Legal Briefs

Landlords Should Know Bankruptcy Rights to Avoid Lost Rent

Your tenant files for bankruptcy — should you give up hope of collecting any rent? No. Tenants are not allowed to occupy leased space without paying rent during bankruptcy proceedings. However, the bankruptcy filing's timing determines how much restitution landlords can expect. As the economic downturn continues, commercial landlords must be alert to the possibility that bankruptcy may interfere with their rental revenue, and they should learn about their bankruptcy rights.

Bankruptcy's Effect on Leases

The U.S. Bankruptcy Code Section 362 automatic stay precludes landlords from terminating leases in default or evicting tenants after they file bankruptcy. Landlords are entitled to seek relief from automatic stay, but bankruptcy courts typically don't grant immediate relief unless a default jeopardizes a property or a tenant fails to fulfill its post-petition lease obligations.

Leases, even those in default, are considered executory contracts in bankruptcy cases because performance is still due from both the landlord and the tenant. Debtors can occupy the premises and are allowed 60 days (subject to extension by court order) to decide whether to assume the lease and continue to occupy the premises or assign the lease to a third party. If a debtor chooses to assume the lease, it must pay all pre- and post-petition defaults or provide adequate assurance that it will do so in a timely way. If a tenant chooses not to assume or assign the lease, the lease is deemed rejected, or terminated, as of the bankruptcy filing date or another date set by the court.

Administrative Rent

Bankruptcy Code Section 365(d) requires debtors to perform all commercial lease obligations until the lease is assumed or rejected. Thus, tenants must pay rent due on the first lease payment date following the bankruptcy petition filing. If the tenant fails to do so, the landlord can move the bankruptcy court to compel payment. Bankrupt tenants also must perform all other post-petition lease obligations, such as constructing improvements and paying common area maintenance, tax, and insurance charges.

Administrative problems arise for landlords when tenants file bankruptcy petitions on days other than the lease payment date. If a tenant fails to pay rent on time and files before the next rent payment is due, it is obligated to pay only the next rent installment and associated charges.

Any amount a tenant should have paid before filing bankruptcy is considered either a pre-petition claim or part pre-petition claim and part post-petition administrative claim. A missed payment is solely a pre-petition claim if it covers a payment period that has ended before the bankruptcy case was filed. If the missed payment covers time after the bankruptcy case was filed, a landlord has a prorated pre-petition claim for the number of days before the bankruptcy filing and a prorated administrative priority claim for the number of days after the filing.

Bankrupt tenants also owe administrative rent if they continue to occupy the premises after a lease expires or is rejected in bankruptcy. Rent due after expiration or rejection is calculated as the property's reasonable rental value, which is generally the amount stated in the lease.

Landlords' Claims

If a tenant does not assume its lease and pay all past defaults as part of the bankruptcy process, the landlord has one or more claims against the bankruptcy estate. The most common claim is an administrative priority claim for unpaid post-petition rent, including other periodic charges, from the bankruptcy filing date until the lease expires or is rejected. Another administrative priority is for the occupancy's reasonable rental value for the period after lease expiration or rejection. Administrative priority claims are not due immediately but have priority over most other creditors and must be paid when the reorganization plan is confirmed. They are secured if the lease required a deposit.

No particular form is required to make an administrative rent claim, but landlords should file a written demand for payment in the bankruptcy court if they believe they are entitled to administrative treatment. If there is an objection to their claim, they will be notified and allowed to defend it.

A landlord has a claim for all unpaid pre-petition amounts due plus late charges and interest accrued on those amounts up to the bankruptcy petition filing date. The Bankruptcy Code puts no limit on the amount of this claim. A landlord also has a claim for lost rental income if the lease is breached or rejected under the Bankruptcy Code post-petition. The Bankruptcy Code limits this claim to the rent specified in the lease, without acceleration, for the greater of either one year or 15 percent of the remaining lease term not to exceed three years, calculated from the earlier of the bankruptcy filing date or the tenant's loss of possession. This claim is subject to reduction by any sums the landlord received or should have received in mitigation. For example, the bankrupt tenant's post-petition administrative rent payments or a replacement tenants' rent payments reduce the claim. Finally, this claim is treated as a pre-petition unsecured claim and so prorates with all other pre-petition unsecured claims. If there is a deposit, a lost rental income claim will be secured to the maximum amount of the deposit, depending on state law.

Preventative Steps

Unfortunately, the actions landlords can take to avoid losing rent after tenants declare bankruptcy are limited. For example, certain lease clauses, such as those that make filing a bankruptcy case a breach of the lease or in which the tenant agrees to surrender the premises or pay a large sum of prepaid rent upon filing, usually are unenforceable.

However, landlords can take preventative measures before tenants declare bankruptcy. To avoid problems collecting a bankrupt tenant's rent, landlords should obtain credit enhancements when signing leases and remain vigilant when tenants fail to pay rent. Credit enhancements include security deposits, letters of credit, surety bonds, third-party guaranties, and anything that provides an avenue for payment not limited by a bankruptcy case. By remaining vigilant, landlords can terminate leases pre-bankruptcy and negotiate new deals after tenants file. New leases benefit landlords because they can include more favorable terms, such as shorter duration, be for only part of the premises, or include a guarantor not previously liable; moreover, the rent on a post-petition signed lease is an administrative priority. Likewise, strong efforts to collect past due rent before bankruptcy may bear fruit by assuring a landlord is not stuck with a large, unsecured pre-petition claim.

Mike C. Buckley, JD

Mike C. Buckley, JD, is a bankruptcy attorney with Reed Smith LLP in Oakland, Calif. Contact him at 510.466.6704 or mbuckley@reedsmith.com. The discussion of legal issues in this column is for informational purposes only. Results may vary depending on state laws and individual circumstances.

Nov.Dec.03

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