the guarantor becomes one of many unsecured claims that will receive cents-on-the-dollar recovery. Personal guaranties from tenant equity holders may provide more protection because of the “skin in the game” and a reluctance of many individuals to file personal bankruptcy. Bottom line: The newer the business or the more limited financial history of your tenant, the more compelling a case for obtaining personal guaranties.
(7) Forecasting Trouble.
Bankruptcy provisions in commercial leases that require the submission periodic financial statements, balance sheets and cash flow statements from a tenant and any guarantors will allow a landlord to monitor the performance of its tenant. Leases containing financial covenants provide a mechanism for a landlord to call a default if financial performance declines. Having a heads-up to financial distress can allow the landlord to exercise remedies quickly and potentially in advance of any bankruptcy filing. The automatic stay does not apply to leases terminated pre-petition, so moving quickly to terminate in a distressed situation may give the landlord a valuable edge in regaining possession of the property outside of the bankruptcy court. Bottom line: The more you know about your tenant’s finances, the better you can react to a deteriorating situation, whether by exercising remedies or bolstering the security for the tenant’s obligations under the lease.
The contents of this article are for informational purposes only and none of these materials is offered, nor should be construed, as legal advice or a legal opinion based on any specific facts or circumstances.
Have questions about about bankruptcy provisions in commercial leases?
Commercial real estate players use letters of intent (LOIs) or term sheets all the time. Buyers and tenants present offers this way, often to see if a deal can be reached before incurring the costs of negotiating an agreement of sale or a lease (the Definitive Agreement). The key question is whether these agreements are binding or not. The legal principles are fairly easy to state: If the parties intend not to be bound to each other prior to the execution of a Definitive Agreement, the courts will give effect to that intent and the parties will not be bound until the agreement has been fully executed and delivered. This is true even if all issues in the negotiations have been resolved. Conversely, if the parties intend to be bound prior to the execution of a Definitive Agreement, the court will give effect to that intent, and the parties will be bound even though they contemplate replacing their earlier understanding with a later written agreement. Courts have consistently stated that the most important factor in determining whether or which provisions in an LOI are binding is the language used by the parties in the letters of intent themselves.
Typically, parties draft letters of intent to be partially binding. The letters of intent will contain provisions not intended to be binding and provisions expressly intended to be binding on the parties. The non-binding provisions consist primarily of the “deal points”, such as a description of the key components of a proposed transaction and any important conditions. For an agreement of sale, these include the purchase price, deposit, due diligence period, deal contingencies (e.g. financing, licensing and land use approvals), time for closing and broker payment obligations. For a lease agreement, these include the rental rate, security deposit, tenant allowance, responsibility for repairs and replacements, use and exclusivity terms, brokers and any unique arrangements. The binding provisions focus on the negotiation time period, including access to information, confidentiality, a “no-shop” or exclusivity provision in which the seller or landlord agrees not to sell or lease the subject property to another for a specified period of time, broker representations and protection and non-disclosure (to third parties) obligations. There should be a termination provision and natural end date for the life of the LOI.
The main purpose of typical letters of intent is for the parties to formulate deal points without committing to the actual transaction. Letters of intent provide counsel a blueprint for preparation of the Definitive Agreement, saving time and money. Letters of intent can keep the deal momentum moving forward while negotiating the details of a Definitive Agreement, especially when they contain milestones for delivering a draft and executing a final version. Moreover, an LOI may be necessary for a lender or investor to move to the next step of its process.
However, there are also potential risks in using LOIs. If inartfully drafted, or if the parties act as though they have reached a deal, the LOI may be deemed a binding contract, obligating the parties prematurely.
Further, many courts have found that execution of a letters of intent creates an obligation for the parties to negotiate, in good faith, a reasonable agreement, which may be an unintended consequence of signing. Another
possible disadvantage of using an LOI is that a party may share the letter with a competing bidder to shop the deal to see if they can get a better offer. Even worse, deal momentum may die while negotiating a trivial LOI provision for a simple transaction that could have gone straight to the Definitive Agreement.
Indeed it is often the case that conceptual agreement on the basic deal points will allow a buyer to prepare
an agreement of sale, without the need to incur the time and expense of negotiating letters of intent. But, for
the complex commercial transaction, an LOI can provide a necessary level of comfort prior to expending significant resources on investigations, inspections, analysis and negotiation of a Definitive Agreement.
If you use letters of intent, be clear and specifically describe the binding provisions, carefully distinguishing them
from the non-binding provisions. If there are no special conditions or complicating factors, go straight to the Definitive Agreement instead of preparing an LOI to avoid unintended consequences, such as a forming a contract or creating an obligation to negotiate in good faith.
The contents of this article are for informational purposes only and none of these materials is offered,
nor should be construed, as legal advice or a legal opinion based on any specific facts or circumstances.
Let’s take a look at New Jersey Construction Lien Law. For builders and contractors alike, the words “construction lien” can be anxiety inducing. Contractors, on the one hand, know that a lien can be a valuable tool for recovering outstanding money; however, the requirements of a New Jersey Construction Lien Law claim are not intuitive, and failure to strictly comply with statutory requirements may result in a waiver of lien rights. Owners, on the other hand, know that encumbrances, even wrongfully filed ones, may threaten the timing of a transaction and cause unforeseen expenses.
The New Jersey Construction Lien Law, N.J.S.A. § 2A:44A:1 et. seq. (“Lien Law”), contains many specific provisions and must be carefully followed. A few essential pointers are highlighted below.
New Jersey Construction Lien Law for Claimants:
1. The filing requirements for lien claims in commercial and residential projects are very different. For commercial construction projects, a lien claim must be filed in the county where the project is located within 90 days of the last date that work, services or material were provided to the project. For residential construction projects, a Notice of Unpaid Balance (“NUB”) is a prerequisite to the filing of a lien claim and must be filed within 60 days of the last date that work, services, or material were provided. There are numerous additional requirements that flow from these preliminary deadlines. Claimants must be cognizant of the type of job they are performing in order to ensure that they do not violate filing deadlines.
2. Be aware of the “last date” of work. Under the Lien Law, the “last date” on which work, services or materials were provided marks the date on which the clock starts ticking on a contractor’s right to file a lien. For practical purposes, contractors should interpret the “last date” as the date on which they achieve substantial completion. Contractors often mistakenly assume that because they were still “on the job,” that the clock did not start to run on their lien rights. This is an incorrect assumption. “Punch list,” warranty, or other corrective work will not extend the deadline for the filing of a lien claim or notice of unpaid balance.
3. Be sure that the contract and all change orders are accepted in writing. Contractors have no right to file a lien claim in connection with work that was not performed pursuant to an executed contract or change order. Handshakes and verbal directives in the field will not pass muster, regardless of whether the work was accepted and approved. Contractors that do not have written agreements may be able to recover payment through a separate lawsuit for breach of contract, however, they will not have lien rights.
4. Do not forget to actually file suit on the lien claim, and to do so on time. A lien claim is a pre-requisite to a lawsuit, but it is not an actual lawsuit. Short of settlement, in order to obtain payment after the filing of a lien claim, the claimant must file a legal action based upon the lien claim. This must be done, not within 1 year of the filing of the lien claim, but within 1 year of the last date of work. It is critical that a claimant understand this distinction and meet the deadline for filing.
New Jersey Construction Lien Law for Owners:
1. Obtain a lien release and waiver with each payment. Owners should not make payments for work, services
or material without simultaneously receiving corresponding progressive, written lien releases and waivers
from their contractors and suppliers. Contractors should, in turn, should be required to obtain releases and waivers from their own subcontractors and suppliers.
2. Consider using joint checks. Making payment by joint check can help ensure that funds reach their intended destination and prevent claims for non-payment by lower tier subcontractors and suppliers.
3. Consult with counsel to scrutinize the filing. Experienced counsel will be able to determine whether any number of substantive or technical requirements have been violated by a given lien claim, including but not limited to: filing deadline errors, service errors, improper identification of the property or project, whether a balance is overstated, whether a claimed balance is based upon a sufficient writing, and whether the claimant is a proper claimant given its tier. Claimants who file improper or overstated lien claims may be forced to pay costs associated with discharging the wrongfully filed lien, such as attorney’s fees.
4. Post a bond. Particularly in instances in which a property is pending sale or transfer, the owner or its contractor (if the lien is filed by a lower tier subcontractor) may post a bond with the clerk of the county where the lien was filed in an amount equal to 110% of the lien claim. The county clerk will then mark the lien as discharged. The claimant’s rights will be unaffected, but the property will be free of the lien, and the pending transaction should be able to proceed. There are carrying costs associated with the posting of a bond; however, use of a bond can be a valuable tool in many instances. If a bond is posted, consider the option of demanding that the claimant file suit within 30 days in order to accelerate resolution of the matter.
The Lien Law is a highly technical statute with numerous requirements; however, when used correctly, it can be a tremendous vehicle for recovery. Claimants and owners should always confer with counsel in order to ensure that their rights and interests are effectively guarded.
Want More Information on New Jersey Construction Lien Law?
Daniella Gordon, Esquire
Hyland Levin LLP
6000 Sagemore Drive, Suite 6301
Marlton, NJ 08053-3900
Let’s explore fixtures, trade fixtures and who owns what at lease expiration. In order to facilitate a smooth transition between commercial tenants, it is important for landlords to understand their rights regarding items attached to their property. Generally, a lease will govern these rights. However, if the lease is silent on the issue, articles annexed to the property deemed “fixtures” must stay with the property, while articles deemed “trade fixtures” may be removed by a vacating tenant.
In New Jersey, a fixture is an object that “become[s] so related to particular real estate that an interest… arises under real estate law.” N.J.S.A. 12A:2A-309(1)(a). In contrast, an article may be considered to be a trade fixture if: (1) the article is annexed to the property for the purpose of aiding in the conduct of a trade or business exercised on the premises; and (2) the article is capable of removal from the premises without material injury thereto. Handler v. Horns, 2 N.J. 18, 24-25 (1949). As such, an important distinction between fixtures and trade fixtures is whether removal of the item will cause material injury to the premises. See e.g. GMC v. City of Linden, 150 N.J. 522, 534 (1997). In applying this test, courts infer that if removal of an article would cause material injury to the premises, the parties must have intended for the article to remain beyond the lease term. Id.
A typical conflict involving this nuanced distinction may involve a vacating tenant removing an item from the leased premises under the assumption that it was (1) attached to the premises for the purpose of conducting a trade or business; and (2) capable of removal without material injury to the premises. A landlord may dispute one or more of these assumptions, arguing that the article was not used in the conduct of business (that it was in fact attached to improve the structure) or is not capable of removal without material injury to the premises. Over the years, vacating tenants have attempted to remove countless items from leased premises, including air conditioning systems, irrigation systems, bolted down light fixtures and even circuit breaker panels, by arguing these items were trade fixtures. See e.g. In re Jackson Tanker Corp., 69 B.R. 850 (Bankr. S.D.N.Y. 1987).
However, it isn’t difficult to imagine a hypothetical where the traditional landlord and tenant arguments are reversed – that is, where the tenant argues that the article must remain with the property and the landlord argues that the tenant is responsible for its removal. This unusual fact pattern may especially arise where the tenant’s business is specialized in nature, and where equipment is not easily removed from the premises.
For example, Landlord rents out space to Tenant, who plans on operating a restaurant. The lease does not specifically address what does and does not constitute a trade fixture. Tenant plans on installing a walk in freezer and other specialized, complex systems. After several years of operating, Tenant declines to renew the lease, closes, and vacates the premises. Tenant removes the furniture, appliances not fixed to the premises and other items it deems to be trade fixtures and leaves the walk-in freezer infrastructure.
Tenant refuses to remove the walk-in freezer, arguing its removal will cause substantial damage to the premises. Unable to re-let the premises to a restaurant tenant, Landlord is left with a walk-in freezer occupying a substantial portion of the premises.
It is important that during the lease negotiation, landlords think carefully about the business their prospective tenant is in, the kinds of equipment the tenant will install and what will happen to that equipment upon termination of the lease. This same thought process applies when landlords receive requests for alterations. In the above hypothetical, Landlord could have avoided being left with a walk-in freezer and a less than desirable space if it addressed the issue during negotiation of the lease. A discussion with prospective tenants concerning the specific kinds equipment the tenant will install is always a good idea, followed by specifications and drawings for approval. Landlords are wise to reduce these conversations to writing, and specifically address each party’s expectations regarding the disposition of specific equipment when the lease inevitably comes to an end. As always, an ounce of prevention is worth a pound of cure.
William F. Hanna, Esquire
Hyland Levin LLP
6000 Sagemore Drive, Suite 6301
Marlton, NJ 08053-3900
When a commercial tenant files for bankruptcy is not often a surprise to its landlord. Rent payments may arrive late, financial covenants may be missed, and the tenant may become generally unresponsive in the pre-bankruptcy period.
While the provisions of the bankruptcy code governing the treatment of leases are among the more complex in the code, this article provides guidance to landlords in navigating a commercial tenant’s bankruptcy and maximizing recovery on its claims.
Beware of the Automatic Stay when a commercial tenant files for bankruptcy
Upon learning a tenant files for bankruptcy , the landlord must abide the automatic stay. The automatic stay restrains actions to collect on a claim against the tenant, including enforcement of a judgment, creation of a lien, or otherwise attempting to recover any of the tenant’s property. The landlord may not, therefore, send a default letter or prosecute an eviction action. While limited exceptions to this general rule exist, a landlord should consult with counsel before taking any post-bankruptcy legal action against its commercial tenant. In some cases, the court may impose sanctions for willful violations of the automatic stay.
Monitor the case and gather pertinent documents when a commercial tenant files for bankruptcy
Carefully monitor a tenant’s bankruptcy case from the outset by reviewing all pleadings sent in connection with the case. Often, motions filed in the first days of a bankruptcy case set critical deadlines and tee-up for court approval mechanisms for funding the debtor through bankruptcy, including authority for the debtor’s use of assets (assets that may be subject to a landlord lien) during the course of the case. Pay special attention to the deadlines for filing proofs of claim and for filing proofs of rejection damages, each of which require affirmative landlord action to recover unpaid sums under the lease. Closely review any budgets filed by the tenant to confirm that the budget includes post-petition rent payments in the correct amounts. Consider retaining counsel to appear in the case, which will ensure that you receive prompt notice of events in the case and relevant deadlines.
Gather all documentation pertinent to the bankrupt tenant in order to readily assert claims in the bankruptcy case, including to support a motion for relief from the automatic stay if it becomes necessary. Ensure you have copies of the following:
• A fully executed copy of the lease, any amendments and guaranties
• Records of rent payments, both before and after the bankruptcy filing
• Records of maintenance obligations and payments
• Default correspondence
• Any property searches obtained showing liens created by the tenant
Disposition of the lease and payment of rent and other sums when a commercial tenant files for bankruptcy
Whether or not a commercial landlord desires to continue its business relationship with the bankrupt tenant, the bankruptcy code allows the debtor to exercise its business judgment to determine whether to assume (retain) or reject (terminate) an unexpired nonresidential lease.
If the tenant assumes the lease, it must make the landlord whole for any unpaid rent and any pecuniary losses stemming from the defaults under the lease. The tenant must also provide to the landlord “adequate assurance” of its future performance under the lease. With respect to shopping center leases, the bankrupt tenant must meet a higher standard than other tenants in order to assume the lease. The shopping center tenant must show: (a) that the debtor, as reorganized, or its assignee, will have at least the same ability to pay the rent as the initial lessee; (b) that any “percentage rent” will not substantially decline; (c) that the assumption of the lease will be subject to the all of the provisions of the lease, including provisions relating to radius, location and/or exclusivity; and (d) that the assumption thereof will not breach the provisions of any other lease, financing agreement or master agreement relating to the shopping center, nor disrupt the tenant mix in the shopping center.
If the tenant rejects the lease, it must return possession of the property to the landlord. Unlike the landlord to an assumed lease who is made whole upon assumption, the landlord to a rejected lease retains only: (a) an unsecured claim for unpaid pre-petition rent or other amounts; (b) an administrative (dollar-for-dollar) claim for unpaid post-petition rent; and (c) a rejection damages claim (unsecured) for future rent that would have been due but for the rejection. While the landlord is entitled to rejection damages, such damages are capped. Rejection damages are capped at the greater of one (1) year of rent or the rent for fifteen percent (15%), not to exceed three (3) years, of the remaining term of the lease. Rejection damages may be cut-off entirely if the landlord is able to re-lease the space for rent that will cover the claim.
Regardless of whether the tenant assumes or rejects the lease, tenants must pay post-petition rent. The bankruptcy code requires a tenant to comply with its obligations under a lease during the pendency of the case. If the tenant fails to comply with the lease terms, the landlord may have grounds for relief from the automatic stay to pursue eviction. Whether cause exists to grant relief from the automatic stay will depend on the particular circumstances of each case. For example, if the post-petition rent is not being paid, if insurance coverage does not remain in force or the property is in danger, a bankruptcy court may find cause for relief from the stay. On the other hand, if the tenant cannot continue its business without operating in the leased premises, a court may consider the property necessary for the tenant’s reorganization and be less likely to grant relief from the automatic stay. Experienced bankruptcy counsel can help assess the merits of any stay relief motion and should be consulted if the tenant fails to uphold any of its post-petition obligations under the lease.
PRE-BANKRUPTCY PLANNING: Hedging your risks when a commercial tenant files for bankruptcy
Landlords can hedge risks when a tenant files for bankruptcy by obtaining additional security to secure the lease,
which will maximize potential recovery in the event of a tenant bankruptcy.
Consider requiring a significant security deposit, including in the form of a letter of credit. Security deposits make a landlord a secured creditor to the extent of the deposit. In some cases, landlords can offset rent payments with a security deposit, which can enhance recovery to the landlord if the tenant ultimately rejects the lease.
Obtaining a third-party guaranty (from an individual or affiliate entity) of the tenant’s obligations under the lease affords a landlord with non-bankruptcy collection opportunities. In most cases, guarantors, unlike debtors, can be pursued for the full amount of the debt owing without respect to the cap on rejection damages that applies to a debtor.
In short, strong lease drafting coupled with vigilant enforcement of the landlord’s rights in and out of the bankruptcy court can make a significant difference in timely maximizing recovery from a defaulted tenant. The contents of this article are for informational purposes only and none of these materials is offered, nor should be construed, as legal advice or a legal opinion based on any specific facts or circumstances.
For More Information on what to do when a commercial tenant files for bankruptcy:
Julie M. Murphy, Esquire
Hyland Levin LLP
6000 Sagemore Drive, Suite 6301
Marlton, NJ 08053-3900
A personal lease guaranty is a crucial feature of many commercial real estate leases. A lease guaranty is a separate contract under which a third party guarantor agrees to meet the obligations of the Tenant to the Landlord. Landlords understandably want to ensure that their Tenants – be they individuals or business entities – have the financial wherewithal to meet the obligations set forth in the lease. If a Tenant without sufficient assets breaches its lease by leaving early, refusing to pay rent, or damaging the space, the Landlord will not be able to recover its damages. The Landlord may have nothing to collect against. For this reason, if a Landlord is unsure about the creditworthiness of a potential Tenant, it will often demand that the Tenant provide a guaranty from an individual or entity who has sufficient assets to secure the Tenant’s obligations.
A lease guaranty is a separate contract under which a third party guarantor agrees to meet the obligations of the Tenant to the Landlord. If the Tenant fails to pay rent, the Landlord can recover the arrears from the guarantor, usually before seeking damages from Tenant. Depending on the scope of the lease guarantee, the guarantor may also be financially responsible for damage to the lease premises caused by the Tenant. In the case of a Tenant entity (i.e. a corporation, limited liability company, or partnership), the guarantor is typically one of the entity’s principal individual owners or a corporate affiliate. In the case of individual Tenants, the guarantor is typically a family member or an investor.
In order to be enforceable, a lease guarantee should state the guarantors’ obligations in clear unambiguous language.
It should explicitly address which obligations the guarantor is securing, how and when can the Landlord collect from the guarantor, and whether there are monetary or temporal limitations to the guaranty. Any ambiguities will be construed in favor of the guarantor. The guaranty should also address the issue of consideration for the guaranty and make clear that the Landlord is entering into the lease in reliance on the guaranty. Finally, the guaranty should be signed by both Landlord and guarantor.
Many commercial Landlords insist upon a lease guaranty up front, but do not then consider how subsequent lease amendments, modifications, or renewals may affect the validity of the guaranty. This is a dangerous mistake. In certain states, a lease guaranty may be limited or even voided if the underlying lease is in any way modified without the guarantor’s express consent.
New Jersey courts take a more nuanced approach to this issue. In New Jersey, a lease guaranty will only be limited or discharged if the lease is subsequently modified in a way that injures the guarantor or actually increases the guarantor’s risk or liability. See Center 48 Ltd. Partnership v. May Dept. Stores Co., 355 N.J. Super 390, (App. Div. 2002). Unfortunately, New Jersey courts have not provided much guidance on what sort of lease modifications actually increase the guarantor’s risk or liability.
Nonetheless, Landlords in New Jersey can take two steps to limit the chances that a lease guaranty will be limited or voided if the underlying lease is subsequently changed. First, the Landlord can include clear language in the lease guaranty stating that the guarantor’s obligations will extend to any increase in rent, extension of the lease term, renewal, or other modification of the lease. The broader and more specific the language the better for the Landlord. The lease guaranty should also explicitly waive the guarantor’s right to consent to such modifications. A second and more effective approach is for the Landlord to require the guarantor to provide a written acknowledgment and consent each time the lease is amended, modified, or renewed.
Lease guarantees provide crucial credit support to commercial Landlords. In order to ensure that a guaranty is enforceable, however, a Landlord must use a carefully drafted form. Simply getting a well drafted lease guaranty executed, however, is not the end of the story. A Landlord must also consider how subsequent lease amendments may affect the enforceability of the lease guaranty and work proactively to ensure that the lease guaranty remains in effect, especially when it comes time to enforce it.
When it comes to the federal income tax treatment of real estate sales it is very important how you treat your real estate gains and losses. If you are a real estate owner or developer, you may be under the impression that your profits and losses from the sale of property must be treated as ordinary income or losses, and that you are therefore subject to federal income tax rates that can be as high as 39.6%. However, it is possible that profits you have received from the sale of property may instead be treated as capital gains, which are generally taxed at a maximum rate of only 20% for noncorporate taxpayers.
Under Section 1221(a)(1) of the Internal Revenue Code (the “Code”), income or losses from the sale of property “held primarily for sale to customers in the ordinary course of a taxpayer’s trade or business” are treated as ordinary. Any income or losses from the sale of property outside this classification are treated as capital gains or losses.
Determining whether the sale of property qualifies as the sale of a capital asset first requires an analysis of whether the property was held “primarily” for sale. This is not necessarily as straightforward as it may seem, since property can be used for more than one purpose. In addition, taxpayers may change their purpose for holding property during their term of ownership. For example, you may own an apartment building that you later decide to convert to condominiums; or, you may own and rent several properties and later decide to sell a handful of them over a period of a few years. How do these decisions affect the federal income tax treatment of real estate sales and reporting your gains and losses?
Case law surrounding the federal tax treatment of real estate sales
The U.S. Supreme Court provided some guidance in its decision in Malat v. Ridell, 383 U.S. 569 (1966). There, the taxpayer was a member of a joint venture that purchased real estate to develop and operate an apartment complex. When the joint venture members had trouble obtaining financing, a portion of the property was subdivided and sold, and the profit from the sales was reported and taxed as ordinary income. The members continued to have difficulties developing the remaining parcels, and the taxpayer sold his interest in the joint venture and treated his profit from that sale as a capital gain. The IRS contended that the property was held by the taxpayer “primarily for sale to customers in the ordinary course of his trade or business,” and that, therefore, the profits should be taxed as ordinary income.
The Federal District Court and the Court of Appeals agreed with the IRS position, but the U.S. Supreme Court disagreed. The Supreme Court held that purpose of Section 1221 of the Code is to distinguish between “profits and losses arising from the everyday operation of a business” and “the realization of appreciation in value accrued over a substantial period of time”, and that, based on this purpose, the word “primarily” as used in Section 1221 means “of first importance” or “principally”. The case was remanded to the District Court to decide the case using the legal standard articulated by the Supreme Court. The District Court found that the properties were not held primarily for sale to customers in the ordinary course of a trade or business, and that the taxpayer (and the other members of the joint venture) could report their profits as capital gains. See Malat v. Riddell, 275 F. Supp. 358 (1966).
While the U.S. Supreme Court’s decision in Malat v. Riddell is helpful in applying Section 1221, it is important to note that holding property primarily for sale “is by itself insufficient to disqualify the taxpayer from capital gains privileges”. See U.S. v. Winthrop, 417 F.2d 905 at 911 (5th Cir. 1969). The Courts have identified three main questions to consider when determining whether an asset is a “capital asset” under the Code:
1. Was the taxpayer engaged in a trade or business, and if so, what business?
2. Was the taxpayer holding the property primarily for sale in that business?
3. Were the sales contemplated by the taxpayer “ordinary” in the course of that business?
Suburban Realty Co. v. U.S., 615 F.2d 171 at 178 (5th Cir.), cert. denied, 449 U.S. 920 (1980).
In addition, the Courts have articulated and applied a series of factors to determine whether a sale occurred in the ordinary course of a trade or business:
1. What is the nature and purpose of the acquisition of the property and the duration of the ownership?
2. What is the extent and nature of a taxpayer’s efforts to sell the property?
3. What is the number, extent, continuity, and substantiality of the sales?
4. What is the extent of subdividing, developing, and advertising to increase sales?
5. Was a business office used for the sale of the property?
6. What is the character and degree of supervision or control exercised by the taxpayer over a representative selling the property?
7. How much time and effort did the taxpayer habitually devote to the sales?
See U.S. v. Winthrop, 417 F.2d 905 at 910 (citing Smith v. Dunn, 224 F.2d 353, 356 (5th Cir. 1955)); See
also Byram v. U.S., 705 F.2d 1418, 1424 (5th Cir. 1983).
In applying these factors, Courts have emphasized that no single factor should be determinative in deciding the federal tax treatment of real estate sales; instead, each case must be evaluated on its own facts. Biedenharn Realty Co., Inc. v. U.S., 526 F.2d 409 (5th Cir. 1976), cert. denied, 429 U.S. 819 (1976).
Based on the foregoing, if you are a real estate owner or developer, and you are making decisions regarding your property, the tax treatment of real estate gains and losses will depend on an analysis of your individual facts and circumstances under Section 1221 of the Code and related Court opinions and IRS decisions. Thus, it is important to consult with your tax advisor to review your sales activities, as it could positively impact your federal income tax liability.
The United States Treasury Department issues Circular 230, which governs all practitioners before the Internal Revenue Service. Circular 230 requires a legend to be placed on certain written communications that are not otherwise comprehensive tax opinions. To ensure compliance with Treasury Department Circular 230, we are required to inform you that this document is not intended or written to be used, and cannot be used for the purpose of avoiding penalties that the Internal Revenue Service might seek to impose on you.
Have more questions about the federal tax treatment of real estate sales?
Stephen M. Geria, Esquire, LL.M.
Hyland Levin LLP, Attorneys at Law
6000 Sagemore Drive, Suite 6301
Marlton, NJ 08053
The New Jersey Permit Extension Act tolled the expiration of numerous development approvals and permits during the “extension period” starting from January 1, 2007 through December 31, 2015.
Because the NJ Permit Extension Act provides that tolling shall not extend the period of approval more than six months beyond the conclusion of the extension period, some approvals may be extended through but not beyond June 30, 2016. Since approvals such as variances, site plan and subdivisions “run with the land,” the determination of whether such approvals remain valid impacts the marketability and value of real property.
The end of the extension period under the NJ Permit Extension Act does not necessarily mean an approval will soon meet its demise. The NJ Permit Extension Act preserved the right to seek additional extensions as provided by law when the extension period ends. For example, there are extensions available for subdivision and site plan approvals under the Municipal Land Use Law (“MLUL”) for up to one year if the developer was precluded from proceeding because of delays in obtaining other legally required approvals that were diligently pursued. A developer must apply for this type of extension before the subdivision or site plan approval period runs or within 90 days after the receiving the last other required approval, whichever is later. See N.J.S.A. 40:55D-49(f), -52(d). There are also discretionary extensions available under the MLUL such as two one-year extensions of preliminary approvals and up to three one-year extensions of final approvals. See N.J.S.A. 40:55D-49(c), -52(a). A developer can apply for discretionary extensions either before or after the approval period runs but the extension will run from the original expiration date. Larger projects may be eligible for longer extensions under the MLUL.
There is also a “tolling” provision under the MLUL where “…during the period of approval heretofore or hereafter granted to an application for development, the developer is barred or prevented, directly or indirectly, from proceeding with the development otherwise permitted under such approval by a legal action instituted by any State agency, political subdivision or other party to protect the public health and welfare or by a directive or order issued by any State agency, political subdivision or court of competent jurisdiction to protect the public health or welfare and the developer is otherwise ready, willing and able to proceed with said development, the running of the period of approval under this act… shall be suspended for the period of time said legal action is pending or such directive or order is in effect.” See N.J.S.A. 40:55D-21.
Other types of development approvals such as NJDEP permits should be carefully reviewed to determine whether an extension is necessary and possible. During any analysis of such permits, it should also be determined whether commencement of work pursuant to a permit is sufficient to vest the right to complete the work. Certain approvals require completion of all work authorized by the permit prior to expiration.
Whether it is done prior to listing a property for sale or during a due diligence period, all development approvals should be examined to determine whether an application for an extension is warranted, even if work has already commenced on a project. For example, a CAFRA permit may be deemed expired if work has commenced but construction activity has lapsed for over a year.
Location of the real property is a critical issue to examine in this process. Under the NJ Permit Extension Act, there is no tolling for development approvals applicable to property in “environmentally sensitive areas,” i.e. planning areas 4B and 5. An amendment to the NJ Permit Extension Act enacted in 2012 carved out growth areas and coastal centers in Highlands and Pinelands.
Another issue for consideration is that other factors such as sewer service area mapping and public water supply capacity may affect the ability of a developer to construct an approved project, regardless of whether the approval remains valid. Sewer service area changes and water supply capacity issues that have arisen during the extension period may impact a developer’s ability to build what was approved. Regulatory changes that have taken effect since the NJ Permit Extension Act was adopted may also curtail the ability of an administrative agency to further extend an approval that was issued under a prior version of a rule.
The bottom line is that buyers, sellers and real estate agents should be aware that development approvals extended by the NJ Permit Extension Act may soon be expiring and that a careful analysis should be conducted to determine the viability of any further extensions under the MLUL or other applicable laws and regulations. All of the parties to a real estate deal should also be cognizant that for any project being bought or sold “with approvals,” every aspect of development should be examined for the viability of constructing an approved project.
Robert S. Baranowski, Jr., Esquire
Hyland Levin LLP
Zoning and Land Use, Environmental, Real Estate, Litigation, Eminent Domain, Property Taxation
Hyland Levin Attorneys at Law
6000 Sagemore Drive, Suite 6301
Marlton, NJ 08053
By Stacy L. Asbell, Esquire Hyland Levin LLP December 18, 2015
Generally, a lease security deposits in New Jersey are a landlord’s security for the tenant’s performance of its obligations under the lease. In the event the tenant does not uphold the tenant’s responsibilities under the lease, the security deposit can be a remedy for the landlord. In New Jersey, there are strict rules for the collection, retention and return of security deposits held by landlords in connection with residential leases. Unlike residential leases, security deposits in commercial leases are a matter of negotiation between the parties.
Commercial Security Deposits in New Jersey
The amount of the security deposit in commercial leases can be influenced by many factors including the amount of rent being paid by the tenant, the amount of up-front investment to be made by the landlord and the financial strength of the tenant and any guarantors. The parties should consider the following in reviewing the security deposit in a lease:
• Will the landlord be obligated to keep the security deposit in a separate account? Practically, most commercial landlords want flexibility to comingle the security deposit with other accounts.
• Will the security deposit be maintained in an interest bearing account and will the tenant be entitled to the interest? Commercial landlords take the position that the tenant is not entitled to the interest on thesecurity deposit if it is maintained in an interest bearing account.
• What is the security deposit intended to protect? Commercial landlords want the right to use the security deposit to secure any and all tenant obligations under the lease. Alternatives include restricting the use of the security deposit to secure only monetary terms, like rent or damage to the leased premises. Tenants should be wary that broader coverage of all claims by the security deposit will permit a commercial landlord to use the remedy as a means of “self-help.”
• Will the application of the security deposit to a tenant default cure the default? In negotiating the security deposit, commercial tenants may want to include provisions that the application of the security deposit will be considered the landlord’s election to cure the tenant default and therefore, the landlord is then prohibited from terminating the lease or evicting the tenant.
• Will the tenant be required to replenish the security deposit in the event the Landlord applies all or a portion of the security deposit to a breach? Consistent with the application of the security deposit to cure a breach, commercial landlords will require the tenant to immediately replace the funds previously applied. This can result in multiple breaches under the lease in the event the tenant defaults and then fails to replenish the deposit.
• What will be the form of the security deposit? Most security deposits will be in the form of cash security or a letter of credit. While letters of credit can be adequate security, the landlord will want to consider: (i) what bank is issuing the letter of credit and its creditworthiness; (ii) whether the letter of credit is irrevocable; (iii) whether a partial draw on the letter may be made; (iv) the term of the letter of credit, which should extend for a period beyond the lease expiration; and (v) what documentation and acts are required by the bank to release the money to the landlord. Letters of credit also have an added benefit as they are not considered part of the tenant’s estate in the event the tenant declares bankruptcy. This means that, unlike the cash security deposit, the letter of credit is not subject to restrictions of the bankruptcy automatic stay.
• Will any portion of the security deposit be released during the term of the lease? Some tenants are able to negotiate “good boy” provisions allowing a portion or all of the security to be released if all payments to the landlord are made on time for a set period. For example, if all rent payments are timely made for two years, half of the security deposit may be returned to tenant.
Residential Security Deposits in New Jersey
Unlike commercial leases, the security deposit in a residential lease is governed by the Security Deposit Law, NJSA §46:8-19 et seq. The Security Deposit Law applies to the rental of all premises used for dwelling purposes pursuant to a lease, contract or license except owner occupied premises with not more than two rental units. Unlike commercial leases, where the security deposit provisions are negotiated, residential landlord are limited by the Security Deposit Law to the following:
• The landlord may not collect more than 1½ times the monthly rent as security.
• If the residential Landlord is receiving deposit money from ten (10) or more units, the landlord must invest the money in an insured money market or deposit the money in a variable rate account at a state or federally chartered bank. Residential landlords receiving deposits for less than ten (10) rental units are required to deposit the money in a state or federally chartered bank in an account bearing interest on
time or savings deposits. Landlords of seasonal rentals (rentals for a term of 125 days or less by a person with a permanent place of residence elsewhere) are not required to comply with the Security Deposit Law investment requirements.
• Interest on the deposit belongs to the tenant.
• Residential landlords are not permitted to commingle the deposit money with other accounts.
• Residential landlords are required to give each tenant a statement notifying the tenant of the location of the security deposit within 30 days of receipt of the deposit. In the event the landlord fails to notify the tenant of the location of the deposit, the tenant may require that the security deposit plus 7% interest per year be applied toward any rent due and owing as a penalty.
• Residential landlords are required to return the tenant’s security deposit within 30 days after termination of the lease along with the tenant’s portion of the interest.
Security deposits are typically assigned in the event of the sale of the leased property. The new owner should be responsible to each tenant for the full amount of the tenant’s deposit, and in the residential setting, the new owner will be responsible whether the new owner is the assigned the security deposit or not at closing. Residential landlords need to be careful to comply with these rules at lease commencement and on an ongoing basis.
Stacy L. Asbell, Esquire: Hyland Levin LLP
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By David G. Gunther, Esquire, Hyland Levin LLP October 2, 2015
Lawyers can be expensive, or so clients claim! Unfortunately, a landlord facing a difficult tenant who is not paying rent or who is otherwise breaching the lease will often be forced into legal proceedings. This is particularly true in New Jersey, a notoriously tenant-friendly state where eviction and collection actions must be filed separately and a non-individual landlord (i.e. an LLC or corporation) must be represented by a lawyer. Landlords, therefore, typically work hard to ensure that they can recover their legal fees from their tenants.
THE AMERICAN RULE
In order to preserve the right to recover legal fees from a defaulting tenant, a landlord must include an “attorneys’ fee” provision in the lease. This is because in America, unlike England, litigants are responsible for their own legal fees – regardless of who prevails in court. Thus, a landlord must negotiate the contractual right to recover attorneys’ fees from its tenant.
THE LEASE PROVISIONS
A typical “attorneys’ fee” clause in a lease will allow a landlord to recover its “actual attorneys’ fees” resulting from any “action” or “other proceeding” against the tenant in connection with the lease or leased premises, including evictions and collections. In most cases, the Landlord will only be able to recover its fees if it “prevails” against the Tenant. There is extensive case law regarding what it means to “prevail” in a legal proceeding that settles or is otherwise resolved without a judgment, although sometimes landlords and tenants negotiate their own definition.
Some attorneys’ fee provisions will allow the landlord to seek reimbursement for legal fees incurred before or outside of litigation. This allows the landlord to recover the money it spends on a lawyer to write a default letter demanding a cure, usually prompt payment of rent. Additionally, landlords are sometimes able to negotiate a broader right to be indemnified from any legal fees resulting from the tenant’s conduct. This broader right would protect the landlord if it is dragged into an environmental or personal injury dispute as a result of the tenant’s conduct, for example.
THE IMPORTANCE OF “ADDITIONAL RENT”
Regardless of the scope of an attorneys’ fee clause, it is important that attorneys’ fees be defined
as “additional rent” under the lease. This will allow the landlord to evict a tenant who fails to reimburse it for its legal fees – even if the tenant has otherwise cured all of the defaults under the lease. Defining attorneys’ fees as “additional rent”, therefore, increases the landlords’ chance of recovery while the tenant is in possession of the premises and reduces the likelihood that the tenant will play “legal” games with the landlord.
In most cases, a tenant will not object to the inclusion of a reasonably drafted attorneys’ fee clause in the lease. The tenant, however, may demand that the provision be mutual. In other words, the tenant will also seek the right to recover attorneys’ fees if it prevails in an action or other proceeding against the landlord. (Notably, as of February 1, 2014, all attorneys’ fee clauses in residential leases must give tenants the same right of recovery that the landlord has.)
Including well-drafted attorneys’ fees clauses in leases is essential for protecting the rights of landlords. Without such provisions, a landlord cannot recover its legal costs from a defaulting tenant. Moreover, the very presence of an attorneys’ fee clause may make a tenant think twice before pushing the landlord into court.
David G. Gunther, Esquire
Hyland Levin LLP
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