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.