It is essential to remember when negotiating the lease of commercial space, either as a landlord or a tenant, that the lease is king when determining the intent of the parties to the agreement.  For most experienced property owners or serial tenants, this should come as no surprise.  However, even the most experienced commercial leasing parties can temporarily forget this concept from time to time.

What I mean by “the lease is king,” is that if you do not get a desired term into the final executed lease, you cannot enforce that term.  There are two primary reasons why this is generally true.  First, most if not all states operate under a statute of frauds which requires certain agreements to be in writing.  In Texas, that statute (section 26.01 of the Texas Business and Commerce Code) specifically includes “a lease of real estate for a term longer than one year.”  While a letter of intent can potentially satisfy the statute of frauds, it will often still be subject to the second reason.

The second reason is integration, as often required by a “merger clause.”  A merger clause restricts the agreement between the parties to the terms of the document containing the merger clause.  A common form merger clause for a lease is:

“This lease, together with its exhibits, contains all agreements of the parties to this lease and supersedes any previous negotiations.  There have been no representations made by the landlord or tenant, or understandings made between the parties other than those set forth in this lease and its exhibits.  This lease may not be modified except by a written instrument duly executed by the parties to this lease.”

The most common situation in which the lease will miss a desired term arises under the letter of intent.  From a business standpoint, the letter of intent is where most of the negotiation occurs.  The parties generally agree to rent rates, security deposit, square footage, and other business terms in this preliminary letter. 

However, it is important to remember that the letter of intent is merely a memorandum of the parties’ understanding and carries no legal weight.  In order to enforce the terms agreed to in the letter of intent, the parties need to be sure that each term is incorporated into the lease itself.  This means a careful review of the entire lease document, and not merely a glance to verify financial terms.

Particular items that are sometimes lost in translation from the letter of intent to the lease include specific landlord finish-out tasks, parking, signage and atypical, tenant-specific lease requirements.

It certainly is not ground-breaking advice to read your lease, but a conscious effort to prevent these mistakes on the front end can prevent substantial costs associated with correcting errors later on.

The very helpful and informative commercial real estate blog, Square Feet (see the link in my blog roll below), has alerted me to a market update performed by RREEF.  While not strictly a legal matter, the status of the leasing market in the United States can have a significant effect on how leases are negotiated and drafted.

I like how RREEF merely updates their previous projections with comments and revisions, so that we can all see how our perceptions of the market continue to change.  You can find the report here.

Of particular note to my readers are the sections on the office and retail markets starting on page 19 of the updated report.  I would love to hear your thoughts on where you think the market is going in the comments section.

In Texas, a broker’s claim to a commission must be based upon the employment of the broker by the party from whom the commission is claimed.  In order to collect a commission, a broker must also prove that he performed the service contemplated by the terms of the employment.  Finally, a commission agreement for leasing real property is a contract for the purchase of real property for purposes of Texas’ statute of frauds, so any leasing commission agreement needs to be in writing to be enforceable.

Generally, under a commission agreement, a leasing broker may earn a commission in one of three ways:

(1) procuring a valid enforceable lease on the terms proposed by its employer (which in leasing is almost always the landlord);

(2) procuring a tenant to whom a lease is in fact made on terms satisfactory to the employer; or

(3) by producing a tenant that is ready, able, and willing to lease.

Looking at these three options, it is clear that a party employing a broker must carefully review the terms of a leasing commission agreement.  Option #3, where the broker merely produces a tenant ready, able and willing to enter into a lease, should never be accepted by the employer (although this may be the default provision in many broker-created forms).  From a landlord’s perspective, what benefit is a ready tenant if such tenant never actually enters into the lease?

Generally, it is advisable for a landlord to enter into a brokerage agreement whereby the broker is paid in installments, with the first installment payable upon execution of the lease, and the second installment payable upon receipt of the first rental payment by the tenant.  This way the broker is paid based upon only the actual benefit realized by the landlord.

Another consideration when evaluating a leasing brokerage agreement is potential future commissions.  These usually arise during extensions or expansions.  Logically, if the lease is extended, the landlord receives more income from the tenant brought in by the given broker.  However, landlords should be careful not to simply “give away” money on these occasions.  Brokers collecting commissions for extensions or expansions, particularly those contemplated in the original lease document, should be actively involved in coordinating and documenting the process in order to earn any commission.  A carefully drafted brokerage agreement can ensure that the broker does not receive an effort-free stream of commissions simply because the leasing relationship continues to flourish.

Finally, there are several key issues involving brokerage agreements which should be addressed in the lease itself.  The lease should specifically identify the brokers involved in the leasing transaction who will be paid commissions.  This helps avoid any potential claim against the landlord by an unknown brokerage party.  A lease need not identify any key terms of the agreement other than the brokers’ names and an acknowledgement that a commission will be paid pursuant to a separate written agreement.  Including terms (such as the percentage commission due) will only create an opportunity for conflicting terms and resulting confusion or dispute. 

To further protect against such claims, the lease should also provide indemnification language whereby the parties (1) certify that only the named brokers are due commissions, and (2) pledge to indemnify the other party to the lease for any liability for brokerage commissions arising by the actions of the indemnifying party.  Put differently, if the tenant has an undisclosed brokerage agreement which landlord is forced to pay to the undisclosed broker, tenant agrees to reimburse landlord for such payment, and vice versa.

Brokers are an essential party to most leasing transactions, as they are typically responsible for bringing the landlord and tenant together.  However, it is important for landlords and tenants to fully understand the nature of their brokerage agreement and how such agreement affects the subject lease in order for all parties to get the full benefit their brokers, without any of the potential headaches.

One provision that is common to commercial leases (both retail and office) is landlord’s relocation option. Generally, a relocation option will give the landlord the right, at its sole option, to relocate the tenant to a comparable space within the given development or building.

For landlords, these provisions are quite advantageous. They provide the landlord with the flexibility to shift around existing tenants (who are already tied to leases) in order to accomodate new tenants the landlord is courting. The common situation is as follows:

1. Each floor of a building consists of four 2,000 square foot suites.
2. Tenant A rents Suite 101 with 2,000 square feet.
3. Tenant B wishes to rent an 8,000 square foot space, and the first floor is the most vacant space in the building, with 6,000 vacant square feet in suites 102, 103, and 104.
4. The landlord exercises his right to relocate Tenant A to suite 202, which also has 2,000 square feet.
5. The landlord combines suites 101-104 to lease Tenant B 8,000 square feet.

Of course, this is a simplified example, but one can see that a landlord would benefit from this provision, as it makes the landlord’s building or development attractive to a larger number of tenants.

In office space, the concerns with a relocation are fewer than those for retail space. Generally, office space is interchangable within a building. A tenant must, however, be sure to negotiate certain items into the relocation provision.

First, the landlord should be responsible for all costs associated with the relocation. This includes finishing out the new space, the actual moving costs, and even the costs associated with redirecting services (such as phone) and reprinting letterhead and business cards. The landlord will usually accept such a change to the provision. Effectively, the shifting of costs merely makes the landlord factor those costs into an analysis of whether or not the new lease is attractive enough to exercise its relocation option.

In addition to cost allocation, office tenants must be sure to include an acceptable notice procedure in the relocation option provision. The possible interruption of business activities involved in a move justifies requiring the landlord to give at least 30 days notice of relocation. Also, the relocation should not materially affect tenant’s business, meaning that landlord should have the new space ready for tenant before tenant must leave the old space.

For retail tenants, the consequences of relocation could be significantly stronger.  Retail tenants often value their location, and will pay a premium for the right to rent certain space.  Thus, if a landlord can freely move them to another space without adjusting rent or any other lease terms accordingly, the tenant could lose the benefit of its bargain in the lease.  Therefore, retail tenants should be much more diligent regarding the negotiation of a landlord’s relocation option.

First, retail tenants will benefit from the cost allocation, notice, and non-interruption concepts discussed above for office tenants.  In addition, though, retail tenants should make landlord’s relocation option non-exclusive.  In other words, the tenant must agree to be relocated.  Requiring tenant approval allows the tenant to determine whether the new space is truly comparable to the current space.  Items such as location within the development, relation to neighboring tenants, and visibility will weigh greatly in the tenant’s decision.  An approval right could also be sought by office tenants, but without a justifiable reason for approval, landlords have little incentive to accomodate such a request.

A final wrinkle that is common to relocation provisions, particularly those that grant tenant approval rights, is a landlord termination option.  Basically, the landlord may terminate the lease if tenant does not agree to relocate.  No tenant should accept such a termination option within this provision.  Basically, the landlord will have the right to remove the tenant if it determines the new lease is more favorable financially.  As a tenant that has put time and money into finding the ideal space and negotiating its lease, an ousted tenant would be seriously injured by landlord’s exercise of a termination right.  Careful drafting and attention to detail can avoid such a situation.

Tenants should remember that landlord’s relocation option will typically only benefit the landlord.  Many times, a tenant can use this provision as a “carrot” in negotiations.  However, tenants must be sure to protect their rights in the process.

A common practice employed by parties to a commercial lease is to create flexible dates for the commencement of the lease.  Typically, this is due to uncertainties with physically preparing the premises for tenant occupancy, the abandonment of the premises by a prior tenant, or business realities of getting the tenant prepared to enter its space.  Floating dates are useful for these situations, but parties need to be careful that they see the whole process through.

A common problem with a floating commencement date is that it affects most subsequent deadlines throughout the lease.  It is not uncommon to see a five year lease where the commencement date is defined as “the later of January 1, 2010 or the date upon which the premises are delivered to Tenant.”  However, the same lease will list the termination date as December 31, 2014.  What if the premises are not ready on January 1?  Suddenly the five year lease is no longer for five years.

Both landlord and tenant should be certain that the dates reflect the parties understanding.  Often it will be better, when a floating commencement date is used, to have floating dates throughout the lease.  The termination date in the above example could easily have been, “that date which is sixty months follwing the commencement date.”

A floating commencment date could also affect the dates for rent commencement (if the parties have agreed to an abatement), escalations in rent, or a termination option.  Each of these can be easily addressed by listing the dates by “lease month.”  For instance, rent may commence in lease month three, while a tenant’s termination option may occur in lease month 36.

There is one key problem, however, to filling a document with floating dates.  The parties must be careful to document the actual commencement date.  If the commencment date is not memorialized properly, the lease can be confusing and sometimes useless when trying to determine future deadlines.  The parties would need to go back to establish the actual commencment date by proving up facts which might not be agreed upon by the parties, possibly leading to unnecessary litigation.  Therefore, if parties to a lease are going to use floating dates, they should be sure to include a memorandum of commencement as an exhibit to the lease and follow through executing such memorandum upon commencment.

While it may be in the best interests of both the landlord and tenant to have flexible deadlines in their lease, it will be necessary that both parties take the proper steps to ensure that the document is consistent and certain upon commencement of their obligations.

I came across a great blog post today by Bob Lowery, a tenant leasing representative in Houston.  He spells out 25 terms every tenant should be familiar with when entering into an office lease.  See his full post here: 25 Terms you should be comfortable with when leasing office space.

Familiarity with these terms can not only help a tenant better understand the lease it is entering into, but also can help the tenant with leverage at the bargaining table, reduce legal fees that can be incurred while attorneys explain these concepts, and aid in communication with employees, investors, or corporate representatives regarding the terms of the lease.

Keep in mind that every term might not apply to every lease, but it is still useful to understand each term for future leases or renegotiation of the current lease.

Commercial landlords are increasingly finding that their tenants are unable to meet the obligations of their leases.  While one option is to negotiate concessions to help the tenant during this troubled time (as discussed in more detail here), another option is to declare the lease in default and proceed to evict the tenant.

First, a landlord must consider whether eviction is the best course of action.  It will be important for the landlord to look at the potential market for the space - were it to become available – and determine whether a market lease to a new tenant would be more favorable than modifying the existing lease with the defaulting tenant.

Once the landlord has decided to evict, it must be careful to document the entire process in order to prevent a wrongful eviction defense or counterclaim from the tenant.  The first item of documentation the landlord should consult is the lease.  For most commercial leases, the procedure for determining a default, and the remedies available to landlord for tenant’s default, will be clearly spelled out.  Also, it will be important to make sure landlord has a fully executed copy of the lease.  If a court proceeding of eviction is required, it will be necessary to produce evidence of the landlord-tenant relationship between the parties.  The lease is the best evidence of such relationship.

If the lease is for a specified term (as opposed to an “at will” lease), tenant will need to have breached a specific provision of the lease for landlord to terminate and evict.  Most often, this breach will be tenant’s failure to pay rent when due.  Landlord’s should take particular note of the lease’s default provisions to see what obligations exist with respect to delivery of default notice, tenant’s right to cure, and applicable time periods for each.

Once a default has been identified pursuant to the terms of the lease, the landlord must serve the tenant with a notice to vacate the premises.  In Texas, this document must include the following items:

1. Landlord’s demand that tenant leave the premises and return possession to landlord;

2. A clear identification of the property or premises subject to the notice;

3. A deadline for tenant to comply – in Texas this is at least a 3 day period; and

4. Demand for monies owed to landlord, including rent and attorney’s fees associated with collection and eviction.

In Texas, delivery of the notice to vacate can be made in person, by mail, or by posting notice on the inside of the primary entrance door of the premises.

Once the time for compliance has passed, and tenant continues to refuse to give up possession of the premises, the landlord is in position to pursue action in court for eviction (also referred to as “forcible detainer” in Texas).

In such an action in Texas, the landlord must establish that (i) it has an actionable landlord-tenant relationship, (ii) breach of the lease has occurred, (iii) proper notice to vacate was given, and (iv) the time for compliance with the notice has passed without tenant vacating the premises.  Once these items are successfully proven, the court will issue a writ of possession.  A writ of possession is a judgement verifying landlord’s exclusive right to the premises.

Generally a Texas landlord would enforce a writ of possession by having a sheriff or constable execute the writ.  Under Texas law, the sheriff or constable may use reasonable force to remove the tenant from the premises.

Keep in mind that this process is Texas-specific, and each state’s law may change the procedure or requirements.  This article is not intended to substitute for the advice of an attorney. However, reviewing the process involved in a Texas eviction can help a landlord think about the level of documentation necessary to successfully complete a lawful eviction.  No commercial landlord wants to find itself in a situation where it must evict a tenant.  Being as prepared as possible, though, will make the process much smoother if it ever does arise.

Successful entrepreneurs often find themselves thinking of the future , while everyone else is focused on the present.  While this trait will prove beneficial for small business owners in many aspects of their business, it will not serve them well when negotiating a lease. 

For many small businesses, leasing office or retail space is essential for their businesses to operate.  It is easy to focus on those elements that affects the bottom line  while glossing over less familiar aspects of the lease.  Because tenants are often making long term commitments for their businesses when they sign a lease, it is important to carefully consider every term of the proposed document. 

More likely than not, the landlord will be a sophisticated party, represented by attorneys, with experience negotiating leases.  The lease being negotiated will likely be on the landlord’s preexisting form.  It is easy to see how quickly the odds can get stacked against an inexperienced tenant.

The below list is designed to help first time tenants be better prepared for entering the negotiation process.  The list is no substitute for the advice of an experienced attorney, but should help the tenant become more familiar with the terms of the lease and the consequences which might result from such terms.

1.  Use Provision - Most leases will have a provision which specifies the permitted uses of the leased premises.  It is important that the tenant carefully read these sections, while always keeping in mind not only its current business model, but potential future business practices.  This is especially important for retail leases where landlords can use restrictive use provisions to attract potentially competing tenants in the future.

2.  Additional & Percentage Rent - In additon to Base Rent, landlords will also likely seek what is often called “Additional Rent” or “CAM” (Common Area Maintenance).  The concept behind Additional Rent is that the landlord bears certain expenses that are not directly attributable to any one leased space (taxes, cleaning services, security, elevator maintenance, etc.).  Also, landlords in retail leases may seek “Percentage Rent” from tenants.  Percentage Rent is a certain percentage of tenant’s sales, above and beyond a prenegotiated threshhold.  A tenant should carefully review the terms and figures associated with any Additonal Rent or Percentage Rent calculation.

3.  Build Out – A tenant will often require physical changes to the premises prior to occupying the space.  Negotiating the allocation of costs for such renovations, as well as the procedure involved, will considerably affect tenant’s start-up costs in the space.  Keep in mind concepts such as repayment of credited costs, any potential construction management fee owed to landlord, and the list of approved contractors.

4.  Alterations – Once tenant occupies its space, it may find that additonal work may be necessary in the future (building new offices, installing retail displays, etc.).  The lease will specify whether tenant must seek landlord approval for such changes and dictate all tenant responsibilities with respect to any permanent changes.

5.  Maintenance - The lease will specify which party is responsible for the day-to-day and large project maintenance of the space.  It is important that the tenant know what costs and liabilities will be assoicated with maintenance of the facility so that it can prepare for any issues appropriately.

6. Assignment/Subletting – Most landlord lease forms will prevent tenants from assigning or subletting the space without prior landlord approval.  Tenants should think ahead to potential issues or situations which might require assignment (such as a sale of the business, creation of a new entity, etc.) or subletting (unused space, future partnerships, etc.).

7.  Tenant Default – Default might be the most important lease provision, both to landlords and to tenants.  A tenant must be certain it understands what will constitute a default under the lease.  Also, if a tenant defaults, it must know what rights it has, such as (i) rights to notice of the default, (ii) a right to cure, and (iii) a right to challenge landlord’s determination of default.  Eviction could be crippling to a tenant’s business.

8.  Termination/Extension - It can be easy for a termination date to sneak up on a tenant focused on day-to-day business activities.  Particular attention should be given to the termination procedure, such as delivery of any necessary notices or exercising any rights of extension.  The tenant must also be aware of the condition of the premises required upon surrender.

9.  Exhibits – Most leases will have exhibits attached to explain concepts in more detail.  A common mistake made by parties to an agreement is to execute the agreement without attaching or reviewing the exhibits.  If the lease references exhibits, the tenant must be sure that they are attached and carefully reviewed prior to execution.

10.  Execution – Tenants should receive a copy of the lease, fully executed by landlord and tenant.  Tenants should carefully review the final lease to ensure that the document presented accurately reflects the document tenant executed.  While it is not common for landlords to try to deceive tenants by substituting new provisons or changing the document, mistakes can be made, and it will always be easier on everyone involved to identify those mistakes early.

Tenants are enjoying increased negotiating power in the current economic environment.  Vacancies in commercial buildings have cause landlords to be far more flexible in negotiating their leases than they otherwise would be.  Many tenants are using this increased power to negotiate exclusive use provisions in their leases.

The Basics

An exclusive use provision is a lease term in which the landlord promises not to lease any other space in the development to a party whose intended use would be in direct competition with tenant’s use of its space. 

Exclusive use provisions are almost solely used in retail leases.  Given the “walk up” nature of many retail businesses, it can be a significant advantage to be the only option for a specific good or service in a popular shopping center, mall or other retail development. 

Generally, there is no competitive advantage gained by a tenant seeking to preclude similar tenants in an office building or industrial space.  The primary exception to this rule would be a medical office complex where specialists might seek to maintain an exclusive practice in such facility.  A good example would be a cardiology practice seeking an exclusive use provision in its lease of space in a hospital.  In such a case, the potential business from hospital referrals would create a competitive advantage for exclusivity.

Must Landlord and Tenant Goals Compete?

A landlord’s goal, when negotiating the exclusive use provision, is to limit the number of businesses this provision would affect.  The reason is obvious: a landlord benefits from having a larger pool of potential tenants to whom it can lease space in its development. 

One might think that the tenant’s goal would be the opposite – to maximize the number of businesses the provision would exclude.  This might not always be the case.  Tenants benefit from a full retail center by receiving increased traffic.  If an exclusive use provision is overly broad, it could prevent the retail center from renting all its space.  Also, certain businesses thrive on comparison and/or “one stop” shopping.  Consider your local shopping mall where stores are often grouped by categories.  It is not uncommon to see three children’s clothing stores, or two bath stores, grouped together.

Negotiating the Scope of an Exclusive Use Provision

There are several means by which the scope of the exclusive use can be controlled.  The first method is by defining the type of business.  Consider the difference between a provision which prohibits “all restaurants” and another that prohibits “all fast-foot burger restaurants.”  The latter is much more likely to not only satisfy the landlord’s goal, but also to more closely represent the type of competitor the tenant seeks to avoid.

The second method of restricting an exclusive use is employing the “primary business” model.  For example, the provision could prohibit the landlord from leasing any space to a tenant whose primary business is the sale of furniture.  Not all businesses that sell furniture would be excluded.  It is essential that an exclusive use provision that follows the primary business model carefully defines the term “primary business.”  Generally, this will involve a certain percentage of gross sales attributable to the excluded business.  In the above example, if the term “primary business” was defined to mean any tenant who derives at least 50% of its gross sales from the sale of furniture, it is easy to see where the line has shifted from a strict exclusive use provision.  While a company like Rooms to Go would still be off limits, leasing to Pottery Barn or Crate and Barrel might be a possibility.

Additional Landlord Concerns

There are certain items a landlord should be careful to include in every exclusive use provision.  First, any rights under the provision should be conditioned upon tenant’s good standing under the lease.  If the tenant is in default, all bets are off.  Next, a landlord should be sure that all current leases are excluded.  A new tenant should have no rights to affect any current leasing relationships.  It would also be wise for a landlord to include language allowing the tenant to waive the provision upon written consent from the tenant.  This way an exception can be made if it appears mutually beneficial to landlord and tenant (and getting it in writing keeps a tenant from being able to change its mind later).  Finally, carefully lay out the remedies for the landlord’s breach of such a provision.  A tenant termination right is a landlord-friendly option because it allows the landlord flexibility.  If a competing tenant seeks to lease a larger space, or space at a higher rent, the landlord can breach the exclusive use provision and watch its less profitable tenant walk.  A tenant might seek to negotiate a rent abatement or reduction for landlord’s breach, as a stronger deterrent.

Conclusion

An exclusive use provision can be an attractive feature to a tenant’s lease.  It ensures that competition within the immediate development will not be direct.  Landlords should also embrace the concept as an attractive carrot for prospective tenants.  With careful planning and negotiation, both landlord and tenant can enjoy the benefits of a properly crafted exclusivity provision.

The past 12 months have been tumultuous for businesses in almost every imaginable sector, even leading several major companies into bankruptcy.  We have seen major retail tenants Circuit City, Linens n’ Things, Mervyn’s and Sharper Image, as well as major office tenants AIG, Lehman Brothers, LandAmerica Financial Group and Washington Mutual all declare bankruptcy during 2008.  While it is easy to understand the effect of a liquidation under Chapter 7 on a landlord, there are also significant effects on the landlords of tenants which reorganize under Chapter 11.

A tenant in bankruptcy, whether operating through a trustee or as a debtor in possession under Chapter 11, has the option, within the first 120 days of the bankruptcy case, to either assume or reject any unexpired lease still in effect at the commencement of the bankruptcy case under Section 365 of the U.S. Bankruptcy Code.  The 120 day period can be extended by 90 days for cause without landlord’s consent. 

During the period leading up to the tenant’s assumption or rejection, however, the tenant must perform all obligations due under the lease.  Even though the bankruptcy code provides for performance of all obligations, courts have split regarding which obligations must be performed.  The bankruptcy code protects landlords during this period by granting them a preferred claim for the full contract amount of such obligations, if the tenant fails to pay its post-petition but pre-rejection obligations.

Assumption 

There are three prerequisites a banrupt tenant must meet in order to assume an unexpired lease:

1.  All defaults must be cured.  This does not include those defaults caused by (i) the debtor’s financial condition, (ii) tenant’s bankruptcy or (iii) failure to meet a penalty provision in the lease.

2. Bankrupt tenant must provide landlord with adequate assurance that landlord will be compensated for any losses associated with such defaults.

3. Bankrupt tenant must provide adequate assurance that it will perform under the lease moving forward.

Assumption comes with the dangerous possible of assignment by the debtor tenant.  The bankruptcy code allows for assignment of an assumed lease, despite any lease clause which might prohibit assignment.

Rejection

A bankrupt tenant may either expressly or implicitly reject its lease.  If the bankrupt tenant does not elect to assume the lease prior to the expiration of the 120 day (or 210 day) period, the lease is deemed rejected. 

The bankruptcy court must approve all rejections.  Generally, this approval will be obtained if the decision is supported by the debtor tenant’s “reasonable business judgment.”  More specifically, the court will consider whether rejection (1) generally benefits the bankruptcy estate and collective creditors, (2) relieves the estate from a burdensome lease, and/or (3) aids the debtor’s reorganization efforts.

Rejection is treated as a breach of the lease occurring immediately before the bankruptcy filing.  Thus, in bankruptcy, a landlord’s claim for a rejected lease is a general unsecured claim which arose prepetition, meaning the claim will be very low in the collection pecking order.  In addition to its unfavorable position, a rejected lease claim is limited by a formula prescribed by the bankruptcy code.  Any such claim is limited to any unpaid rent (without acceleration) due, plus the greater of (1) one year’s rent, or (2) a sum equal to 15% of the remaining rent due under the lease.  However, in no case will a claim for a rejected lease exceed three years’ rent.

However, some careful planning when entering into a lease might protect the landlord.  Some landlords are opting to use letters of credit in lieu of traditional security deposits for their leases.  The advantage of a letter of credit is the concept of the “independence principle”.  This principle provides that the issuer of a letter of credit (such as a bank) pays the draws under the letter of credit, and therefore is the sole party obligated under the letter.  At least one court has interpreted this practice to exclude the proceeds from the letter of credit from the calculation of the claim limits.  Otherwise, a traditional security deposit offsets the potential claim.  This step could help a landlord recover that much more in bankruptcy.

Takeaway

Bankruptcy is not a pleasant process for the debtor.  However, when that debtor is also a tenant in a commercial lease, the pain of its debts to the landlord can be significantly reduced.  If a lease is rejected, the landlord will likely receive only a fraction of the bargain it made with the debtor.  Unfortunately, there is little a landlord can do to avoid this outcome once it learns the tenant is headed for bankruptcy.  The use of a letter of credit in lieu of a traditonal security deposit might help soften the blow.

Landlords will certainly be best served by a lease that is accepted by the debtor tenant.  The court will allow the tenant to either continue operating under the lease or permit assignment of tenant’s rights to another entity.

The assignment process can be a scary situation for the landlord, as the uncertainty of a new tenant is not mitigated by standard due diligence.  However, landlords will be availed of all the existing protections in the lease for any shortcomings or failures by the new tenant.  Also, an increasingly common practice makes the assignment process more palatable to landlords.  Often in modern bankruptcies, a debtor anticipating bankruptcy can split into two entities: one stronger, surviving entity and one weaker entity headed for bankruptcy.  Assignment allows leases to the weaker entity to be passed to the stronger entity post-bankruptcy.

 Although a tenant’s bankruptcy is generally a no-win situation for a landlord, the proper preparation and knowledge of the process can relieve the anxiety of recovering its claim and help ease the pain of the landlord’s loss.