What to Do If Your Tenant Is Bankrupt
On September 15, President Biden announced a tentative deal with unions representing tens of thousands of railroad workers that helped narrowly avoid a strike that threatened to devastate the country’s delicate supply chains that have been strained since the beginning of the pandemic. Now the country awaits the outcome of the union member votes (which we may not know until mid-November), but even if the members approve the deal, the retail sector will still face empty shelves, job vacancies and surging inflation.
In fact, the retail industry has been facing economic headwinds for years. As the red flags continue to mount, commercial landlords may justifiably grow concerned regarding the financial health of their tenants. Although some tenants may show signs of financial distress or even approach their landlords seeking rent relief or some other form of forbearance, landlords often have little or no advance warning of a bankruptcy filing. Fortunately, landlords can take steps before any filing in order to protect their interests.
First, all landlords should be familiar with their rights and obligations under the applicable lease documents. For example, landlords should know the leases’ events of default and whether any notices must be sent (or any other actions taken) after a default. If a lease default does occur, then landlords must take the appropriate steps in the time prescribed by the applicable lease in order to avoid an unintentional waiver. For this reason, these actions should still be taken even by a landlord that is engaging with a tenant on a potential forbearance deal. Similarly, every landlord should be familiar with the consequences of a default, such as rent acceleration or default interest.
Second, landlords should confirm the amount and form of their security deposit (if any). Once a bankruptcy is filed, a cash security deposit can be used to set off a landlord’s claim, but only with prior court approval. Alternatively, if the security deposit is in the form of a letter of credit, then a landlord can usually freely drawdown on the letter of credit before or after the bankruptcy filing. Relatedly, in any forbearance negotiations landlords should consider ways to enhance their credit position such as with an increased security deposit or third-party guaranty.
If a bankruptcy is filed, landlords should stay informed regarding the status of the case in order to not miss key deadlines such as the final date to file a claim. Failure to timely file a claim may result in the claim being barred entirely, which is a harsh but avoidable result. Critically, the automatic stay goes into effect immediately upon bankruptcy and prohibits landlords from terminating their leases or taking any other adverse action against the debtor’s property, including commencing or continuing eviction proceedings. However, landlords will be entitled to timely rent payments after the filing date.
During the bankruptcy, a lease may be: (i) assumed by the debtor, (ii) assumed and assigned to a third party, or (iii) rejected. The Bankruptcy Code requires tenants of nonresidential real property to decide what to do with their leases within 210 days after the bankruptcy filing date, subject to a one-time 90-day extension by the court or other extension agreement between the parties. During this time, tenants may ask their landlords to renegotiate unfavorable lease terms or may market favorable leases to third-parties. Either way, the Bankruptcy Code’s strict deadline provides important leverage to landlords. If a tenant-debtor fails to decide what to do within the timeframe set out, then the lease is deemed rejected.
Lease rejection is treated as a breach as of the bankruptcy filing date, and landlords are entitled to damages for the breach, which will be treated as an unsecured prepetition claim. The damages for unpaid, future rent will be capped at the greater of (i) one year, or (ii) 15% of the remaining lease term but not to exceed three years, measured from the earlier of (i) the filing of the bankruptcy, and (ii) the date on which the lessor repossessed or the tenant surrendered the property.
If a tenant instead decides to assume or assume and assign the lease, then all existing defaults must be cured. This means that any amounts due to a landlord, including for prepetition rent, must be paid promptly upon assumption or assumption and assignment. As a result, it is critical that landlords thoroughly assess any defaults and precisely calculate any amounts due so that they can demand the proper amount of cure. Notably, many leases allow landlords to seek reimbursement of costs and expenses, including attorneys’ fees, which should be added to the landlords’ assertion of cure. Failure to assert any existing defaults will likely bar a landlord from seeking payment for such defaults in the future, which is, again, a harsh but avoidable result.
Landlords may also have the right to demand adequate assurance of future performance. Specifically, if debtor-tenants either (i) have already defaulted on their leases or (ii) seek to assign their leases to a third-party, then their landlords have the right to receive evidence that the debtor or assignee can perform for the remainder of the lease term. Significantly, the Bankruptcy Code overrides all anti-assignment provisions that would ordinarily prevent a debtor from assigning a lease unilaterally. Therefore, adequate assurance is a critical bargaining chip for landlords who can, among other things, demand additional guaranties from the debtor or assignee.
In sum, as the economic outlook continues to darken, it is advisable for landlords to be proactive to protect their interests. If a tenant does file for bankruptcy, the rules can be unforgiving to inattentive parties, but they also provide important tools to parties that are informed and prepared to act.