My commercial tenant filed for bankruptcy! Now what? The rights and obligations of landlords

This article focuses on the rights and obligations of landlords when a tenant files for bankruptcy protection. The Automatic Stay A fundamental aspect of all bankruptcies is the automatic stay. Pursuant to section 362 of the Bankruptcy Code, creditors, including landlords, are prohibited from taking most actions against the debtor which relate to claims that arose prior to the date of the bankruptcy filing (the filing date). Specifically, landlords are prohibited from commencing an eviction proceeding and taking any other action to enforce its rights arising pre-filing date. Exception: If the lease expired before or during the bankruptcy case, the stay does not apply and the landlord is entitled to obtain possession of the property. If the debtor contests the expiration or termination of the lease prior or during the bankruptcy, the landlord should obtain legal counsel before acting. Rent All rent owed by the debtor after the filing date will likely be considered an administrative claim as long as the debtor continues to occupy the premises. This claim will typically be paid in full. All rent owed prior to the filing date is considered an unsecured claim, which depending on each bankruptcy case, likely will be paid pennies on the dollar. Caveat: All rent owed, whether arising pre-filing date or post-filing date will be paid in full if the debtor elects to assume the lease (see section below). “Stub-rent” The debtor rarely files for bankruptcy on the day before rent is due. “Stub-rent” is considered the rent owed for the period from the filing date to the date that the first post-filing date rent payment is due.1 Courts have differed as to whether “stub-rent” must be paid immediately: • Second Circuit courts (including the Bankruptcy Court for the Southern District of N.Y.) hold that the debtor is obligated to pay “stub rent” immediately. • Third Circuit courts (including the Bankruptcy Court for the District of Delaware) hold that the debtor is only required to pay “stub-rent” in full if the landlord files an administrative claim and demonstrates that the debtor occupied the premises. • “Stub-rent” only becomes an issue if the debtor rejects the lease (see section below). If the debtor assumes the lease, the debtor must “cure” all prior defaults and must pay all past due rents, including pre-filing date rent and “stub-rent” owed. Assumption, Assignment and Rejection Section 365 of the Bankruptcy Code provides that the debtor may assume or reject any unexpired lease of the debtor. Rejection In the event the debtor rejects the lease, the debtor and landlord walk away from their obligations. The debtor is considered to be in breach of the lease as of the filing date. The debtor will surrender the premises and the landlord can file a proof of claim against the debtor for: (i) all amounts owed to the landlord that arose prior to the filing date, and (ii) future rent under the lease for the greater of (a) one year or (b) 15 percent, not to exceed three years, of the remaining lease term. Claims arising from rejection are considered unsecured claims and, depending on the debtor’s case, likely will be paid pennies on the dollar. • Retroactive Rejection: Debtors often seek retroactive rejection of leases, especially with regard to locations that have been closed as of, or prior to, the filing date. Many courts will approve retroactive rejections where (i) the debtor unequivocally manifested its intention to terminate, (ii) possession of vacant premises was, in fact, tendered, and (iii) no objection has been interposed. Assumption The lease survives the bankruptcy and its terms will continue to control if the debtor elects to assume it. To assume the lease, the debtor must (i) “cure” defaults and, (ii) provide adequate assurance of future performance under the lease. • Cure. To “cure” defaults, the debtor must make the landlord whole by paying all amounts owed to the landlord for rent, additional rent and taxes arising pre-filing date and post-filing date. Depending on the lease, the “cure” claim may also require the debtor to pay the landlord’s attorneys’ fees incurred with respect to the debtor’s bankruptcy. In addition, the debtor is required to “cure” non-monetary defaults, including the failure to maintain insurance, if curing such non-monetary default is possible.2 Notably, accrued items not yet due, such as year-end adjustments or real estate taxes, need not be “cured” at the time of assumption. • Adequate Assurance. The debtor must also provide adequate assurance that it will perform under the lease. The debtor may satisfy this element by providing the landlord with projected financials, as well as a security deposit, letter of credit, personal guarantee, and/or some other form of security. Assignment A lease may be assigned to a third party once it is assumed. To assign the lease to a third party (i) the debtor (or the assignee) must “cure” existing defaults, and (ii) the assignee must provide adequate assurance that the assignee will perform under the existing lease. • Anti-Assignment Clauses are Unenforceable. The lease may be assigned notwithstanding any provision therein that prohibits, restricts or conditions the assignment. • Use clause. Use clauses are generally unenforceable if their primary purpose is to restrict the assignability of the lease. • Shopping Center Exception. If the underlying premises is located in a shopping center, the assumption and assignment of the lease must (i) be consistent with the use clause set forth in the lease, and (ii) must not disrupt the tenant mix of balance in the shopping center. • Sale of Lease Designation Rights. In lieu of deciding whether to assume or reject the lease, the debtor may sell its rights to make such decision to a third party. Upon the consummation of such sale, the purchaser essentially stands in the shoes of the debtor and may then decide whether to assume/assign or reject the lease subject to the limitations stated above. • Timing: The debtor has 120 days from the filing date to assume or reject the lease. Upon request, the bankruptcy court may extend this deadline by 90 days, meaning the debtor has, at most, seven months to make a decision. If the debtor does not assume the lease by this deadline, the lease will be deemed rejected and the debtor must surrender the property. While deciding whether to assume or reject, the debtor must pay all rent due to the landlord if it occupies the premises and does not obtain retroactive rejection. Preferences In the event the lease is rejected, the landlord may be subject to a preference or clawback claim. This claim, subject to certain defenses, may require the landlord to re-pay the monies received from the debtor within 90 days of the debtor’s bankruptcy filing.3 Notably, if the lease is assumed, the landlord is not subject to a preference claim. Primary Defenses • New Value: To avail itself of the new value defense, the landlord must provide “value” to the debtor after the date of the payment. Value can be provided in the form of the debtor continuing to occupy the premises after the date of the payment. • Ordinary Course of Business: To avail itself of the ordinary course of business defense, the landlord must demonstrate that the payment was made either (i) in the ordinary course of dealing between the parties, or (ii) in the ordinary course of industry standards. To successfully assert this defense the amount, timing and method of payments made within the 90 day period must be consistent with historical practices between the parties or in the landlord’s industry. • Contemporaneous Exchange: To avail itself of the contemporaneous exchange defense, the landlord must demonstrate that the payment was intended to be a contemporaneous exchange for new value and in fact was a contemporaneous exchange for new value. Footnotes: 1. For example, rent is due on the 1st of each month. The debtor files for bankruptcy on June 15th. The debtor failed to pay June rent prior to the bankruptcy filing, but continues to occupy the premises. “Stub-rent” is the rent owed during the period of June 16th through June 30th. 2. An example of a non-monetary default impossible of being cured is a pre-filing date breach of a clause requiring the tenant to continuously operate. 3. Under the bankruptcy code, a payment is considered a preferential transfer if: (i) the payment was made to or for the benefit of a creditor (i.e. the landlord), (i) the payment was for or on account of an antecedent debt (i.e. obligations arising under the lease), (iii) the payment was made while the debtor is insolvent (the debtor is presumed insolvent during this period), (iv) the payment was made within 90 days before the filing of the petition, and (v) the payment enabled the creditor (i.e. the landlord) to receive more than it would have received in the debtor’s bankruptcy case if the payment was not made. Nicholas Rigano, Esq., is an associate at LaMonica Herbst & Maniscalco LLP, Wantagh, N.Y.