Commercial tenants are defaulting at a faster rate due to the pandemic. But whether we are in a pandemic or not, commercial landlords need to know what to do if their tenants file bankruptcy be it Chapter 7 (liquidation) or Chapter 11 (reorganization). In this regard, the landlord needs to consider being proactive in the process because their rights are limited. There are two primary issues facing the commercial landlord: whether its commercial debtor tenant will assume the lease and perhaps assign it to a third party, and whether there is a need for the landlord to take action to evict the commercial tenant.
Assumption or Rejection of the Lease
Under a Chapter 7 filing, the Trustee has 60 days to assume or reject the lease. Typically, a trustee will reject the lease, but there may be instances in which the Trustee chooses to operate as the debtor and then perhaps assume and assign the lease to a third party.
Under a Chapter 11 filing, the debtor has 120 days to assume or reject the lease, subject to a 60-day extension. A Chapter 11 debtor will choose to reject, assume, or assume and assign the lease. It is not uncommon for a Chapter 11 debtor to file bankruptcy simply to reject those leases that are burdensome to the estate and then assume the rest of the leases with the possibility of assigning them to achieve an effective reorganization.
Assumption and Assignment
Under an assumption and assignment scenario, all defaults and arrearages must be cured. In addition, if the Chapter 7 trustee and/or debtor assume and assign, there must be a showing that the assignee can provides adequate assurance of future performance under the lease. The landlord has the right to oppose assumption and assignment if it so chooses and if opposed, more often than not, “adequate assurance of future performance” becomes a contested issue and the parties will be required to present evidence supporting or opposing the assumption and assignment of the lease. Issues raised by the landlord will also include the assignee’s ability to cure and maintain monetary and non-monetary obligations under the lease.
Because the debtor has to remain current on its post-petition obligations, if the debtor fails to cure all defaults and arrearages, the landlord can always move to require the debtor to reject the lease or require the debtor to bring the lease current and comply with the remaining terms and conditions of the lease such as maintaining insurance. Such a motion may be accompanied with a motion to modify the automatic stay seeking permission to evict the debtor from the premises.
Importantly, a retail shopping center landlord is afforded some additional protection in the event that a debtor/tenant elects to assume and assign the lease. The landlord has the right to ensure that any such assignment does not violate any exclusivity arrangements or other provision regarding composition of the shopping center. In addition, the assignee must have a similar financial condition as the original tenant at the time the original tenant entered the lease. Finally, if the lease requires a percentage of revenue, there must be a showing that any percentage of rent owed under the lease will not substantially decline.
Now, with the pandemic, even though debtors are expected to remain current with their post-petition obligations, some bankruptcy judges have been sympathetic to the commercial tenant and have allowed them additional time to cure during the 120-day period. It is not so much a free pass but it allows for a timed payout as opposed to an immediate cure.
Breach and Rejection
Nevertheless, once the deadline to assume or reject under Chapters 7 or 11 has passed, if the debtor has failed to do anything, then the lease is automatically rejected, which constitutes a breach of the lease as of the date of the order or, on occasion, retroactively as of the date of the bankruptcy petition, and thus requires the tenant to surrender the premises. Upon a rejection, the landlord is entitled to recover damages by filing a proof of claim. That said, the damages are capped at the unpaid rent from the earlier of the petition date or the date the landlord repossessed the premises, plus the greater of (a) one year’s rent or (b) 15% of the rent owing (not to exceed three years’ worth of rent). The cap may be construed as not applying to damage claims that are not based upon rent. Further, the cap applies to limit a landlord’s claim against a debtor guarantor who guarantees a tenant’s rent obligations under the lease.
Modifying the Automatic Stay
In the event the commercial tenant is not timely paying its post-petition rent, the landlord may want to consider filing a motion to modify the stay in addition to requiring the tenant to make a decision to assume or reject prior to the deadline. Modifying the stay will allow the landlord to take such action necessary to seek relief in the State Courts to evict the tenant from the leased premises.
To modify the automatic stay, the commercial landlord will need to show that it is not being adequately protected and may demonstrate this through a number of factors with the most important being that the debtor is in default of the lease. Such defaults can be monetary or nonmonetary. In this regard, the debtor will be required to cure the defaults in order to adequately protect the landlord and in some instances, the court may require an additional security deposit — a “drop dead” provision — allowing the stay to lift without further order of the court or such other adequate protection that will protect the landlord in the event the debtor defaults again.
Because commercial tenants’ rights are limited in a bankruptcy proceeding, if the commercial tenant is in default of the lease, the landlord may want to consider terminating the lease in lieu of terminating right of possession. If the lease is terminated, it cannot be assumed and the landlord can simply seek relief to modify the stay to ultimately evict the commercial tenant.
Keep in mind, however, if the market is soft, it may behoove the landlord to renegotiate in lieu of risking the lease being rejected. These are strange times and because the Bankruptcy Code allows a debtor to reorganize, leases are in play and sometimes flexibility is the better course of action. For obvious reasons, it depends on the circumstances and knowing one’s rights in the event of a bankruptcy.