Legal issues

What to Do When a Tenant Files Bankruptcy

A tenant bankruptcy conjures up images of valuable space being interminably occupied by a deadbeat who neither pays rent nor allows the landlord to obtain a new tenant who will pay rent.

While bankruptcy is frustrating for all creditors, landlords who know the rules can protect themselves better than other creditors when dealing with tenants. When bankruptcy is filed, a landlord should know the status of the lease, what rights the tenant can exercise, and what options are available to the landlord. Through vigilance in the bankruptcy proceedings, landlords can maximize their recovery and even preserve their tenant despite past delinquencies.

Bankruptcy Basics

The legal position of landlords and tenants is best understood when basic principles of bankruptcy are known.

Bankruptcy chapters-Tenants in business file bankruptcy petitions under either Chapter 7 or Chapter 11. When a business files for a Chapter 7 bankruptcy, the court immediately appoints a trustee to liquidate all of the debtor's assets, to use whatever is available to repay creditors as much as possible. In a Chapter 11, the debtor keeps control of the business with a view toward continuing the operation in order to pay the creditors more money than they would receive in a liquidation. If the business cannot successfully reorganize, a Chapter 11 case may be converted to a Chapter 7 case; when this happens, the court appoints a trustee.

Types of claims-Obligations of a tenant created before bankruptcy is filed are referred to as "pre-petition" claims. Claims or debts created after filing are "post-petition" claims.

If the tenant stays in the premises any time after the bankruptcy is filed, the claim for rent for this period of time is considered an "administrative claim." Administrative claims are post-petition claims and are paid before any other claims in the bankruptcy, whether the tenant has filed a Chapter 11 or a Chapter 7. Thus, to the extent that there is any money to pay any creditors, the rent incurred after bankruptcy commenced will be paid. If there is not enough money to pay all administrative claimants (those people providing goods or services to the bankrupt tenant after commencement of the bankruptcy), then the administrative claimants all share proportionately in whatever money is available.

Rent owed for periods before bankruptcy was filed, known as pre-petition rent, is an "unsecured" claim. This is the last type of claim to be paid and, if paid at all, is almost certain to be severely discounted.

Automatic stay - When a tenant files for bankruptcy, all collection actions against the tenant stop. This includes unlawful detainers or other efforts to collect money. Filing bankruptcy creates an "automatic stay," which means that creditors cannot take any action against the debtor without court permission. However, the landlord can still pursue and collect back rent from any guarantors named under the lease, even while the tenant is in bankruptcy.

Conditions for Terminating a Lease

After bankruptcy -Virtually all leases contain provisions that say that if the tenant files bankruptcy, the lease is breached and the tenant can be evicted. Regardless of what the lease states, however, the law forbids the landlord from declaring a termination or breach of the lease as a result of bankruptcy. Furthermore, provisions that make performance of the lease more onerous after bankruptcy is filed rather than before are also unlawful. For example, a lease cannot require a tenant to pay more rent or increase a security deposit because of the bankruptcy.

Before bankruptcy - In most states, a lease is terminated when the landlord has given a notice to pay rent or to quit and the tenant does not pay rent by the end of the period of time required by state law or agreed to in the lease (usually three days). If the landlord accepts rent at the end of the notice period, the lease remains in effect, even though the landlord might have previously terminated. In fact, accepting a partial paymentrequires the landlord to give another notice to pay rent or to quit; in order to terminate the lease, the new notice must expire without any payment. Thus, a tenant making any payment that the landlord accepts after the notice period expires is able to claim that the lease is in effect when bankruptcy is filed.

If the landlord has terminated the lease before bankruptcy, then the tenant has no right to continue the lease after bankruptcy is filed. At the same time, the landlord cannot continue any pending unlawful detainers without permission of the bankruptcy court. However, if the lease is terminated and the tenant is not paying rent, the landlord will be able to quickly evict the tenant.

Status of Leases in Bankruptcy

If a tenant's lease has not terminated when a Chapter 7 or Chapter 11 bankruptcy is filed, then the tenant must assume or reject the lease within 60 days of filing bankruptcy. Before the 60 days are up, the tenant may make a motion to the court asking for an extension of the 60-day period. The landlord must be told what date the 60-day period expires.

It is important that the landlord be mindful of deadlines and motions made by the tenant concerning the lease. When the tenant asks the bankruptcy court for permission concerning any aspect of the lease, the landlord receives notice and must state its position. The landlord is dependent upon the rent and common area reimbursement expenses to pay the mortgage and to pay for other services such as maintenance, repairs, and insurance. The landlord must express to the court the impact of the tenant failing to promptly pay its obligations, particularly emphasizing the financial burden and the potential and real detriment to the landlord's entire project.

Effect of tenant assumption -A landlord should not assume that a debtor in Chapter 7 will automatically reject the lease. Even though a business is being liquidated, a trustee might still choose to assume the lease of a profitable (or potentially profitable) retail location so that the business of the debtor can be sold as a going concern at that location, or if the lease at that location is sufficiently valuable, the trustee may assume the lease in order to sell or sublease the property. A debtor in Chapter 11 may also attempt to sell some of its locations or leasehold interests in order to raise additional funds for the continuing business.

A tenant who assumes a lease in bankruptcy is agreeing to fulfill all the terms of the lease. If the tenant was in default of the lease at the time the bankruptcy was filed, then the tenant must make up the delinquent rent within a reasonable period of time. This is one of the few times any creditor in a bankruptcy can collect money that was owed before the bankruptcy was filed. If all the delinquencies are not cured by the end of the 60-day period, then the court must approve the tenant's efforts to establish that all arrearages of rent and other obligations under the lease can and will be paid within a reasonable time, normally no more than a few months.

Rejection of lease -The bankrupt tenant has the right to reject the lease within the same 60-day period. If the tenant does not assume the lease, it automatically rejects, or cancels, the lease. A tenant can reject a lease before the 60-day period expires. The landlord cannot do anything to stop a tenant from exercising the absolute right to cancel a lease. The landlord and the tenant, however, can negotiate a new lease that will be valid and binding if approved by the Bankruptcy Court.

When the debtor rejects the lease, the landlord can obtain an immediate order from the bankruptcy court to force the tenant to vacate the premises. This can be far more expedient than the conventional unlawful detainer. Additionally, in this situation the bankruptcy court is the tenant's last resort, whereas in the usual unlawful detainer, the tenant has a variety of tactics that can delay eviction (including filing bankruptcy).

The landlord's losses as a result of the tenant rejecting the lease are only an unsecured claim, even though the actual rejection does not occur until after the petition in bankruptcy is filed. In this instance, the value of the future rental stream that the landlord receives under the new lease is no better than pre-petition, unpaid rent. It will fall under the lowest class of claim and result in the landlord being paid only a certain percentage of back claim. Any lease that obtains from the premises after the rejection can be used to offset any losses from the rejection.

Working with Tenants to Minimize Losses

The landlord's ability to minimize losses from bankruptcy could depend on how the landlord conducts business with tenants who are in default but have not yet filed for bankruptcy.

Preference rules -When working out a new lease arrangement with a tenant who is in default but has not filed for bankruptcy, a landlord must be careful not to violate "preference" rules. The preference rules, which apply if the tenant subsequently files for bankruptcy, were established to stop one creditor from gathering the debtor's assets to pay pre-petition bills to the disadvantage of the other creditors. Although preference rules can be complex, they generally work this way: a payment to a creditor can be treated as a preferential transfer if the money was owed for more than 30 days before the date of payment and if the payment was made within 90 days before the debtor filed for bankruptcy. If it is a preferential payment, then the creditor can be forced to repay the money that was justly paid by the debtor before bankruptcy. In this way, the debtor (or all the other creditors) will have the payment available to pay claims or continue the debtor's business operation.

Thus, any time a landlord receives a payment for rental arrearages that are more than 30 days overdue and the debtor files bankruptcy within 90 days of that payment, the landlord runs the risk of the payment being treated as a preference. Since the landlord does not know whether the debtor will file bankruptcy within the next 90 days, the landlord must be cautious about how the lease and payment of back rent is negotiated.

Should the debtor assume the lease, then a payment made to the landlord within 90 days of the bankruptcy is not treated as a preference, since the landlord will be entitled to the payment as part of the assumption of any lease. If the lease is rejected, the debtor or trustee in bankruptcy may require that the money received within the 90-day period be returned. There are precautions a landlord can take to reduce the prospect of a debtor being able to claim a payment made 90 days or less before the bankruptcy is a preferential payment.

Non-bankrupt delinquency - Landlords need to evaluate not only whether a tenant is likely to avoid bankruptcy, but also what could happen in the bankruptcy. Several steps can assist in doing this. First, a landlord should always get a current financial statement on the debtor. If the tenant has adequate assets to pay all of its creditors on liquidation (even though the tenant normally is expected to pay all of its creditors when money is due) then the landlord is in a safer position to accept the payment without it being characterized as a preferential transfer. One requirement of a preferential transfer is that the creditor receive more than he would have received in a liquidation.

Second, the landlord should obtain affirmative representations from the tenant about the tenant's financial condition. If the representations support the adequacy of the tenant's net worth, they will act as presumptions in any proceedings brought by the tenant in bankruptcy against the landlord.

Third, consider forgiving the back rent altogether and entering into a new lease. Rental under the new lease can be increased as a means for paying the old rent. If the tenant is willing to give the landlord cash to pay the old rent, then the cash can be accepted as an increased security deposit for the new lease. The new lease can give the tenant the right to apply a certain amount of the security deposit to future rent without breachingthe new lease.

Finally, the landlord can get a guarantee of the payment of the rent, or can receive the actual back due rent payment directly from a pre-existing guarantor rather than from the tenant. If the guarantor receives the money from the tenant, the landlord can argue that any preference problem is a problem for the guarantor and not the landlord.

Re-Leasing the Premises

Once the tenant has either defaulted or filed bankruptcy, landlords should constantly be trying to re-lease the premises. Since many prospective tenants look for space well in advance of the need to relocate, a landlord can be planning for a new tenant. Knowing the bankrupt tenant must assume or reject the lease enables the landlord to plan for another tenant or continue the same tenant.

The prospect of losing a potential new tenant is also a good reason not to allow the bankrupt tenant additional time to assume or reject a lease. Tenants frequently make requests for such extensions because they do not know how they will reorganize their business when they file bankruptcy. For example, a retail chain that files bankruptcy may not know within 60 days which stores it will keep (assume the lease) or which ones it will close (reject the lease).

Vigilance is Key

The specter of bankruptcy can threaten the economic viability of a real estate property. And, unfortunately, the rules of bankruptcy are complicated and often confusing. However, by knowing the rules, by planning for bankruptcy when negotiating with delinquent tenants, and by being well aware of the debtor's maneuvers in bankruptcy, landlords can minimize the losses and maximize the predictability of regaining rent.

John A. Barclay

John A. Barclay is the managing attorney with Barclay Law Corporation, Newport Beach, California. Barclay practices in the areas of real estate, bankruptcy, business, and environmental law. He frequently speaks on a range of legal topics. Barclay can be reached at (800) 847-5432 (in California only) or (714) 476-2672.

May.Jun.94

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