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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?
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