Non-Residential Leases and Tenant Insolvencies

June 18, 2009

Landlords of non-residential property have always appreciated and understood the risk that their tenants might become insolvent. In fact, tenant bankruptcies have been viewed as part of the normal business cycle, and many property owners (at least those that are concerned about long-term success) incorporate some calculation of risk in determining rents, demanding security deposits (and the form of such deposits), and in crafting lease provisions. Tenants go bankrupt even in times of economic prosperity, although in the past few years, with steadily rising rents and fewer concessions by landlords, sharp focus on protection of landlord’s interests was not necessarily critical. In today’s economic environment, we are now beginning to see the effects that a tenant bankruptcy can have not only on a poorly prepared landlord, but also on subtenants and even other tenants in a multi-tenant building or retail center.

Most practitioners understand the basics of the effect of a bankruptcy filing by a tenant. Regardless of the type of bankruptcy selected (Chapter 11 – reorganization, and Chapter 7 – liquidation being the usual options), a tenant is granted an immediate and automatic stay upon filing a petition (it is critical for landlords to understand that the stay becomes effective without notice or any hearing). This automatic stay prevents court actions from commencing against the tenant, and stops all legal proceedings pending against the tenant as of the date of filing of the petition. It is unlawful for a landlord to commence or continue any collection, eviction or other repossession actions against a tenant in bankruptcy. A landlord may not send notices of default, may not hire a broker to show the premises, or otherwise enter the premises and, importantly, the landlord must continue to perform its lease obligations during the period of the stay. Also, and only because these provisions continue to appear in leases from time to time, lease clauses that permit a landlord to terminate a lease by reason of tenant’s insolvency and bankruptcy are not generally enforceable as a matter of law, although there may be reasons for continuing to include variations on such provisions in leases. Bankruptcy courts also may invalidate other provisions of leases in order to ensure the availability of greater assets for the bankruptcy estate.

A fact which may be lost on the less experienced landlord is that tenants in bankruptcy are required to continue to pay rent. Any unpaid rent during bankruptcy becomes an administrative expense that is given preference over certain other debts (assuming, of course, that funds are available, and understanding that collection of administrative expenses may take significant time, depending on the particular bankruptcy case).

Ultimately, a tenant in bankruptcy has three choices under the Bankruptcy Code with respect to any real estate lease: (i) assume the lease; (ii) reject the lease; or (iii) assume the lease and assign it to a third party. This decision ordinarily needs to be made during the 120 day automatic stay period (or before the entry of an order confirming a plan of reorganization if that occurs first), although the Bankruptcy Code does provide that the stay period may be extended for an additional 90 days for cause. If a tenant fails to assume or reject the lease, the Bankruptcy Code provides that the lease is deemed to be rejected. By law, rejection of a lease (whether express or implied) terminates the tenant’s obligation to perform under the lease and allows the landlord to assert a rejection damages claim. It may also terminate the leasehold estate, although this should not be assumed. Section 365(d)(4) of the Bankruptcy Code provides that upon rejection, “the trustee shall immediately surrender [the] … real property to the [landlord].” However, some courts have held that rejection is only a breach of the lease and not necessarily a termination of the lease itself. Rejection damages can be difficult to calculate and there are express limits upon the amount that a landlord may claim. The structure of such a claim, therefore, becomes critical.

A tenant choosing to assume a lease must provide landlord with assurances that it will be able to perform on a going forward basis and must also cure all defaults (including any non-monetary defaults). This is not an automatic process, in other words, and landlords should carefully consider whether it should file a written objection with the bankruptcy court as to any assumption (and/or assumption with assignment to a third party).

What all of this means is that landlords must, at a very early stage, consider the exit strategy in the event their tenants become insolvent. Merely demanding large security deposits is not sufficient (since those deposits become part of the bankruptcy estate in most instances), nor is relying upon the hope that rents continue to increase sufficiently such that future tenants will indirectly make good on any losses from prior tenants. Requiring third party guarantors for lease obligations, demanding letters of credit (and ensuring that they are properly drafted so that they do not become part of the bankruptcy estate) and, most importantly, properly drafting leases to place the landlord in the best possible position if bankruptcy occurs are all essential.

For more information, visit our Greater Washington-Baltimore Region Transactional Real Estate practice.