When A Tenant Files Bankruptcy

Once frustrated by the bankruptcy code, landlords now are finding several forms of recourse.

by Robert S. Bernstein, Esquire
Bernstein-Burkley, P.C.

The United States Bankruptcy Code—once a landlord’s worst enemy—now is showing signs of becoming a property owner’s friend. Although the code is not perfect and may be interpreted and imposed differently throughout the country, it now offers landlords certain protections.

The benefits for a landlord found in the bankruptcy code are best understood through the following scenario.

Let’s assume a tenant is incorporated, operates 40 stores in three states and was the subject of leverage buyout three years ago. It is one of three anchor tenants in a shopping center that is thriving.

But the tenant, a discount department store, is experiencing a slowdown in business and has had some financial difficulty during the past few years. Several of its stores are unprofitable and the one in this center is in the fifth year of a 15-year lease. Late one Friday afternoon, the tenant files Chapter 11 reorganization proceedings. From here on out, the tenant is the “debtor”.

Once the bankruptcy code imposes an “automatic stay” of all collection and enforcement proceedings, this prevents eviction proceedings or other action—either for possession or for money damages—without first receiving the bankruptcy court’s permission.

Early in a Chapter 11 case, the debtor appears to have the advantage. It has the exclusive right to file a plan of reorganization during the first 120 days of the proceeding and 60 days from the filing to either assume or reject the lease or to seek an extension of time to assume or reject it.

Upon filing the petition (the original bankruptcy filing), the code requires the debtor to perform all obligations of the lease from that date until the lease is assumed or rejected. If the debtor fails, the landlord may seek relief from the automatic stay and proceed with its remedies, which include an action for possession of the premises.

It is important to note that the bankruptcy code does not recognize defaults that are breaches of lease covenants relating to either insolvency of the financial condition or the debtor. The code also does not recognize the fact that the debtor filed a bankruptcy proceeding, or that a trustee or custodian has been appointed.

Other than those three exceptions, if there has been a breach of the lease before the bankruptcy is filed, the debtor cannot require the landlord to provide services or supplies after the bankruptcy and proper to the debtor’s assumption of the lease.

Understandably, deadlines for debtors to assume to terminate the unexpired lease or executory contract can cause a significant amount of litigation, but it is a reasonably strong weapon for landlords. An executory contract still has obligations to be performed by all parties. If the lease is rejected, it is treated as having been breached by the debtor before the bankruptcy filing and then any damages that landlord might suffer are treated as pre-petition general unsecured claims.

The code limits “rejection damages” to either 15 percent of the balance of the rent reserved in the lease or the rent reserved for one year from the filing date or the date the premises were surrendered, whichever is earlier. In addition, the claim can include any pre-petition rent due at the time of the filing.

Assumption of the lease requires the debtor to prove various elements, and the lease becomes its post-petition obligation, making any claim from a subsequent default and expense of administration of the Chapter 11 proceeding. That claim then becomes a high priority in the distribution of funds in the event of a liquidation.

In order to assume a lease, however, a debtor must provide adequate assurances that it (or another tenant, if it intends to sublease) will promptly correct any defaults, compensate the landlord for any financial loss resulting from a default and provide adequate assurance of future performance.

In a shopping center lease, “adequate assurance of future performance” includes the assurance of the source of rent, that any percentage rents will not substantially decline, that the lease will be subject to all the present use restrictions, and that the reorganized debtor will not disrupt the tenant mix.

These assurances requirements protect the landlord if the debtor wants to either assume the lease, or assume and assign it. They provide arguments for the landlord to defend against the attempted assumption.

The code says if the debtor does not assume or reject an unexpired lease within 60 days, or an extended time period set by the court, then the lease is rejected.

What constitutes cause for the extension of time is different in every case, but there is some general agreement among the courts as to what factors should be considered: Is the lease a primary asset of the debtor? Has the debtor had time to intelligently appraise its financial condition? Is the debtor currently on all post-petition lease obligations?

The first skirmish between the landlord and the debtor usually concerns this extension of time. In one recent case, Glosser Brothers Inc., in Johnstown, PA, was the debtor holding leases for approximately 70 stores. The retailer filed a motion requesting that the court extend the time to assume or reject until its plan of reorganization was confirmed. Several landlords objected, claiming the debtor did not show sufficient cause, and further, that the debtor’s request for an unlimited extension of time was improper.

The court extended the time as requested, but on appeal by one landlord, a higher court agreed with the landlord and vacated the order.

There are times when the court will extend the time, particularly in cases when many leases are involved and when those leases are central to the debtor’s reorganization. In those cases, some courts—and most landlords—favor a series of short extensions, rather that one long extension. This allows the landlord to argue his position before a judge each time.

If the lease is rejected, or the time period to assume or reject passes, the lease automatically is terminated and the landlord gains immediate possession.

If the debtor obtains an extension, there still are options for the landlord, depending on how badly the landlord wants to oust the tenant.

The landlord can seek to have a trustee appointed for the debtor, hoping that the trustee would reject the lease. If a trustee is appointed, the debtor’s exclusive right to file a plan of reorganization would terminate automatically. At the termination of the debtor’s exclusive time to file a plan, the landlord could file a plan or reorganization or liquidation, either of which could terminate the landlord’s lease.

Naturally, the plan would have to take all of the other interests and claimants into account, and that process could take a great deal of investigation and negotiation. The results can be a plan to sell or liquidate the debtor.

The landlord also may have the court convert the debtor from a Chapter 11 proceeding to a more drastic Chapter 7 liquidation so the liquidating trustee might find less value in the lease.

The alternatives available to the landlord depend on the lease’s value. It is more difficult for a landlord to engineer a rejection of a long-term below market value because it is beneficial to both the estate and the creditors.

Usually the debtor, trustee or creditors will want to either assume the lease or assume and assign it in order to further the value. If the landlord really wants the debtor out, it may be worth his money to pay the estate to terminate the lease.

If the debtor negotiates a sale of the lease, the landlord may attack the attempted assignment on a number of fronts. All of the debtor’s attempts to limit defaults and provide “adequate assurance of future performance” should be examined and challenged. On each point, the landlord can force the debtor to convince the judge of his future performance.

The more the landlord knows, the greater the proof the debtor must show. In the end, if the lease is assumed or assumed assigned, the safeguards in the bankruptcy process often can protect an informed landlord in the future.

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