What General Counsel Should Know When a Company's Tenant Files for Bankruptcy

Inside Counsel

Authored Article

Your tenant files for bankruptcy-what’s your move? Debtors who are lessees under real property leases have certain rights regarding their lease under § 365 of the Bankruptcy Code. Essentially, the debtor has two options: 1) reject the lease or 2) assume the lease, provided that the debtor can cure any defaults existing under the lease. Additionally, the debtor may have the right to assume and assign the lease to a third party.

The company should ensure that its counsel monitors the bankruptcy case regarding several key events and deadlines. In particular, the company should note the deadline for filing a proof of claim. The Bankruptcy Code limits the landlord’s claim against the debtor’s estate. Generally, a creditor will only be entitled to a general unsecured claim, this is similarly true regarding landlords’ claims for prepetition rent. Section 365(g) of the Bankruptcy Code deems the effective date for a rejected lease as occurring "immediately before the date of the filing of the petition," thereby relegating most rejection claims to unsecured status. Additionally, section 502(b)(6) of the Bankruptcy Code provides a statutory "cap" on the amount of the non-accrued damages resulting from the breach of the lease. This section provides that the claim for damages by a lessor under a terminated lease of real property shall be the rent reserved under the lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of the lease, plus any unpaid rent due under the lease, as of the earlier of the date that the lessor surrenders the premises or the bankruptcy petition date. Although a landlord may have an unsecured claim that is capped in the case of a rejected lease, the landlord will likely want to file a proof of claim in such case, especially if there will be any distribution to unsecured creditors.

While the company may not pursue eviction based on the debtor’s pre-petition delinquency, the debtor tenant is not entitled to maintain the space “rent free” during the bankruptcy. The tenant is required to pay all rent or other charges that arise during the bankruptcy case. If the debtor does not timely pay its post-petition rent, the landlord will generally be entitled to an administrative priority claim under § 503 of the Bankruptcy Code for the unpaid, post-bankruptcy rent. One question that may arise is what happens when the debtor files for bankruptcy at the beginning of the month, but after its rent payment is due. Must the debtor pay for this partial, post-bankruptcy month? It depends. Some courts will require the debtor to pay the “stub rent” (i.e. the rent due during the post-petition part of the month). However, other courts have determined that the entire month of rent constitutes pre-petition debt such that the debtor will not be obligated to pay as part of its on-going post-bankruptcy rent.

In a Chapter 11 bankruptcy case, the debtor may seek to assume the lease, or assume and assign the lease, particularly if the terms of the lease are favorable and will benefit the debtor in its reorganization efforts. In order to assume the lease, the debtor must cure all monetary defaults existing under the lease at the time of assumption. For example, if the tenant is four months behind on its rent, it must pay this money to the landlord prior to assuming the lease. If there is a non-monetary default, the debtor may be required to cure this type of default as well. The debtor can also assume and assign the lease to a third party, notwithstanding language in the lease that prohibits such assignment, provided adequate assurance of future performance by the assignee is provided.

The debtor must assume or reject a lease on the earlier of i) 120 days after the bankruptcy petition date, or ii) the confirmation date of the debtor’s bankruptcy plan. The debtor may seek court approval to extend that deadline for an additional 90 days, which many debtors do. If the landlord wants to expedite the timing of the assumption or rejection by the debtor, it may move the court to force the debtor to assume or reject the lease on an earlier date.

Different timelines relating to a real property lease apply in a chapter 7 bankruptcy case. Most likely, the Chapter 7 trustee will reject the lease to minimize administrative costs to the bankruptcy estate. However, the trustee may attempt to cure the lease with an eye to assume and assign it to a third party to generate funds for the bankruptcy estate. If the trustee determines that the lease does not provide any value to the bankruptcy case, the trustee may abandon its interest in the lease. Communication with a chapter 7 trustee soon after the trustee is appointed is usually the best practice to determine whether the trustee is willing to abandon the lease and the lessor can repossess the leasehold.

Shopping center landlords are entitled to stronger protections under the Bankruptcy Code to avoid having their lease assigned to an unfavorable tenant. First, the assignee must be at least as financially sound as the debtor at the time the lease was originally signed. Second, the assignee must demonstrate that the percentage rent due will not decline substantially. Next, the assignment may not disrupt the tenant mix in the shopping center. Finally, the assignment may not violate any location, use, radius or exclusivity provision of the lease, or of any other leases, at the shopping center.

A bankruptcy filing by a tenant may significantly affect the lease. Therefore, monitoring the previously referenced deadlines in the event of a tenant bankruptcy filing is extremely important. Additionally, retaining bankruptcy counsel well-versed in the complexities facing a landlord with a bankrupt tenant is a good idea and will help the landlord navigate other potential pitfalls resulting from the bankruptcy filing.

Republished with permission. This article first appeared in Inside Counsel on July 28, 2015.