8. Modification of Leases
Although tenants can assume, assume and assign or reject their unexpired commercial leases without the landlord’s consent, tenants cannot modify the terms of their leases without the landlord’s consent. This is the result of the cum onere rule described above – if the debtor/tenant assumes a lease, it must accept the burdens of the lease, along with its benefits. To the extent the landlord and the tenant agree to modify the terms of the lease, the tenant must then request bankruptcy court approval to assume the lease as modified by the parties’ agreement.
An interesting issue arises when a lease is part of a battery of other documents that may be considered an inseverable whole. This issue arose in the Buffets Inc. case, where the debtors sought to reject certain leases (but not all of the leases) that were integrated into master leases. The landlords argued that the debtor could not pick and choose only specific leases within the master lease portfolio to reject (while assuming the other leases in the portfolio). Instead, the landlords argued that all of the leases in the master lease portfolio must either have been assumed or rejected in toto. The bankruptcy court agreed with the landlords based on the facts of the case and the applicable state law.
9. Credit Support for Landlords: Security Deposits, Letters of Credit and Personal Guarantees
There are several ways for landlords to obtain credit support to reduce their risk of the tenant defaulting under the lease. One method is a traditional cash security deposit. However, because traditional cash security deposits are normally deemed to be property of the tenant’s bankruptcy estate (even though the landlord holds the deposit), it is not the best credit support mechanism from a bankruptcy perspective. This is because the landlord will only be able to set off the deposit against unpaid amounts due under the lease after it obtains relief from the automatic stay or if the tenant’s Chapter 11 plan permits it. The inherent delay in applying the deposit can harm a landlord that relies on the rent payments from its tenants to meet the landlord’s own mortgage obligation on the property. In addition, if the amount of the security deposit exceeds the landlord’s claim amount, the tenant may seek “turnover” of the excess. The landlord is only obligated to return the security deposit amount that exceeds its allowed claim.
Another form of common credit support is a letter of credit, which the tenant would obtain from a third-party issuer (typically a bank). The letter of credit will provide that the third-party issuer will pay the landlord directly upon demand, with the landlord being permitted to make such demand if the contractual conditions to payment under the letter of credit (e.g., the tenant’s payment default under the lease) are met. Because of the “independence principle” inherent in letter of credit law, the automatic stay in the tenant’s bankruptcy case should not prevent the landlord from drawing on the letter of credit, so long as the lease and the letter of credit do not obligate the landlord to take any action vis-à-vis the tenant (such as providing notice to the tenant). This is because of the “independence principle,” which provides that a letter of credit is an independent contractual obligation of the issuer. As a result, landlords are well-advised to obtain a third-party letter of credit instead of a cash security deposit, and to ensure that the terms of the lease and the letter of credit do not obligate the landlord to take any action vis-à-vis the tenant before being able to draw on the letter of credit.
Another form of credit support is a guarantee by either an entity that is affiliated with the tenant, or one or more principals of the tenant. If the tenant files bankruptcy, but the guarantor does not, in most cases the landlord will be free to collect on the guarantee without ever having to set foot in bankruptcy court. This is because the automatic stay generally only applies to the specific entity or individual that has actually filed bankruptcy. However, in a few cases, the tenant will be able to obtain a bankruptcy court order extending the automatic stay to affiliates and principals that have not filed bankruptcy. Courts that have extend the automatic stay to non-debtor affiliates and principals typically only have done so because “unusual” or “extraordinary” circumstances existed.Additionally, if the guarantor itself files bankruptcy, the automatic stay in the guarantor’s own bankruptcy case will halt the landlord’s efforts to collect on the guaranty.
10. Financing Issues
Once a tenant files bankruptcy, it typically requests bankruptcy court approval to use the “cash collateral” of its lender and/or requests a new loan from a lender, which is called a debtor-in-possession (“DIP”) loan. In the first circumstance, the lender will be entitled “adequate protection.” In the second circumstance, the DIP lender likely will request security for its new loan and the pre-petition lender (if there is one) would be entitled to adequate protection if the tenant proposes to grant the DIP lender a lien that is senior to or pari passu with the pre-petition lender’s lien. In both circumstances, the lender may request a lien on the tenant’s leasehold interest, or at least a lien on any proceeds that the tenant might receive by assigning its lease.
Bankruptcy courts typically permit the debtor/tenant to grant the lender a lien simply on any proceeds that the tenant might receive by assigning its lease, as granting a lien only on assignment proceeds would not affect the landlord’s rights as to the property.
The question of whether a tenant may grant a lien on the leasehold interest (as opposed to mere proceeds) is critical. Typically, if the tenant is unable to reorganize and assume or assign its lease in Chapter 11, the landlord can regain the premises. However, if the tenant has previously granted a lien on its leasehold interest to a lender, that lender could foreclose on the tenant’s rights under the lease without having to comply with the landlord protections relating to assumption and assignment that are discussed above.
There is little case law addressing the question of whether a tenant may grant a DIP lender a lien on its leasehold interests when (a) the lease contains an anti-hypothecation provision, and (b) the landlord objects to the debtor’s request to grant such lien. On this issue, DIP lenders have contended that anti-hypothecation provisions in leases are invalid under Section 365(f) of the Bankruptcy Code. They also have cited cases suggesting that a bankruptcy court, in approving DIP financing under Section 364(c), can grant a lien on assets that are subject to negative pledge covenants. On the other hand, landlords have argued that such invalidation could apply only if such leases were actually assumed under Section 365(b). Landlords have also noted that where the lease is in a shopping center, Section 365(b)(3) of the Bankruptcy Code contains special protections for landlords in shopping center leases, and that granting a lien on the leasehold interest would eviscerate those protections.
Regardless of how a court would rule on this issue if it were contested, a debtor likely could still grant security interests on a leasehold interest when the applicable landlord fails to object to the cash collateral motion or DIP motion at issue. This means that if the lease contains an anti-hypothecation provision, the landlord should consider filing an objection to the tenant’s cash collateral or DIP motion, on the basis that the tenant should not be permitted to grant a lien on its leasehold interest under the express terms of the lease.
11. Going Out of Business Sales
Landlords that have retail tenants may also need to contend with “Going Out of Business” (“GOB”) sales. Despite any lease provisions that prohibit GOB sales, tenants will often seek (and receive) bankruptcy court approval to run GOB sales during the bankruptcy case. A bankrupt tenant’s GOB sale can negatively affect the landlord’s other tenants, because of the extensive (and colorful) signage, and the usual messiness and poor maintenance of the premises during GOB sales. Landlords often also consider GOB sales undesirable because they are associated with financially unstable companies, and may lead current or future tenants to perceive that the premises cannot support a successful business operation. Landlords typically cannot entirely prevent a tenant-debtor from having a GOB sale, because a GOB sale may be the only way for the tenant and the tenant’s creditors to maximize value for themselves.
Even though landlords typically cannot wholly prevent a GOB sale, they can try to minimize the sale’s negative impact on the premises. For example, landlords can:
- negotiate a finite time period for the sale;
- monitor the signage and advertising to ensure that it does not disrupt other tenants;
- monitor the sale to ensure compliance with applicable guidelines for the premises, such as noise levels, capacity, and cleanliness; and
- monitor the premises to ensure proper maintenance.
If a landlord cannot reach an agreement with its tenant regarding GOB sales or if the tenant does not comply with its agreement, the landlord can seek intervention by the bankruptcy court to force tenant compliance. Indeed, pursuant to Sections 105(a) and 363(e) of the Bankruptcy Code, bankruptcy courts have the discretion to condition the time, place, and manner of GOB sales to balance the interests of bankrupt tenants and their landlords.
Strategic Considerations for Commercial Landlords and Tenants
With these basic principles of bankruptcy law that affect the landlord/tenant relationship in the event of tenant bankruptcy in mind, we now explore the strategic considerations that landlords and tenants should consider where the threat of a tenant bankruptcy is a real possibility.
1. Landlord’s Considerations
Given the current conditions in the marketplace, commercial landlords can safely surmise that one or more of their tenants is facing, or may soon be facing, financial stress. Landlords that become aware of a tenant’s potential financial stress (whether through direct communication with the tenant, the tenant’s failure to pay rent, abandonment of its space, or through third-party sources) should attempt, as promptly as possible, to gather information to confirm whether the tenant has reached a point where it is (or will be) unable to pay all of its obligations as they become due. As part of that information-gathering exercise, the landlord should consider asking the tenant directly about its current financial condition and its prospects. If the lease provisions contain financial or operational reporting obligations on the part of the tenant, the landlord should press the tenant to deliver the required reporting.
In addition, the landlord should not be surprised if, during its discussions with the tenant regarding possible rent relief and lease modifications, the tenant states that it may file bankruptcy if the landlord does not agree to the tenant’s demands. Indeed, the threat of bankruptcy is often a negotiation tactic in many restructuring discussions, as the tenant could file bankruptcy and, without the landlord’s consent, reject the lease - which could leave the landlord with little or no recovery - or take advantage of a below-market rent and assume and assign the lease to a new occupant. This threat of bankruptcy and subsequent lease rejection (or assumption and assignment) could lead the landlord to agree to a negotiated workout in order to minimize the chances of the tenant’s bankruptcy filing. Although landlords should not necessarily take the threat of bankruptcy at face value, astute landlords will consider what their likely outcome would be if their tenants ultimately do file bankruptcy.
Below are some steps that a landlord should take when its tenant is facing financial difficulties and there is a possibility of the tenant’s bankruptcy.
A. Familiarize Yourself With Your Lease Documents
Before a landlord makes the determination to place the tenant in default, or commences any discussions with a tenant concerning a possible lease modification, the landlord (with the assistance of counsel) must review the existing lease documents. In particular, the landlord should review the default provisions of the lease (and any relevant provisions which may excuse performance) to determine what actions or omissions have occurred may constitute a default by the tenant, applicable notice and cure periods, and whether any event excuses the tenant’s duties to perform. In addition, the landlord should review applicable remedies for the default under the lease, and any obligation to mitigate the damages caused by the tenant’s breach.
B. Default Notices: The Clock is Ticking
Once a landlord determines that a default or an event of default has occurred under the specific terms of the lease, it should send any required default notice to the tenant as soon as possible. With the threat of the tenant’s bankruptcy looming, the landlord needs to be cognizant of the substantial advantage of having the lease terminated prior to the bankruptcy filing. If the lease is not terminated before the tenant’s bankruptcy filing, the tenant will be able to remain in the premises until it either rejects the lease, assumes the lease, assumes and assigns the lease, or the automatic stay is lifted to allow the landlord to terminate the lease (and, until such time, the landlord will be unable to enforce any of its remedies for the tenant’s default and/or re-let the premises to a more palatable tenant). This will be the case even if the landlord has declared a default under the lease prior to the bankruptcy. In fact, once the tenant files bankruptcy, the landlord may be in violation of the automatic stay if it subsequently sends a default notice without first obtaining a lift-stay order from the bankruptcy court.
Accordingly, if the landlord seeks the leverage of having the lease terminated prior to the bankruptcy, taking the first step in that process – sending any required default notice – promptly is critical. The timing sensitivity is particularly acute since many leases give the tenant some period of time after the notice is delivered to cure the applicable defaults. Even worse, if the landlord waits too long to send any notice that is required under the lease, the tenant may argue that the landlord has waived the default, or that equitable principles (such as the doctrines of laches or estoppel) preclude the landlord from exercising its remedies.
The landlord is advised to send any required default notice to the tenant, even if it expects to negotiate a workout or does not yet intend to exercise its remedies. By sending the notice as soon as the default is identified, the landlord can:
- maximize flexibility and avoid delays if the landlord needs to terminate the lease before the tenant files bankruptcy; and
- minimize the risk of the landlord inadvertently waiving remedies that are not promptly exercised.
In addition, the lease may permit the landlord to apply the security deposit or to draw a letter of credit against unpaid lease obligations after a default has occurred, so sending out the notice earlier may allow the landlord to exercise its rights as to the security more quickly. This is particularly critical if the landlord holds a cash security deposit, because the automatic stay would delay (and limit) the landlord’s ability to apply the cash security deposit against the outstanding amounts due under the lease. If the landlord is the beneficiary of a letter of credit, the landlord should limit its draws to the amount in default, so that the balance would not be held as a cash security deposit that could be subject to the automatic stay.
C. Possible Termination of the Lease
The proper termination of a lease before the tenant’s bankruptcy filing prevents the lease from becoming property of the tenant’s bankruptcy estate, and as set forth above, the tenant will not be permitted to elect to reject, assume or assign the lease. This significantly reduces the tenant’s leverage over the landlord, because the bankruptcy filing will not resuscitate a lease that was validly terminated before the bankruptcy, and the landlord will be free to pursue an eviction of the tenant. Even if the lease is terminated, the landlord would still be free to negotiate a new lease with the existing tenant, if the landlord believes that a restructured lease with the existing tenant is more desirable than entering into a lease with a new tenant.
The word “proper” is emphasized in the paragraph above, because a bankruptcy court could conclude that the landlord’s purported termination of the lease was ineffective. This can occur if the landlord fails to terminate in strict compliance with the express terms of the lease and applicable law. For example, if the lease requires the landlord to provide seven days’ prior notice to the tenant, but it purported to terminate the lease on only three days after delivering notice, the termination may be ineffective. As another example, if the landlord demands payments that are higher than those to which it is entitled under the lease, the landlord's subsequent termination of the lease because of the tenant's failure to pay such higher amount may be improper. In addition, any action that the landlord takes against the tenant under the mistaken assumption that the tenant was in default could expose the landlord to liability.
The Bankruptcy Code overrides lease language that provides for the termination or modification of the lease due to the tenant’s commencement of a bankruptcy case, the insolvency or financial condition of the tenant at any time before the closing of its bankruptcy case, or the appointment of a trustee in the tenant’s bankruptcy case. Only a “proper” termination of the lease before the tenant files bankruptcy will be recognized by the bankruptcy court.
Even if the landlord does everything that it is required to do under the lease and applicable law to terminate the lease, it should be prepared for the tenant to dispute the termination in court. In certain situations, the bankruptcy court may find a way to restore a tenant’s contract rights notwithstanding the lease terms. This is especially true where lease defaults are non-monetary, where a landlord can be made whole if the tenant makes all outstanding payments, or where the terms of the lease or the issues in dispute are unclear or subject to differing interpretations.
D. Tenant Bankruptcy vs. Lease Workout
In connection with considering defaulting the tenant and pursuing the landlord’s remedies under the lease, where such action may force the tenant into bankruptcy, the landlord must compare its potential recovery in the bankruptcy process against what the landlord may be able to achieve through a lease modification.
First, the landlord needs to consider what is the likelihood that the tenant will actually file bankruptcy. In doing so, the issues that the landlord should think about include whether:
- the lease represents a significant portion of the tenant’s total expenses;
- the tenant has other leases or other contractual or debt obligations that it is having trouble satisfying;
- any principal or affiliate of the tenant has guaranteed the tenant’s lease obligations; and
- the landlord holds any collateral to secure its claim for lease damages and in what form such security exists (g., cash security deposit or letter of credit).
If the lease represents a small portion of the tenant’s expenses, if the tenant is not experiencing difficulty in complying with its obligations under other leases and debt instruments, or if a solvent principal or affiliate has guaranteed the tenant’s lease obligations, the tenant may be less inclined to actually file bankruptcy if a lease workout is not agreed to. This may give the landlord more leverage during any lease workout discussions with the tenant.
On the other hand, if the tenant is behind in its obligations under several other leases and under its other contractual and debt obligations, and is in severe financial distress, the tenant is likely to file bankruptcy regardless of whether the landlord reaches a deal with the tenant with respect to its particular lease. In that circumstance, the landlord needs to more closely consider what it will realize from the lease if the tenant files in bankruptcy.
Second, the landlord needs to consider whether the rent under its lease is above-market (i.e., the rent under the lease exceeds the current market rate) or below market (i.e., the rent under the lease is less than the current market rate). If the rent is above-market, the tenant may be more bold in requesting rent reductions, and less likely to agree to continue paying rent at the rate provided under the lease. In this situation, the landlord should be reminded that its claim for damages resulting from the tenant’s lease rejection will be subject to a cap under the Bankruptcy Code. Therefore, the landlord may be better off agreeing to a modification of the lease to avoid the tenant’s bankruptcy. Conversely, if the rent is below market, the tenant could potentially monetize the lease, so it may be less willing to suffer a lease termination. Instead, a tenant holding a below market lease may more seriously consider filing bankruptcy to interrupt any eviction action and to assign the lease to a third party. In this situation, the landlord may want to attempt to negotiate a termination of the lease, in lieu of incurring the risk of the tenant assigning the lease to a third party in bankruptcy where the tenant (rather than the landlord) will enjoy the profit on the assignment and the landlord could be stuck with a new tenant it never bargained for. As noted previously, a number of courts have held that profit-sharing provisions in leases are unenforceable in bankruptcy, because they effectively act as restrictions on assignment.
Third, closely tied to the market rental rate discussed above, the landlord needs to consider whether there are potential alternative tenants for the leased premises, and how likely it would be that the premises would remain vacant if the landlord evicts the tenant or if the tenant rejects the lease in bankruptcy. If the tenant presents a serious ongoing credit risk, and the landlord expects to be able to re-let the premises to an acceptable tenant relatively swiftly, the landlord will certainly lean toward rejecting the tenant’s workout demands and terminating the lease. In that situation, the landlord may be less concerned about the tenant’s bankruptcy, as a seriously struggling tenant might not be able to satisfy its obligations if it tried to assume the lease in bankruptcy; but the landlord would want to move ahead with terminating the lease aggressively in order to not have the availability of the leased premises for re-leasing delayed by the bankruptcy process. Conversely, if the landlord expects there to be relatively few acceptable replacement tenants, the landlord may be more interested in reaching a deal with the tenant (thereby reducing the risk of a bankruptcy filing).
Fourth, if the tenant is behind in its payment obligations under the lease, the landlord may face preference liability under Section 547 of the Bankruptcy Code if the tenant pays the overdue arrearages and subsequently files bankruptcy. Section 547(b) of the Bankruptcy Code provides that a debtor-in-possession or a bankruptcy trustee may avoid a pre-bankruptcy transfer of the debtor’s property (e.g., a payment to a landlord) that is:
- made to a creditor;
- on account of an antecedent debt;
- while the debtor was insolvent;
- within ninety days before the bankruptcy filing (or one year before the bankruptcy filing if the transfer was made to an insider); and
- that made the landlord better off than it would have been if the transfer had not been made and the debtor had liquidated in Chapter 7.
A landlord may try to assert one or more of the statutory defenses to preference actions, which are enumerated in Section 547(c) of the Bankruptcy Code. A common defense is that the debtor made the transfers at issue to the landlord “in the ordinary course of business or financial affairs of the debtor and the landlord” or “according to ordinary business terms.” Another common defense for landlords is that they “gave new value to or for the benefit of the debtor” after it received the transfers at issue.
Fortunately for landlords, the 2021 CAA provides a temporary new statutory respite from certain types of preference liability. Specifically, the 2021 CAA added a new Section 547(j) to the Bankruptcy Code, which creates a temporary new exemption from preference liability for creditors, which is designed to encourage rent deferral and vendor workout agreements. It prohibits any debtor in possession or trustee in any bankruptcy case from avoiding payments made by a debtor during the preference period for "covered rental arrearages.” To qualify for the exemption, the debtor and the landlord must have amended the lease after March 13, 2020, and the amendment must have deferred or postponed payments that were otherwise due under the lease. The preference exemption does not apply to the payment of fees, penalties, or interest in excess of the fees, penalties, or interest the debtor would otherwise have owed without the deferral. This new provision expires on December 27, 2022, which is two years after the 2021 CAA was enacted. However, it will continue to apply in any bankruptcy case that is commenced before the December 27, 2022 sunset date.
Fifth, the landlord should consider what its likely outcome would be if the tenant ultimately were to file bankruptcy. For example, if the tenant files bankruptcy while it remains in the premises, the landlord can take advantage of the landlord protections under the Bankruptcy Code, such as the debtor’s obligation to pay the reasonable value of its leasehold interest during bankruptcy, unless and until the tenant rejects the lease in bankruptcy. In addition, the landlord might be able to pursue its rights with respect to any credit support that the tenant provided, such as a cash security deposit, a letter of credit or third-party guarantee. However, the landlord should be cognizant of any possible limitations, such as how the automatic stay may delay its ability to exercise its setoff right with respect to a cash security deposit or its ability to draw on a letter of credit if the landlord is obligated to first provide notice to the tenant (which may violate the automatic stay). The landlord should also take into account the legal fees it may incur in fighting the tenant in bankruptcy, as well as the limitation on the damages that a landlord may assert if the tenant rejects the lease.
In light of the COVID-19 pandemic, among the risks that the landlord must consider if its tenant files bankruptcy is the possibility that the bankruptcy court may suspend the tenant’s bankruptcy case, as recently occurred in the Modell’s Sporting Goods, Inc. and the Pier 1 Imports, Inc. cases. In those cases, the landlords endured substantial delays in receiving their post-petition lease payments during the period of the case suspensions.
Sixth, if the premises are located in a shopping center or in another type of multi-tenant development, the landlord should consider whether the bankruptcy of the tenant will impact other tenants’ rights under the landlord’s leases with those other tenants (such as co-tenancy conditions).
Finally, the landlord should also think through the tenant-side considerations that are discussed in Section II below. For example, does the landlord believe that the benefits the tenant might obtain through bankruptcy are worth the disruption to the tenant’s business, and the costs and administrative burdens that a bankruptcy filing would impose on the tenant?
E. Opportunities For the Landlord To Modify the Lease
In the current economic environment, many landlords are unable to find substitute tenants that make more economic sense then maintaining the current tenant in place, even with the landlord granting the existing tenant rent relief. If the landlord determines that its best business decision is to grant the tenant rent relief, rather than pursuing its default claim and leading the tenant into bankruptcy, the landlord should consider certain modifications that can add value to the lease in exchange for such relief. The following is a non-exhaustive list of concepts the landlord may consider negotiating into the lease in exchange for granting the tenant rent relief:
- additional credit support, such as a letter of credit or a third-party guaranty;
- increased rent in future periods, particularly if the rent under the lease is currently below market;
- extension of the term of the lease, particularly if the tenant has complied with its lease obligations until now and the landlord would otherwise like to keep the tenant in place;
- reduction in the term of the lease or landlord early termination right, if the landlord would prefer the tenant to vacate soon;
- elimination of any rights of first refusal or rights of first offer, or options to extend, on the part of the tenant;
- the restructuring of any economic terms, such as lease assignment profit-sharing provisions, that may be unenforceable in the tenant’s bankruptcy case;
- for example, the landlord may negotiate to receive more rent in the future, in exchange for removing the profit-sharing provision;
- modification of the existing default notice and cure provisions to the extent they can be made to be more favorable to the landlord;
- for example, a default can be self-executing, without the requirement of notice by the landlord; and
- in light of the current COVID-19 pandemic, a requirement for the tenant to apply for governmental assistance programs and to pay any proceeds from those programs toward deferred or forgiven rent.
If the landlord has mortgaged the property, it must confirm its rights to modify the applicable lease without lender’s consent. Among other prohibited modifications, the loan documents may limit the latitude that the landlord has to grant rent relief. In addition, many loans contain covenants that require minimum debt-service coverage ratios, levels of rent and/or occupancy levels. Similarly, if the landlord is an investment trust it might have fiduciary duties to its shareholders that limit its options in aiding an insolvent tenant. In either event, the consent of the applicable third party (e.g., the mortgage lender or the shareholders) may be required as a condition to the landlord entering into the applicable lease modification.
2. Tenant’s Considerations
On the other side of the table, when a tenant faces financial distress and contemplates seeking rent relief or other lease modifications from its landlord, it make sense to consider the strategy of threatening bankruptcy. If the lease is at an above-market rent, then the tenant’s threat to file bankruptcy could leave the landlord at risk of obtaining limited damages if the lease is subsequently rejected in a tenant’s bankruptcy case. If the tenant’s lease is at a below-market rent, then the tenant’s bankruptcy could leave the landlord unable to capitalize on terminating the lease and capturing the higher market rent under a lease with another tenant, because the tenant may elect to assume and assign the lease in bankruptcy without the landlord’s consent (notwithstanding a lease provision requiring landlord’s consent to the contrary). Additionally, the tenant likely can assume and assign leases without giving effect to any lease clause that requires the tenant to share with the landlord a portion of any net profits that the tenant receives in connection with the assignment. Moreover, as noted earlier, the tenant’s bankruptcy filing will result in the imposition of the automatic stay, which can delay the landlord’s ability to set off a cash security deposit against the tenant’s unpaid lease obligations; and as explained above, the landlord faces the risk of delays in receiving post-petition lease payments, in the event the bankruptcy court allows the case to be suspended in light of the COVID-19 pandemic.
The tenant can typically assume, assume and assign, or reject a lease in bankruptcy without the landlord’s consent. After the lease is rejected, the landlord will be left with:
- an administrative expense claim for any unpaid post-petition rent relating to the period between the bankruptcy filing date and the rejection date; and
- a general unsecured claim for damages arising out of the rejection (g., lost post-petition rent, the costs of re-letting the premises and attorneys’ fees, all to the extent such amounts are specifically provided under the lease).
That general unsecured claim for rejection damages will be limited to the greater of one year’s rent, or 15% of the remaining rent due under the lease, up to a maximum of three years of rent. Particularly where the lease is at an above-market rent, the landlord will be faced with the risk of receiving little or no recovery on account of its rejection damages claim (in addition to the time and cost of pursuing its remedies in the bankruptcy). Accordingly, the threat of bankruptcy can give the tenant meaningful leverage during lease renegotiation discussions.
In some circumstances, it will make sense for the tenant to file bankruptcy if it cannot reach a workout agreement with the landlord, particularly if the tenant has substantial other debts that it is unable to pay, if it wishes to sell its assets to a third party that wants to purchase the assets “free and clear” of liens and claims, or where the lease is at a below-market rental rate. If the tenant files bankruptcy, in addition to the right to reject the lease described above, the tenant will typically have the right to assume, or assume and assign, its lease. To the extent that the tenant wishes to sell its assets to a third party, the tenant will be able to assign its lease to that party.
The threshold question for the tenant to answer is whether it can make a credible threat to the landlord that it will actually file bankruptcy. This will depend on the tenant’s particular facts and circumstances. Even financially solvent tenants can file bankruptcy, because insolvency is not a requirement for a bankruptcy filing. As a general matter, the tenant will be allowed to remain in bankruptcy if:
- it is suffering some sort of financial distress that can be ameliorated through the bankruptcy process (even if it is solvent);
- it is not filing bankruptcy simply to obtain a tactical litigation advantage; and
- the bankruptcy filing serves a legitimate bankruptcy purpose.
Legitimate bankruptcy purposes include the reorganization of the tenant’s balance sheet, to halt and centralize pending or threatened litigation against the tenant, to make operational changes (including exiting geographic markets and rejecting leases), or to sell the tenant’s assets as a going concern to a third party.
If the tenant files bankruptcy primarily to reject a lease and therefore to subject its landlord to the Bankruptcy Code’s statutory cap on rejection damages, there will usually be an open question about whether the bankruptcy case could be dismissed as a “bad faith” filing. The particular facts and circumstances of the tenant’s case will drive the bankruptcy court’s analysis. If the tenant is suffering financial distress that can be ameliorated by the bankruptcy case and has filed bankruptcy to preserve value for creditors, the court will be more likely to allow the case to proceed and allow the tenant to assume, assume and assign, or reject the lease. The reverse is true if the bankruptcy court finds that the tenant was not in financial distress and only filed bankruptcy to obtain a tactical litigation advantage. Ultimately, the tenant will be able to more credibly threaten a bankruptcy filing to its landlord if the tenant is truly in financial distress and if a bankruptcy filing would serve a legitimate purpose other than simply permitting the rejection of the lease.
If the tenant’s bankruptcy filing is able to proceed, and is not dismissed as a “bad faith” filing, the tenant would most likely be able to assume, assume and assign, or reject its lease, so long as the requirements to do so under the Bankruptcy Code are satisfied (e.g., the obligation to cure defaults and to provide adequate assurance of future performance, if the tenant seeks to assume or to assume and assign its lease). Bankruptcy courts normally will defer to the business judgment that the tenant makes in determining whether it is most beneficial to the tenant to assume, assign or reject its lease.
Tenants should be aware of the material drawbacks and risks to a bankruptcy filing, however. First, a bankruptcy filing can be extremely disruptive to the business, particularly if appropriate pre-bankruptcy planning is not performed. For example, customers and vendors may refuse to do business with bankrupt tenants (particularly if no contract requires such third party to continue doing business with the tenant), as those customers and vendors may be concerned that the tenant’s business will liquidate, and thus not be able to comply with its obligations to those customers and vendors. Second, Chapter 11 bankruptcy is a time-consuming and expensive process, and the tenant typically will need to pay the fees and expenses of not only its own professionals, but also those of any official committees that are appointed in the case. Third, operating in bankruptcy requires the tenant to comply with numerous administrative responsibilities, such as preparing bankruptcy schedules and statements of financial affairs, and appearing at required meetings and court hearings. The tenant will need to determine whether these drawbacks and risks to filing bankruptcy are worth the benefit of assigning or rejecting a lease in a bankruptcy case.