Publications > C & A News Alert - January 2012

Tenant Chapter 11 Bankruptcies: A Primer for Commercial Landlords

In an era of uncertainty and disruption in the commercial real estate markets, the filing of a bankruptcy petition by a tenant throws the landlord/tenant relationship into great flux and represents a significant financial threat to the property’s value and operations. While it may appear that commercial debtor/tenants hold all the cards, landlords do possess some significant protections.

The federal Bankruptcy Code contains a series of complex rules and are embodied in the most complicated and intricate section of the Code (11 U.S.C. § 365). This Code section is designed to balance the debtor/tenant’s interest in a successful bankruptcy reorganization¹ against the landlord’s interest in certainty, continuity, and financial compensation.

The Status of a Lease

The vast majority of the claims and relationships between third parties and the debtor in bankruptcy cases involve fixed claims generated (for the most part) prior to the filing of the bankruptcy case or after the commencement of the bankruptcy case. These claims are relatively straightforward; either the debtor owes a fixed or liquidated amount or it doesn’t. Complications abound when the relationship between the parties is a continuing one that crosses the bright line between pre- and post- bankruptcy events. These relationships all concern the Bankruptcy Code’s treatment of so-called “executory contracts,”² the overwhelming majority of which are real estate leases.

The practical issue is that the debtor/tenant is occupying the landlord’s property under an existing contract that is fully enforceable by the debtor/tenant and only partially enforceable by the landlord.

The Landlord's Rights

Under the Bankruptcy Code, the debtor/tenant in a Chapter 11 bankruptcy case must remain current in its payment of rent and other related leasehold-related charges (such as common area maintenance expenses or “CAM,” and real estate taxes) after the filing of the bankruptcy case. This obligation includes lease escalations, if there are any. The debtor/tenant’s obligations to pay post-bankruptcy are enforceable by the landlord and may include judicial eviction in the case of a tenant’s post-bankruptcy lease default.

Because the debtor must remain current with obligations arising after the filing of the bankruptcy petition and because landlords may not seek to enforce the default provisions of a lease for defaults that have occurred prior to the filing, it is wise for a landlord to separate the two time periods (pre- and post- bankruptcy) in its accounting records. Creating a bright line between the tenant’s pre- and post- bankruptcy obligations will enable the landlord to enforce its current rights in the event of a post-bankruptcy lease default without interfering with the debtor’s rights to be free of attempts to pursue collection of its debts for pre-bankruptcy acts and omissions.

The Debtor/Tenant's Rights

In a Chapter 11 bankruptcy case, the debtor/tenant is allowed to “assume” or “reject” its leases. If the debtor elects to assume its leases, it is obligated to continue to perform its obligations but must “cure” its defaults (generally pay any arrearages in rent, CAM, and associated charges) as a prerequisite. If the debtor elects to reject its leases, it is relieved of future obligations but must move out. Under the Code, the landlord gets a claim for damages it suffers on account of the tenant’s rejection of the lease, but that claim is relegated to a low-priority general unsecured claim and is capped (see below).

There is a third option available to debtor/tenants – an assignment of the lease. The debtor may be able to capture the value in a below-market lease by assigning it to a third party. For example, if the tenant’s lease rate is $10 per square foot and the current market rental is $18 per square foot, the tenant might be able to assign the lease – or, in essence, sell it – at, say $14 per square foot thereby netting $4 per square foot for the remaining balance of the lease term. Such an assignment requires bankruptcy court approval. The landlord is entitled to object. However, those objections are somewhat limited. The existence of an anti-assignment provision in the lease is not a valid basis for an objection. A debtor may, with bankruptcy court approval, compel a landlord to accept an assignment of the lease.

When a tenant proposes to assign its lease, the landlord’s rights – to the extent that it has any – are: (1) the debtor must cure all defaults incurred both pre- and post- bankruptcy; (2) if the property is in a shopping center, the assignment to the new lessee must not interfere with restrictions on radius, location, use, or exclusivity; and (3) the landlord must be provided with “adequate assurance of future performance,” meaning that the landlord must be given “adequate” assurance that its new tenant will perform its obligations under the lease (the meaning of “adequate” being subject to interpretation).

The Cap on Damages

As mentioned above, the debtor’s rejection of a lease in a bankruptcy case will result in a claim in favor of the landlord for the damages attributable to the rejection. For purposes of the Bankruptcy Code, a lease rejection is treated as though the debtor/tenant had breached the lease immediately before the filing of the bankruptcy case. The landlord’s damages are not only accorded the lowest priority, but are artificially capped. The landlord’s damages are limited to either the rent reserved under the lease for one year, or fifteen percent of the remaining term, not to exceed three years’ rent, whichever is larger. To this the landlord may add all unpaid rent due at the time of the filing of the bankruptcy petition.

Extensive litigation has arisen under this provision of the Bankruptcy Code. Because landlords’ claims for future lease damages may be severely restricted, landlords have challenged and sought to define the cap in their favor on a number of issues. Disputes, and a variety of opinions from courts and commentators, have arisen on the following issues: the inclusion of items other than purely “rent” in the damages calculation, the existence of letters of credit supporting the tenant’s obligations and their application to the cap, environmental remediation and repair obligations, attorneys’ fees attributable to the debtor’s rejection, and so on. Generally, courts require that tenants’ security deposits be netted against the capped claim rather than the landlord’s overall gross claim.

While commercial landlords are not without significant rights in tenant bankruptcies, such as the right to current, post-bankruptcy rent and the right to the adequate assurance of future performance by a lease assignee, the bulk of the Bankruptcy Code’s protections and privileges fall squarely on the side of the debtor/tenants. Navigating these unfriendly waters can be a challenge and avoiding hardship to our landlord clients is one of our strengths. Please contact your Coman & Anderson, P. C. advisor with questions on landlords’ rights, remedies, and pitfalls when tenants file for bankruptcy.

¹This article assumes generally that the debtor/tenant has filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code and is seeking to “reorganize” or stay in business and get back on its financial feet. In liquidation under Chapter 7 of the Code, the bankruptcy trustee will also be obligated to pay rent so long as he or she occupies the property after the bankruptcy filing, but will often vacate as quickly as possible.

²Executory contracts are contracts in which there is performance which remains to be completed on both sides.