Step one is to read the lease to understand your rights and remedies as well as restrictions on the lessor and the lessee.
The key to protecting a lessor’s interest in leased property is to be proactive. The primary interest of the debtor (the company that commenced the bankruptcy case) is to maximize the value of its assets. Unexpired leases may be significant assets. However, sometimes maximizing value can be at a lessor’s expense.
The debtor may seek to assign a lease to a proposed tenant that the lessor thinks is undesirable for multiple reasons. The proposed assignee’s financial condition may be questionable. In a shopping center (where there are special rules governing tenant mix) the proposed lessee may be a direct competitor of an existing tenant or may significantly overlap products sold. Courts want to maximize the value of an estate because the proceeds can be used to fund a reorganization. Do not expect another party to protect a lessor. Debtors, banks and creditors inevitably urge the court to approve a sale regardless of whether there is strict compliance with the lease provisions or with the bankruptcy code. Although the court has some discretion in interpreting the bankruptcy code and in interpreting lease provisions, if there is a way to maximize the estate by approving a disputed lease assignment the court will be urged to do so.
Contact whomever the debtor has engaged to sell unexpired leases in order to be informed about the status of the lease. Be prepared to act proactively. A quiet lessor may be taken advantage of.
The lessor also should file a notice of appearance early on so that it receives all pleadings filed in the case. In order to plan accordingly the lessor must be aware of motions to sell the debtor’s business, downsize, liquidate its assets, or reorganize its financial affairs.
Q: Can I evict my tenant?
Upon commencement of a bankruptcy case, the automatic stay goes into effect which is an injunction against creditors taking action against the debtor without court permission. If there is no dispute as to whether the lease was validly terminated, and the debtor has the held over the lessor may evict the tenant. If there is a dispute over valid termination the lessor should seek authorization of the bankruptcy court to proceed with eviction proceedings.
Q: How does the bankruptcy code work?
Section 365 of the Bankruptcy Code permits a debtor to assume or reject an unexpired lease. When a lease is assumed the debtor or its proposed assignee must cure all defaults, provide adequate assurance of future performance and continue to fulfill all obligations under the lease. When a lease is rejected the lease ends upon the rejection date and the premises are surrendered to the lessor.
A debtor typically rejects a lease if the premises are not necessary to the debtor’s reorganization such as by downsizing its business or if the lease is priced above market. If the lease is below market the debtor may seek to assume and then assign the lease to a third party.
The Bankruptcy Code has a priority scheme pursuant to which creditors are paid. After the payment of secured claims, administrative claims (claims incurred by the debtor during the bankruptcy case) are entitled to payment. Obligations of the debtor for post-petition rent have administrative status. They are on par with the fees of professionals retained in the case. Priority claims such as taxes are next and then general unsecured claims get paid. If a lessor is not being paid post-petition rent on time, it should promptly file an application with the court pursuant to section 503(a) to compel payment rather than hope that its administrative claim gets paid later.
Although post-petition rent has administrative priority there is no guarantee that all administrative claims get paid. In some instances, a debtor might be withholding rent payments due to competing administrative claims such as those of vendors or professionals.
Q: What lease terms does bankruptcy overrides?
“Ipso facto” clauses provide that a lease is terminated if the tenant commences a bankruptcy case, becomes insolvent or is in financial distress. But section 365(e)(1) of the Bankruptcy Code makes ipso facto clauses unenforceable.
Many leases contain anti-assignment clauses. However, section 365(f) makes these clauses unenforceable.
Q: What are my protections if the debtor seeks to assume a lease?
The debtor can assign the lease subject to the requirements that: (a) adequate assurance of future performance under the lease is given to the lessor and (b) all defaults under the lease are cured. The debtor cannot amend or modify the lease unless the lessor consents.
The lessor is entitled to demand financial information on the proposed tenant in order to evaluate the adequacy of assurance of future performance.
Q: Are shopping centers different?
The Bankruptcy Code includes special protections for shopping center owners in the event of a tenant’s assumption and assignment of a lease. It defines “adequate assurance” in this context to include requirements that:
- The “financial condition and operating performance” of the proposed assignee and its guarantors are similar to those of the tenant and its guarantors.
- The percentage rent due under such lease will not decline substantially.
- The assignee’s proposed use of the leased premises will not violate any radius, location, use, or exclusivity provisions of the lease or any such provisions contained in any other agreements related to the shopping center.
- The assignee’s proposed use of the lease premises will not disrupt any tenant mix or balance in the shopping centers.
Q: When will I know if my tenant is staying or leaving?
Section 365(d)(3) requires the debtor to comply with the lease terms -including paying rent until the lease is assumed or rejected. The debtor has 120 days from the commencement of the bankruptcy case to assume or reject leases. However, the court can extend the time period by up to an additional 90 days. If the debtor does not assume or reject a lease within the allowed time period, the lease is deemed rejected.
Sometimes it is better for the lessor to purchase the lease early in the bankruptcy case in order to have certainty, control who becomes the tenant, and avoid potential costs of litigation. Debtors often prefer an uncontested quick lease sale back to the lessor because during the sale process they must pay rent on property that they no longer want to occupy. The debtor’s concern is that if the sale process takes too long the sale price may not cover the accrued post-petition rent.
Q: What happens if the debtor auctions off its leases?
The court will hold a hearing on proposed auction procedures. The application to approve auction procedures is on the court’s docket which is a public record. After the auction, there will be another court hearing to approve the auction results. The lessor can attend all court hearings including on auction procedures, attend the auction and also bid on its own lease at the auction.
Q: What happens if the debtor seeks to conduct going-out-of-business sales on the leased premises?
In retail cases “going out of business” (“GOB”) sales are common when a debtor is downsizing or liquidating. Despite any lease provisions that prohibit GOB sales, debtors will seek bankruptcy court authorization to conduct GOB sales. A debtor’s GOB sale can adversely affect the lessor’s other tenants in a shopping center especially if the liquidator brings in special merchandise to sell during the liquidation sale. Also, a GOB sale can affect a shopping center’s image, especially if it is conducted for an extended period of time with bold signage. The signage, time length of sale and products offered during the GOB sale must be watched closely. When the debtor seeks court authorization to conduct a GOB sale, the lessor has the opportunity to object to potentially damaging aspects of the sale. In non-retail cases, the debtor may retain a liquidator or auctioneer or move its property to another location. Here too the lessor should pay attention. The lessor should designate what can and cannot be sold on the premises (such as fixtures) and it should carefully monitor for damage to the premises.
Q: If my tenant leaves, what kind of claim do I have?
A lessor whose lease is rejected has a general unsecured claim for rent arrears plus damages arising due to rejection. However, rejection damage claims are capped at the greater of rent due for (i) one year; or (ii) 15% of the remaining term, not to exceed three years. Note that how the 15% is calculated may be different depending upon the jurisdiction in which the bankruptcy case was commenced. The limitation applies only to damages arising out of the rejection. Damages not arising from rejection such as the cost of removing abandoned property can be included in the lessor’s damage claim and are not subject to the cap.
Q: What kind of security deposit is best?
If the lessor received a cash security deposit before the tenant commenced its bankruptcy case, it cannot set off against the security deposit without court authorization. The security deposit is deemed property of the bankruptcy estate. Consequently, it is better for the lessor to obtain a letter of credit as security. This is because the debtor is not a party to a letter of credit contract. A letter of credit is a contract between the lessor and the issuing bank.
If possible, seek a third-party guarantee. Typically, the automatic stay only applies to the debtor. A guarantee by the debtor’s parent will be subject to the automatic stay if the parent also has commenced a bankruptcy case. Consider a guarantee from a non-debtor affiliate, investor or stockholder in the debtor.