Bankruptcies in the retail space are prevalent these days. Some of the more recent and prominent bankruptcies are Pacific Sunwear, Sports Authority, American Apparel and RadioShack. Even if you do not have a lease with a “big box” retailer, plenty of smaller retailers are in distress as well. For Landlords, what do you do if one of your tenants files Chapter 11?
Let’s start with what not to do.
- Discontinue demanding past-due rent payments that came due before the bankruptcy filing.
- Do not attempt to immediately set-off any security deposit that you are holding without obtaining advice from your bankruptcy counsel.
- Do not commence eviction proceedings – even if the tenant is behind in paying rent.
Taking any of the preceding actions could land you in hot water with the Bankruptcy Court for violating the automatic stay provisions of the Bankruptcy Code. Violating the automatic stay can result in fines, sanctions, or other penalties. Simply put, it can make a bad situation for the landlord a whole lot worse.
What can a landlord do when dealing with a bankrupt tenant?
And, what can the landlord expect the tenant to do as long as the tenant is in Chapter 11?
The tenant is required to fulfill any obligations under the lease within the first sixty (60) days of the bankruptcy filing. That means that the tenant must pay rent, keep the premises insured, and otherwise abide by the terms of the lease. If the tenant fails to honor the obligations under the lease after the bankruptcy filing, the landlord has the right to ask the Bankruptcy Court to “lift” the automatic stay. If the court lifts the automatic stay, the landlord can then take some of the actions described in the preceding paragraph, and can otherwise exercise many of the remedies provided for in the lease agreement.
If the lease was not terminated before the bankruptcy filing, a bankrupt tenant has the option to “assume” or “reject” the lease. To assume the lease and remain in possession of the leased premises, the tenant must cure all defaults, pre- and post-bankruptcy filing, and must provide adequate assurances that the tenant can perform its obligations under the lease. From the landlord’s perspective, this means that the tenant must pay all past due amounts on the lease in full at the time the lease is assumed. If, however, the tenant rejects the lease, then the Bankruptcy Code deems the lease terminated immediately prior to the bankruptcy being filed. Upon rejection, the landlord can re-take possession of the leased premises. The landlord will have a claim for its damages, subject to certain limits imposed by the Bankruptcy Code.
Often, in connection with the tenant seeking to assume the lease, the tenant will also seek to assign the lease to a third party. Does this mean that the landlord can be stuck with any third party? No, it does not. The third party must be able to fulfill the obligations of the lease, and will be required to honor any use restrictions that are imposed by the lease. A provision in the lease prohibiting the assignment of the lease is not likely to be enforceable once a bankruptcy is filed. So while the landlord may be stuck with a third party tenant, not of its choosing, it cannot be forced to accept any third party tenant that comes along. Also, if the leased premises is located in a shopping center, additional, rigorous requirements are imposed on the tenant before the tenant can assume or assign the lease to a third party.
As a best practice, certain provisions should be included in a commercial lease agreement in the event of a tenant filing bankruptcy:
- The lease should require the tenant to pay the landlord’s attorney’s fees and other costs in the event of any default under the lease.
- The lease should contain use restrictions when appropriate.
Landlords often attempt to bolster the creditworthiness of their tenant by obtaining financial guaranties or letters of credit as additional collateral for the tenant’s obligations under the lease. Financial guaranties and letters of credit are not impacted by a tenant’s bankruptcy filing, and therefore, landlords can seek to enforce these instruments without worry of violating the automatic stay of the Bankruptcy Code.
Source: B. Saintsing, D. Sparks, B. Davidoff, webinar presented to the Real Estate Section of the Association of Corporate Counsel, April 19, 2016.