Landlords' Rights: Protecting Your Financial Interests When a Tenant Files for Bankruptcy
Bankruptcy filings continue to increase even as the economy shows signs of emerging from the longest recession since World War II. Sooner or later, a landlord is likely to be faced with a tenant that files for bankruptcy. While the filing of a bankruptcy petition by a tenant limits the remedies a landlord enjoys under state law, the Bankruptcy Code affords federal protections that are often overlooked. For owners of commercial real estate, a working knowledge of your rights as a landlord will go a long way toward protecting your financial interests.
First, the bad news. When a tenant files a bankruptcy petition, the automatic stay imposed by the Bankruptcy Code acts as an injunction that prohibits any action against a debtor that a landlord could have pursued before the bankruptcy. Thus, a landlord is prohibited from bringing an eviction action or attempting to collect rent that is owed without first obtaining relief from the automatic stay from the United States Bankruptcy Court. If a landlord violates the stay (e.g., by obtaining an eviction order without informing the judge that the tenant is in bankruptcy), the landlord could be liable for damages incurred by the tenant, including attorney's fees. If the violation is found to be intentional, the tenant may also recover punitive damages.
But all is not lost for a landlord whose tenant files for bankruptcy protection. While in bankruptcy, a tenant is required to satisfy all of the terms of its lease until it (1) rejects the lease, (2) assumes it, or (3) assumes and assigns it to a third party. During this interim period, the tenant is obligated to pay the landlord rent when due, and failure to do so entitles the landlord to an administrative claim for any rent owed after the bankruptcy filing. Although administrative claims are given a higher priority in bankruptcy cases than unsecured claims, they do not assure a recovery if the bankruptcy estate is administratively insolvent.
The length of time a debtor has to decide whether to accept or reject a lease depends on the type of property involved and the Bankruptcy Code chapter under which the case was filed. Typically, a debtor that leases commercial property has at least 120 days to make a decision, but a landlord may file a motion asking the bankruptcy court to shorten this period. In deciding whether to grant the motion, the court will consider whether the tenant has had sufficient time to evaluate its options, the effect of the delay on the landlord, and whether the tenant has performed its obligations under the lease.
Oftentimes, leases are rejected in bankruptcy. Assume a tenant in your shopping center has a store that is unprofitable. The tenant may reject the lease and abandon the location, in which case your claim for unpaid rent for the remainder of the lease term will be treated as an unsecured claim in the tenant's bankruptcy case. Under this scenario, you may not be entitled to the full amount of unpaid rent due under the lease. The Bankruptcy Code imposes a cap on a landlord's “rejection damages” equal to the greater of one year's rent or 15% of the rent due under the lease, not to exceed three years' rent, plus pre-petition amounts that were not paid.
If, on the other hand, your tenant decides to assume the lease, it must cure all pre- and post-petition defaults or provide adequate assurance that it will do so before the bankruptcy court will allow the lease to be assumed. Therefore, if the debtor wishes to remain a tenant because the location is profitable, you will likely be able to recover all unpaid rent, taxes and other charges that are allowable under the lease ahead of other creditors.
The Bankruptcy Code also allows a tenant to assume a lease and assign it to a third party. This often occurs when a tenant has a lease in a desirable location with terms that are more favorable than could be negotiated in the current marketplace. When an assignment occurs, the tenant transfers all of its rights under the lease and is relieved of all future liability. Favoring the goal of a fresh start for debtors, the Bankruptcy Code allows a tenant to assign a lease even when its terms require the landlord's consent before the lease may be assigned. This right is not unlimited, however; if you can show that an assignment will result in economic harm or create an unfavorable tenant mix in your shopping center, the bankruptcy court may disallow the assignment. Usually, the interests of the tenant and landlord coincide and the assignment is allowed to occur, provided the tenant cures all arrearages and the assignee posts a deposit or other security for the performance of future obligations.
It should be noted that landlords are not entirely without recourse when a tenant files for bankruptcy. For example, a tenant's bankruptcy filing does not prevent you from taking action against a lease guarantor, provided the guarantor is not itself in bankruptcy. Alternatively, some landlords require tenants to post a letter of credit as security at the outset of a lease. If that is the case in your situation, you may be able to draw on that letter of credit, even if your tenant files for bankruptcy protection.
When a tenant files for bankruptcy, the Bankruptcy Code provides powerful remedies that inevitably affect a landlord's rights. Therefore, it is incumbent upon the landlord to become involved in the proceedings and move quickly to protect its interests. To take full advantage of the protections that the Bankruptcy Code does provide, commercial landlords should consult with their attorneys as early in the process as possible.