Bankruptcy / 10 min read
What Happens When Your Lease Counterparty Files for Bankruptcy?
Last month, we found out what happens when your contract counterparty files for bankruptcy. Now, you have just found out that your lease counterparty filed for bankruptcy, what happens next?
Commercial lease contracts in bankruptcy have special issues and provisions of the Bankruptcy Code, with some differences from other types of executory contracts. It can be tricky to decipher next steps and/or your legal rights. There are also options when determining whether the debtor is the landlord or the tenant.
Understanding Executory Leases
First, from a bankruptcy point of view, it is important to understand the term "executory lease." The Bankruptcy Code has an extensive section (Section 365) that deals with executory contracts and leases but does not define the term "executory." Instead, courts, including the U.S. Supreme Court, have adopted a definition that means that each party to the lease still has material obligations outstanding to the other party on the date when the bankruptcy case was filed. For leases, almost by definition, absent the lease having expired, or having been terminated pre-bankruptcy, invariably a lease will be "executory" if either the landlord or the tenant files for bankruptcy.
At any point during the lease contract, each party has outstanding obligations owed to the other party per the lease and/or applicable law. Here, if a lease has expired by its own terms, often the lease, or applicable law, may create a hold-over, or month-to-month tenancy which will be recognized in bankruptcy. Further, for a lease to no longer be "executory" because it was fully terminated, all the steps and timing as set out in the lease must have taken place (or as otherwise provided by applicable law) before the bankruptcy was filed. This timing includes the satisfaction or expiration of any notice, grace or cure periods provided in the lease and/or by applicable law. For example, if the landlord has sent a default and termination letter to a tenant with notice that the tenant has ten days to cure or vacate, and the tenant files for bankruptcy before that cure period has expired, the lease will likely be viewed as "executory" for purposes of the tenant's bankruptcy case.
Economic Considerations in Lease Bankruptcy
Second, often what happens, or may happen to a lease in bankruptcy, depends on the economics involved in the underlying lease. At its most basic, if the lease is below market, the tenant wants to keep it, and the landlord wants to get a new tenant at higher rent. However, if the lease is at above market terms, the landlord will want the tenant to remain, even if it means renegotiating some lease terms, because getting in a new tenant means less revenue.
Options for the Debtor or Trustee
With that very important foundation, what happens to your commercial lease depends on which of 3 options the debtor or trustee exercises during the bankruptcy case. Generally speaking, the debtor or trustee can request a bankruptcy court to approve:
- an assumption of the lease;
- an assumption and assignment of the lease to a new third party; or
- rejection of the lease.
Assumption – Assumption/Assignment
Landlords – Tenant Bankruptcy
For landlords, having your lease assumed, or assumed and assigned, is often a good outcome because it provides for a way to get paid on all outstanding obligations including past due rent, taxes, and CAM charges. Moreover, an assumption, or assumption/assignment, provides a pathway for performance and/or payment of post-bankruptcy use and occupancy through the lease term. For a tenant debtor or trustee to assume, or assume and assign a lease, all defaults must be cured or paid as part of the assumption, which includes curing any non-monetary defaults (e.g. insurance, inspections, and permits).
Many bankruptcy cases involve sales of assets or assumption/assignment of leases related to those assets to a third-party purchaser. The process for how the sale and/or lease assignment occurs is often put in place early on in a bankruptcy case via a motion to approve bid, sale and/or lease assumption procedures. If you find yourself in this circumstance it is critical that you contact us as soon as possible because the approval of a sale and/or lease assumption procedures largely dictate the end results. Importantly, the lease assignment procedures set out the timing of filings including objections by landlords to protect their rights. This timing is often short, so it is imperative that you are diligent in protecting your rights and claims.
A typical lease assumption process provides for a debtor or trustee to file a schedule of all the debtor's executory lease contracts, along with a disclosure of what amount the debtor asserts is owed. This contract schedule is often filed before there are any bids made for a debtor's assets and before there is any information on whether a sale and/or lease assignment will occur and to whom. One of the most important parts of any lease assignment process relates to responding to a debtor/tenant's schedule of "cure" amounts. Here, a typical lease assignment process will include a debtor filing a list of all its lease contracts by location or store number, name of counterparty, and the debtor's statement of outstanding payment amounts. Unfortunately, we see all too often incomplete information on lease schedules, including name and address of landlord, and other issues along with zero-dollar cure amounts. This means that the landlord must object and respond with what is owed (often with a reservation that additional or continuing amounts are being incurred) otherwise, the amount as scheduled will govern.
It is important to know the deadline for filing objections to the listed "cure amount" because failure to timely object creates a serious obstacle to collecting what is owed. If you believe there is no executory contract because the lease expired with no automatic renewals or option periods, or the lease was completely terminated before bankruptcy, it is important to assert that in an objection as well.
Outside the scope of this article, in virtually every tenant bankruptcy involving multiple lease locations, an important issue arises on the debtor/tenant's payment of post-bankruptcy lease obligations. Although the Bankruptcy Code requires debtor/tenants to pay such rent and post-bankruptcy rent is given special priority of payment, it often is not timely paid and/or there are issues as to whether what is owed is a pro-rated portion of the rent (along with taxes and CAM charges) or just the next month's rent (e.g. if the lease provides for payment of the first business day of the month but the tenant files on the fifteenth day of the month, does the debtor's post-bankruptcy rent obligation include the pro-rated portion of the month in which it filed, or is the first post-bankruptcy rent due the following month). The case law on how post-bankruptcy lease obligations is calculated and paid is not uniform among the bankruptcy courts so again, it is critical to contact counsel to understand your rights and the timing of when you need to raise your hand/object.
The next part of the lease assignment process relates to whether the tenant is assuming the lease and continuing to occupy the space or seeking to assign the lease to a third party. In a case where the debtor/tenant is just assuming the lease and will continue to occupy it, the main issue is the curing of lease defaults as addressed above, and some proof that it will be able to pay going forward. However, if the lease is being assigned, there are other issues including the proposed assignee's ability to perform all lease obligations going forward. Further, if the lease is in a shopping center, the underlying lease may have restrictions on to whom the lease can be assigned, or what type of business can operate in the lease space, and these types of shopping center use provisions can be enforced in bankruptcy, if timely objections are made.
In large retail bankruptcies we have seen cases where a tenant assigns or sells its rights to assign, so-called "designation rights." In these cases, third parties will pay significant sums to essentially broker the further assignment of leases. This process can be complicated and complex but there are several cases where it has been approved even though the Bankruptcy Code itself does not expressly provide for it.
Final point here for landlords is that lease clauses that provide for (i) default upon tenant's bankruptcy or (ii) anti-assignment language, is typically not enforceable in bankruptcy.
Tenants – Landlord Bankruptcy
While most commercial lease bankruptcy cases involve tenants as the debtor, landlords file bankruptcy as well. For the non-debtor tenant, the issues addressed above apply. If the landlord seeks to assume the lease, the tenant should ensure that any defaults by the landlord are cured (or required to be cured). If the lease is being assumed and assigned to a new landlord, in addition to ensuring any defaults are cured, the tenant should request information on the proposed assignee's financial and operational ability to perform under the lease going forward. If a new management company is coming in on behalf of the new landlord, the tenant should request information on that new management company. Once assumed or assumed and assigned, the lease terms should remain unaffected.
Rejection
One of the important issues to understand in cases where a commercial lease is being rejected is that rejection is not a termination of the lease, instead it is a breach of the lease where the non-debtor party has options about what remedies or options it wishes to pursue including potential termination. The available remedies or options are largely governed by the terms of the lease itself, understanding that the debtor will not be making payment on any damage claim, instead any amounts due or that become due are converted into pre-bankruptcy claims. In many bankruptcy cases, recovery on pre-bankruptcy claims is modest or nominal pennies on the dollar.
Landlords – Tenant Bankruptcy
When the tenant seeks to reject the lease, the question is generally whether the rejection is being used to renegotiate lease terms or the tenant is really moving out (or has already vacated). The landlord will have a pre-bankruptcy claim for breach of the lease and potentially a post-bankruptcy claim if the tenant uses or occupies the space after the bankruptcy filing. For landlords, all damages under the lease are converted into bankruptcy claims. If personal property is left behind it will be important to determine whether there is a secured creditor with liens on that property and whether you have any landlord liens or similar claims to the property under your lease and applicable law. Our experience tells us that if the personal property has any value, it is typically removed or sold as part of vacating the leased space. Further, if the tenant rejects a long-term lease that is near its commencement, the Bankruptcy Code provides a cap or limit on the landlord's rejection damage claim.
Tenants – Landlord Bankruptcy
If your landlord is the debtor and rejects your lease, the Bankruptcy Code gives the tenant the option to either stay or leave. Rejection is not termination, instead it is the landlord breaching the lease. While it may seem strange to have a tenant elect to stay in the lease space when the landlord rejects the lease, the tenant has that right absent some other disposition of the underlying property. A tenant's decision is often based on what rights, if any, it has against the owner, if the owner is not the debtor (e.g. absent direct contractual right to quiet use of the lease space between the tenant and the owner, often the debtor/landlord is in default of its obligations to the owner and the owner can foreclose which often preempts the tenant's lease and occupancy of the property). If it is possible to remain, and the tenant elects to do so, lease payments continue subject to other rights of the tenant under the lease. The tenant will need to determine to whom those payments are made. If the tenant elects to treat the rejection of the lease by the landlord as terminating the lease, the tenant's damages are converted into pre-bankruptcy claims.