Tenants in Bankruptcy: A Commercial Landlord’s Introduction

Every commercial landlord should be familiar with the phrase “retail apocalypse.” It’s a phrase that refers to the recent epidemic of retail store closings, many of which were the result of those companies filing for bankruptcy. Unfortunately for landlords, store closures and other vacancies are trends that do not appear to be slowing. And it’s important that landlords are aware of their rights in bankruptcy and the potential traps involved. Here’s what commercial landlords need to remember as they navigate this dynamic landscape:

The Automatic Stay

Once a tenant files for bankruptcy, an automatic stay or injunction is invoked to protect that tenant from new or continued collection activities. It also prevents landlords from initiating an eviction, changing the locks or even demanding payment of past-due rent. A landlord’s violation of an automatic stay may allow the tenant to recover actual damages, including attorneys’ fees and, in some cases, punitive damages.

A landlord can file a motion with the bankruptcy court to seek relief from the automatic stay if certain conditions are met. Landlords should be aware that automatic stay is applicable even if the terms of the lease state that the lease is terminated upon the filing of a bankruptcy case.

Lease Assumption and Rejection

Under Section 365 of the Bankruptcy Code, a tenant has the option to assume or reject the remainder of the lease. If the tenant does not assume the lease prior to 120 days after the petition date or the date confirming a plan of reorganization, then the lease is considered rejected. The tenant then must immediately surrender the property to the landlord. That period may be extended by 90 days upon motion.

Often, the tenant will reject the lease for economic reasons. In such cases, the landlord becomes an unsecured creditor with a claim for damages for unpaid rent based upon the statutory formula in § 365. However, as a result of being a general unsecured creditor, a landlord will likely receive less than the actual amount of the rejection damages claim.

Also, the rejection of a lease does not remove a tenant from the leased premises. The landlord may need to incur additional expenses in removing the tenant through an eviction action in state court.

Fortunately, even if the tenant rejects a lease, it is liable to the landlord for rental payments that became due after the petition was filed and before the tenant rejected the lease. These and other monetary lease obligations are paid as administrative expenses, which allows the landlord to recover those amounts on a priority basis.

From the landlord’s perspective, it is clearly preferable that the tenant assumes the lease. Not only do the premises remain occupied, but the tenant must also provide assurance that they will be able to address any defaults and meet the terms of the lease. The tenant may also assign the lease, or sublet, to another tenant. This occurs when the lease has value, but the tenant does not want to continue to operate in that location. Because the Bankruptcy Code provides that anti-assignment clauses in leases are generally not enforceable in cases of bankruptcy, the tenant has a lot of leeway in determining whether to assign a lease to another party. If they choose to assign the lease, the tenant must reconcile any past debts and ensure the new tenant will be able to meet the terms of the lease.

If the lease involves premises within a shopping center, the landlord generally has more protections against assignment. In order to assign a lease in a shopping center, the tenant must demonstrate that the new tenant can fulfill the obligations of the lease, any percentage of rent due will not decline substantially, the original terms of the lease still apply, and the assumption or assignment of the lease will not disrupt any tenant mix in the shopping center.

Proof of Claim

If a landlord is owed damages by a tenant, it must file a proof of claim by a claims bar date. The landlord may not know the amount of damages to claim by this date if the tenant has not yet decided to assume or reject the lease. As a result, landlords are provided a certain amount of time to assert damages if the tenant rejects the lease. It is important that a landlord be aware of these dates and file a proof of claim in a timely fashion.

As rumors that large retailers and smaller companies are on the brink of bankruptcy continue to swirl, it is clear that the “retail apocalypse” is not ending soon. Commercial landlords would therefore be well served to gain a thorough understanding of their rights and restrictions when dealing with a tenant in bankruptcy. Doing so will allow them to recover the money they are rightfully owed and avoid having legal action taken against them.

Patrick Hruby is an attorney in Walter | Haverfield’s Corporate Transactions group. His practice also extends into the Litigation Services group. He can be reached at phruby@walterhav.com or at 216-619-7878.