Legal issues

Guarding Against Tenant Bankruptcy

These Strategies Can Help Landlords Protect Their Interests When Tenants File.

For years, bankruptcy has signified the end of the line for struggling companies. But in today's economic climate, many businesses use the U.S. Bankruptcy Code as a blanket of protection from creditors while they attempt to reorganize and emerge on more solid financial ground.

Despite this trend, tenants who file for bankruptcy protection can become an unprepared landlord's worst nightmare. Depending upon the situation, landlords may stand little chance of collecting money owed upon a default such as past-due rent and damages. But landlords can follow several strategies to protect their interests both before and during a tenant's bankruptcy.

Bankruptcy Basics In its bankruptcy petition, the tenant must declare what type of bankruptcy it is commencing. If the business is not salvageable, the tenant will file a Chapter 7 liquidation. Under Chapter 7, all of the tenant's assets are consolidated in the bankruptcy estate and liquidated by a court-appointed bankruptcy trustee, with the goal of paying each of the tenant's creditors as much as possible. However, creditors -- including landlords -- often only recover a fraction of what they are owed.

If the tenant has determined that the business can be saved, it will file a Chapter 11 reorganization. Under Chapter 11, the tenant will continue to operate as a debtor-in-possession and will attempt to recapitalize the company. The goal in a Chapter 11 case is for the business to rehabilitate itself, either independently or with the help of an outside consultant, and return to financial health.

Upon filing any type of bankruptcy petition, a tenant is granted an immediate automatic stay, which gives the bankruptcy estate an opportunity to gather its assets and determine if it will be able to survive. The automatic stay stops all legal actions against the tenant and prevents additional court actions from commencing. For the period of the stay, no collection or repossession activities can occur against the tenant. Creditors can attempt to have the stay lifted, but to do so they must prove to the bankruptcy court that failing to lift the stay will cause irreversible harm.

Assuming or Rejecting Leases Typical anti-assignment lease provisions allowing landlords to declare a default upon bankruptcy of a tenant are not enforced by bankruptcy courts. According to Section 365 of the U.S. Bankruptcy Code, a business has the option to assume or reject any of its unexpired leases. Currently, Section 365 allows the tenant 60 days to make this determination, though bankruptcy courts often extend this period an additional 60 days or more. If the tenant fails to assume its lease at the end of this period, the lease automatically is considered rejected. However, provisions in the pending Bankruptcy Reform Bill could extend the assumption or rejection period to 120 days for retail leaseholders with a limit of one extension.

Section 365 exists for several reasons. First, leases are one of the most valuable assets owned by bankruptcy estates. Below-market leases can be assigned to third parties to provide cash to pay existing creditors or to help finance reorganization. Second, the ability to reject a lease can provide a bankrupt tenant the leverage needed to renegotiate an existing pre-bankruptcy above-market lease in an attempt to continue as a tenant under more favorable terms.

Lease Assumption. If the tenant assumes the lease, it either can remain in the space or assign its leasehold to a third party. However, upon assumption, the tenant must provide assurance that it will cure all defaults in a timely manner and provide adequate assurance that it will meet its future lease obligations. Unfortunately, no specific legal definition of “adequate assurance” exists. Usually, the assurance is the same as what the landlord required when the lease was signed. Therefore, landlords clearly should define these assurances in their leases.

If the tenant defaults on its lease after assumption, the landlord can enforce the provisions of the lease covering defaults and remedies.

Assignment of the Lease. In some situations, the tenant may decide to assume the lease and then assign it to a third party. If this should occur, the assignee steps into the shoes of the tenant and is responsible for complying with all existing lease obligations. At that time, the assigning tenant is absolved of all obligations under the lease.

An assignment can be profitable for the tenant if the lease is for a below-market rent. In such a situation, the tenant is not required to share the profits with the landlord, even if the lease required a division of profits by a solvent tenant. The landlord can negotiate to gain a portion of the profit by claiming to the bankruptcy court that the proposed assignee is inadequate. Rather than risk losing the assignee, the tenant may compromise and divide the assignment profits.

The landlord also can object to the bankruptcy court if it finds the potential assignee unacceptable. While bankruptcy courts would prefer to approve lease assignments, they will protect landlords and other tenants from the consequences of an unsuitable assignee, such as one that lacks the proven financial capacity to meet its lease obligations.

Rejection of the Lease. If the tenant chooses to reject the lease, the bankruptcy estate is considered to be in default. The Bankruptcy Code limits the damages the landlord can collect to the greater of one year's rent or 15 percent of the remaining lease term up to a maximum of three years. These time periods begin on the earlier of two dates: the date the tenant files its bankruptcy petition or the date the landlord regains possession of the leased premises. Any other claims the landlord possesses against the tenant become general unsecured claims. General unsecured claims have the lowest priority, meaning they are the last claims satisfied and often receive pennies on the dollar, if anything.

Special Rules Governing Shopping Centers. Shopping center leases are subject to a different set of rules in bank-ruptcy. Unlike anti-assignment clauses, exclusive-use and co-tenancy clauses in shopping center leases are enforced by bankruptcy courts.

Also, in order to assume or assign leases according to Section 365 provisions, shopping center tenants must satisfy three additional criteria to provide adequate assurance of future performance. First, the tenant must prove it can pay significant percentage rent if any is included in the lease. Tenants can attempt to prove this in any possible way, such as presenting performance results and marketing data from other stores in similar demographic areas that show evidence of financial strength. Second, the tenant or proposed assignee must meet all other lease provisions, such as exclusive-use or co-tenancy. Third, the tenant cannot assign the lease to an entity that would disrupt the tenant mix. Each of these criteria provides landlords with a degree of leverage in assignment negotiations.

How Landlords Can Protect Themselves Once a tenant enters bankruptcy, a number of provisions such as the automatic stay protect it from actions the landlord may want to take. Thus, landlords can defend themselves best by acting before a tenant files bankruptcy.

First, landlords should choose their tenants carefully. They should conduct rigorous financial background checks by obtaining prospective tenants' credit reports and current financial statements and interviewing previous landlords and creditors. If a prospective tenant's finances appear suspect, a landlord should require a guarantor or letter of credit.

Writing defensive leases is another proactive strategy. Landlords should include net worth and financial ratio covenants in lease documents and make failure to meet these covenants a condition of default; however, making it a default for a tenant to declare bankruptcy is unenforceable. These lease provisions will help protect the landlord from a financially weak tenant, and even may provide the landlord with a warning that the tenant is failing before the tenant can file for bankruptcy. This early warning may provide the landlord with enough time to evict the tenant before the bankruptcy petition is filed.

Next, landlords should limit the amount of time a tenant has to cure defaults and specify the number of times per year that tenants can use the cure period. Typically, landlords will provide for notice and a cure period once in a 12-month period and a total of twice during the term of the lease.

Also, landlords should include a statement that the lease is a shopping center lease if their property reasonably can be considered a shopping center (such as an office building with retail on the ground floor). If the court agrees it is in fact a shopping center lease, the additional adequate assurance provisions previously discussed will be considered.

In addition to negotiating strict lease provisions, landlords should monitor their tenants' financial conditions closely by requiring them to meet certain financial hurdles and obligating them to provide financial statements at least once per quarter. If a tenant fails to meet the financial conditions, the landlord either can investigate the tenant's finances more thoroughly or declare a default.

Finally, if a tenant has defaulted, landlords should evict the tenant before it files for bankruptcy.

What to Do Once a Tenant Has Filed Once a tenant files a bankruptcy petition, the landlord's freedom of action is restricted, yet hope for collecting money owed is not lost.

Tenants are required to pay rent during the proceedings, even though many ignore this fact. Fortunately for landlords, accrued rents are considered an administrative expense that is given preference over other debts.

Also, letters of credit and guarantors are not protected by the automatic stay. Landlords should look to these entities for payment of defaults if necessary.

As with other creditors, landlords can ask the bankruptcy court to lift the automatic stay, but they must prove that they will suffer irreparable damage if the stay isn't lifted.

While the best-case scenario is to avoid leasing to tenants that are unstable financially, this may be impossible in today's market. Thus, landlords should keep the possibility of bankruptcy in mind when constructing relationships -- and leases -- with tenants.

Andrew H. Mittler, CCIM, JD

Andrew H. Mittler, CCIM, JD, is an associate at Patton Boggs LLP in Dallas. Contact him at (214) 758-3522 or amittler@ccim.net.

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