In today’s distressed retail market, the possibility of a tenant’s bankruptcy is a top concern for managers and owners of retail centers. Owners of commercial office buildings in many parts of the country are becoming increasingly concerned about tenant bankruptcies, too. Landlords need to know the options available when a tenant files for bankruptcy and should anticipate a tenant/debtor’s likely maneuvers in bankruptcy. This article provides a summary of relevant law and key strategic considerations to help landlords minimize losses and protect their interests when a tenant files bankruptcy.
Leases & “Executory Contracts”
Section 365 of the Bankruptcy Code allows a debtor (i.e., an entity that has filed for bankruptcy) to either assume or reject an executory contract or unexpired lease. This way, a debtor may decide to assume any valuable contracts and reject any burdensome ones. If a bankruptcy tenant decides to assume an unexpired lease, the lease will remain in effect through and after completion of a Chapter 11 reorganization. Assuming the lease does not mean the tenant gets to stay in the space free of charge. The tenant must cure any outstanding defaults and perform all pending obligations in the lease.
The Pre-Assumption/Rejection Time Period
When a tenant files bankruptcy, its unexpired lease, as well as the tenant’s other executory contracts, remain in existence and enforceable by, but not against, the tenant-debtor. This remains so until the tenant decides to assume or reject the lease. If the tenant remains in possession of the lease space pending a decision to assume or reject the contract, the tenant must pay for that privilege. Bankruptcy courts may adjust the lease’s rent price to a new “reasonable value” payment in certain circumstances.
Time Period for Assumption/Rejection
The 2005 amendments to the Bankruptcy Code shortened the time limit for a commercial tenant to decide whether to assume or reject a lease. This change is welcome news for landlords who were frustrated with the prior law, which many people thought gave bankrupt tenants an almost endless right to remain in place without paying rent. Under current law, a tenant in bankruptcy is deemed to have rejected its lease unless it formally assumes the lease within 120 days of the date bankruptcy is filed. The court may order only one 90-day extension; any subsequent extension requires the landlord’s consent.
Procedure for Assumption or Rejection
If your bankrupt tenant indicates that it wants to assume the lease, get it in writing. Moreover, get court approval. Best practices require the landlord and tenant to agree in writing on all back-rent, late charges, and other fees to be brought current; any changes to the lease’s terms; and any side agreements. This written agreement should be submitted to the bankruptcy court for approval, either as part of the tenant’s reorganization plan or by a separate motion.
The Easier Path: Terminate the Lease Before Bankruptcy
One way to avoid the uncertainty of whether your tenant is going to assume or reject its lease is to terminate the lease before the tenant files for bankruptcy. Most retail tenants will send signals of their financial distress before filing for bankruptcy: late rent payments, requests to make payment in installments rather than on the date it is due, inquiries from the tenant’s lender or trade creditors asking if you have had any problems with the tenant, to name a few. If you receive a percentage of sales in rent, a quick historical analysis might show how the tenant’s current sales compare to historical periods; a significant decline in revenue should prompt you to review the lease. News reports about your tenant or your tenant’s industry may also be an indication of trouble on the horizon.
If the rent is late or you perceive that your tenant is in distress, review the lease’s terms regarding tenant defaults. Is the tenant in default? If so, provide notice of the default and wait any required cure period. If the default is not cured, or if no cure period is required, consider terminating the lease.
Landlords are sometime hesitant to terminate a lease because they would rather have a slow-paying tenant than dark space. Keep in mind that terminating the lease is different than evicting the tenant. Most leases allow for a tenant to remain in possession of the leased space after the lease is terminated on a month-to-month basis. If the tenant files Chapter 11, it is much easier to evict a month-to-month tenant than it is to evict a tenant whose lease is in effect and enjoys all the lease-related protections afforded by the Bankruptcy Code. Even if you prefer not to evict the tenant, the fact that you have the legal right to do so will help you in negotiations for new lease terms.