In the Event of a Landlord Bankruptcy

June 11, 2009

When a tenant learns that its landlord intends to declare Chapter 11 bankruptcy to pursue reorganization, the tenant should be alert to circumstances which could lead its landlord to sell the building or attempt to reject the tenant’s lease. This is a particular concern for a tenant that has a below-market lease or a tenant that has (or is in the midst of building) extensive leasehold improvements in its space. The landlord, or more correctly the debtor-in-possession (DIP), might benefit from rejecting such leases and re-tenanting its building with more profitable tenants. Even a tenant with an above-market lease should be on the alert if its landlord declares bankruptcy because a landlord can pursue a sale of the building and, in some circumstances, may seek to terminate the lease.

The Bankruptcy Code allows a bankrupt landlord to accept or reject the lease of an individual tenant, but sets limits to protect a tenant from eviction by allowing it to occupy its space at the same rental rate and to renew and extend as provided in the lease and permitted by state law. The Bankruptcy Code through portions of Section 365 provides additional, although minimal, protections to the tenant by allowing the tenant to offset the amount of any damage suffered by the tenant due to the landlord’s non-performance after the date of the rejection against the tenants rent deposit, but only up to the amount of the deposit.

If the landlord rejects a shopping center lease, Section 365(h)(i)(C) provides that the rejection does not affect the enforceability under state law of non-monetary restrictions on radius, location, use, exclusivity or tenant mix. The protection applies to the tenant’s successors, assigns or lenders, to the extent permitted by the lease.

The Bankruptcy Code includes other provisions that facilitate a bankrupt landlord’s sale of its properties to generate money to pay creditors. The Code encourages the sale of a debtor’s property by permitting a purchaser to acquire good title to assets (such as a leased building) which could not have been sold outside the bankruptcy, free of any liens encumbering the property, which can include undesirable leases. However, if anyone that holds an interest in the property objects to the sale and is not given “adequate protection”, (a concept that is not defined under the Bankruptcy Code) the sale is prohibited. Counsel may argue that a tenant’s rights under the lease must be protected in any sale.

Recent case law has muddied the waters in this unsettled area. Given the apparent conflicts between Sections 363 and 365 of the Bankruptcy Code, when a tenant hears its landlord is considering bankruptcy or receives a notice of its landlord’s bankruptcy, a tenant should immediately contact counsel. The tenant should be prepared promptly to request relief under at least two sections of the Bankruptcy Code (Sections 365 and 363) in order to protect its rights under its lease or to be compensated for losses that may occur.

New leases could include language entitling a tenant to the value of its leasehold improvements, as well as its costs of relocating to new space, in the event its landlord terminates the lease early in connection with bankruptcy. Furthermore, given the possibility that a landlord could file for Chapter 11 bankruptcy protection, tenants in new leases should ensure that any significant tenant improvement allowances or other large cash concessions are protected until the tenant improvements are completed. The tenant may require that landlord provide the tenant with a letter of credit, or that the landlord’s lender escrow the funds at lease execution, with an agreement that the lender release the funds to the tenant as lien-free work is completed and invoices are paid by the tenant.

For more information please see our Greater Washington-Baltimore Region Transactional Real Estate section.