As we are all now too aware, circumstances, whether health or financial, can change rapidly. In addition to impacting our personal lives, global events can impact drastically what was an otherwise productive business relationship. One example of the turmoil that can result from such an upheaval for a commercial landlord is the rapid failure of a tenant’s business and the resultant inability of the tenant to meet its rent obligations.
This may often lead to the tenant filing bankruptcy. In that event, what are your rights and obligations as a landlord with a bankrupt tenant, and what might a landlord do to protect themself before the bankruptcy is ever filed?
- The bankruptcy “automatic stay” immediately stops any lease enforcement action.
When your tenant files for bankruptcy protection, the immediate result is the imposition of the “automatic stay” of the Bankruptcy Code. The automatic stay can be envisioned as a wall that immediately protects the tenant (now called the “Debtor”) from any collection actions by its creditors, including its landlord. This means that if you have started the eviction process, you must stop. In fact, you cannot pursue eviction during the pendency of the case unless you receive approval from the Bankruptcy Court to do so (this is called getting “relief from stay”).
In addition, you cannot pursue any amounts owed prior to the date that the Debtor filed for bankruptcy (the “pre-petition” amounts owed). However, if the Debtor continues to occupy the leasehold, you are likely entitled to continue collection of “post-petition” rents as provided for under the lease. This is discussed below.
- What happens to the lease in bankruptcy?
The Debtor has three options regarding the lease:
- It can assume the lease (stay in the space under the current lease) and continue performing all obligations;
- It can assume and assign the lease to a third party. This risk necessitates the drafting of tight use restrictions in all commercial leases; or
- It can reject the lease and surrender the premises.
Whichever route the Debtor chooses to take, it must be approved by the Bankruptcy Court, and you have an opportunity to weigh in and object if needed.
The Debtor has 120 days to decide whether to “assume or reject” the lease. The Debtor can also ask for one 90-day extension of this time period, which is freely given by the Court. This means that you may have to deal with a tenant in bankruptcy for potentially seven months.
If the Debtor-tenant fails to assume or reject the lease within the 120-day period and no extension is granted, the lease is deemed rejected. This is a significant provision for landlords, as the rejection of the lease allows you to arrange for a new tenant and stop the financial bleeding. To be proactive, landlords should review all pleadings filed in the tenant’s bankruptcy proceeding to see if the Debtor-tenant sought an extension of time to assume or reject. Additionally, landlords should review the tenant’s motions to assume, motions to assume and assign, as well as motions to reject leases. The exhibits to these motions often contain schedules identifying the leases affected by the motion.
- What is the status of a tenant’s rental obligations while in bankruptcy?
While in bankruptcy, the Debtor must pay all rent (and other financial obligations) from the date the bankruptcy petition is filed (“post-petition”) to the date the Debtor assumes or rejects the lease. This of course includes paying rent due after the petition is filed.
A landlord’s claim for unpaid post-petition rent receives “administrative claim” status, which is a higher priority of claim than many of the other claims against the Debtor. If the Debtor fails to pay the rent as provided under the lease, you can file a motion for payment of administrative rent with the Bankruptcy Court. The rent motion in some instances can be heard within thirty to sixty days from the date in which it was filed. However, if an evidentiary hearing is needed to resolve the motion, several months could pass before the Court issues a decision.
- What about the security deposit?
Because a case security deposit is in your possession, you might think that you can draw down on that deposit to satisfy pre-petition amounts owed. On the contrary, cash security deposits are considered property of the bankruptcy estate and are generally required to be returned to the Debtor. However, in some instances, the Court may allow a landlord to set-off their claim against the security deposit. This results in added court costs and only provides relief in the amount of the deposit.
On the other hand, there are alternatives to requiring a cash deposit. One alternative is a rent performance bond. These bonds are provided by an insurance company and are not property of the bankruptcy estate. Therefore, they are not affected by the bankruptcy, and you can pursue these in the event of default to satisfy pre-petition and post-petition amounts owed. The downside is the need to make a claim to the insurance carrier, which presents its own delays and risks.
Another alternative is to require an Irrevocable Standby Letter of Credit, which is also not property of the estate. In the event of default with one of these in place, you proceed to the bank with a “sight draft” and obtain repayment of the amounts owed.
If possible, you should also look at requiring personal guaranties from the principals of any tenant that is an entity.
- What should you do if you receive notice of a tenant’s bankruptcy filing?
Once you receive notice of a tenant’s bankruptcy filing, you should contact your attorney immediately. There are deadlines approaching, and bankruptcy has special rules and special deadlines. Your regular attorney will likely have a relationship with bankruptcy counsel and will need to work with that lawyer.
Please contact Todd Egland at Chmelik Sitkin & Davis P.S. if you have questions about whether your commercial lease is “bankruptcy ready,” the bankruptcy process in general, or if you need further assistance.