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Handling financially troubled commercial tenants.

Today's chronically weak economy and attendant rise in business bankruptcies has highlighted the need for landlords and property managers to familiarize themselves with bankruptcy issues. A general knowledge of bankruptcy law helps managers understand what they can expect when a commercial tenant files for bankruptcy and allows them to structure lease clauses that will protect them more effectively in the future.

The Bankruptcy Code is divided into several chapters, each of which covers a different type of filing. A commercial tenant would be likely to file a petition under either Chapter 7, which governs liquidations, or Chapter 11, which governs reorganizations.

Under Chapter 7, a trustee automatically is appointed to manage the tenant's affairs, while Chapter 11 allows the tenant to continue managing its own business.

In either case, an "automatic stay" immediately comes into effect that prevents the landlord or its agent from attempting to collect pre-bankruptcy debt from the tenant. This includes any eviction proceeding or any action to collect rent or other lease charges (i.e., real estate taxes, common-area maintenance, or insurance) that accrued prior to the date on which the petition was filed. In addition, a stay generally prevents a landlord from sending a notice of past due rent or a notice of eviction.

Tenants can handle leasing issues in two ways in bankruptcy proceedings: they may either "assume" or "reject" an unexpired lease. If the lease is assumed, the tenant essentially affirms its lease obligations and agrees to abide by the terms between the assumption of the lease and its expiration.

If the lease is rejected, the tenant generally must surrender the property. Rejection damages claimed by a landlord become an unsecured pre-petition claim against the tenant. If these damages are paid, the tenant must do so in accordance with a court-approved plan of reorganization.

If the tenant assumes the lease

In a Chapter 11 proceeding, a tenant that wishes to continue leasing the property after completing its reorganization usually will seek court permission to assume the lease. However, if the tenant determines that the property is not necessary to its reorganization, it will reject the lease.

In today's climate, tenants in bankruptcy often will use the threat of rejection as a bargaining chip to negotiate more favorable terms. In a Chapter 7 liquidation, the trustee usually will reject an above-market lease but attempt to assume a below-market lease and assign it to a third party.

Under Chapter 11 reorganization, a commercial tenant must assume or reject its lease(s) within 60 days of filing for bankruptcy. The court may, and often does, extend this period, especially in larger, more complex cases.

In order to assume a lease, the tenant must pay off any outstanding pre-petition and post-petition defaults; compensate the landlord for any actual financial loss resulting from such defaults; and provide adequate assurance of future performance under the lease.

It is important to note that although anti-assignment clauses often are written into leases, they generally are not enforceable in bankruptcy. Similarly, clauses that modify or terminate a tenant's rights because of its financial condition or when it files a bankruptcy petition also are unenforceable.

A tenant has the right to assign an unexpired lease to a new tenant regardless of provisions to the contrary. However, the new tenant must provide the landlord with adequate assurance of future performance. This requirement is not specifically defined except in shopping center leases, where the tenant must prove that assignment of the lease will not disrupt the tenant mix or balance in the shopping center.

For other types of commercial leases, adequate assurance of future performance usually means providing the landlord with some proof of the new tenant's financial health. Once there has been an assignment, the former tenant is released from any further liability under the lease. However, the landlord may want to protect its future interests by requiring a security deposit based on the financial condition of the new tenant.

If the tenant rejects the lease

If the tenant decides to reject its unexpired lease following the bankruptcy filing, this will be considered the same as a breach of the lease prior to the petition date.

The landlord then will have a pre-petition damages claim which is on par with those of other pre-petition unsecured creditors. These damages generally are calculated as they would be outside of bankruptcy, with one important limitation--there is a cap on the amount that the landlord may claim. This is either one year's rent or the rent for 15 percent of the remaining term of the lease (up to a maximum of three years' rent), whichever is greater. This remaining term is calculated either from the petition date or the date the premises were surrendered to the landlord, whichever is earlier.

Having filed for bankruptcy, a tenant must "timely perform" all its obligations, including the payment of rent, until it assumes or rejects the lease. Rent arising during the bankruptcy generally is given an administrative priority; in other words, if the tenant does not comply with the law and promptly pay its rent when due after the bankruptcy petition has been filed, the landlord is entitled to a priority claim for that amount.

In some jurisdictions, however, the courts will allow the landlord to claim only for the tenant's fair "use and occupancy" of the property, rather than the lease rate. This often will be less than the original rate because of market conditions or because the tenant may have downsized and be using less of the leased space after the petition date.

Security deposits

Under the Bankruptcy Code, security deposits usually are treated like collateral. Therefore, the landlord may not use a tenant's security deposit while the bankruptcy is pending without a court order.

A tenant may ask the court for permission to use its security deposit, but this generally will be allowed only if the tenant provides the landlord with "adequate protection." In this context, adequate protection probably would mean substitute collateral, which may or may not be cash.

Preferential payments

A tenant may recover any payments that were made to the landlord or other creditors for pre-bankruptcy debts if those payments were made within 90 days prior to filing. (Payments made between 90 days and one year before the petition date may be recovered if the landlord was an insider of the tenant when the payments were made. The Bankruptcy Code defines an "insider" as an officer, director, partner, or affiliate of the debtor.)

The same law may affect rent payments made to a landlord within 90 days prior to the petition date if those payments are credited to previous months. Therefore, when faced with a financially troubled tenant, a landlord always should apply rent payments to the current month first.

In addition, checks should be deposited or cashed as quickly as possible because the 90-day or one-year preference period begins to run from the moment the check clears the bank, rather than when it is received by the landlord.

Structuring lease transactions

Although it never is possible for a landlord to structure a transaction to negate all the effects of a tenant's bankruptcy filing, it is possible to take certain preventive measures to soften the blow.

Whenever possible, a landlord should obtain a letter of credit to guarantee a tenant's obligations under the lease. A letter of credit is a contract between a bank and a landlord, neither of which is a debtor. Unless the court prevents it, the letter may be drawn upon after a tenant files for bankruptcy.

Often, a tenant will offer the guarantee of a principal or related company to secure its lease obligations. While this may be welcomed if the entity is well capitalized, a guarantee from an insider of the tenant could result in an extension of the preference period to one year if the tenant eventually files for bankruptcy. Consequently, letters of credit or cash are the preferred forms of security when dealing with a financially troubled tenant.

Because there is a cap on the damages that can be claimed if a tenant files for bankruptcy and rejects its lease, the landlord should refer to any monthly payment over and above the base rent as "additional rent" and invoice all amounts due each month as the total "rent." If the landlord does not call utility and tax escalations and similar payments "rent" or "additional rent," these amounts will not be included in the yearly rent when the cap is calculated.

In contrast, reimbursements that might be due from the tenant in the event of a rejection should be clearly delineated in the lease; these include brokerage and attorney's fees and other costs associated with reletting the property. These amounts can be claimed by the landlord as rejection damages and will not be limited by the cap.

Reacting to a bankruptcy filing

After a tenant files for bankruptcy, the landlord's course of action will depend on whether it wants to retain the tenant to avoid interrupted rent flow or to regain possession of the property and find a new tenant. Regardless, a landlord should oppose a commercial tenant's motion to extend the 60-day period in which it may assume or reject its lease(s).

However, if the landlord is certain that it would like the tenant to remain on the property and continue paying rent, it might consent to extend the 60-day period in return for a court order that: clarifies the tenant's obligation to pay its rent at the lease rate by a certain date each month while the bankruptcy proceedings are pending; permits the landlord to send monthly invoices for rent and additional rent due; and gives the landlord the right to evict the tenant and repossess the property if the tenant defaults on its post-petition lease obligations, or the right to seek this remedy on limited notice.

If the landlord does not wish to retain the tenant and there are existing defaults that would permit the lease to be terminated by its own terms, the landlord should take court action to put pressure on the tenant. One way to do this is to file a motion for relief from the automatic stay to terminate the lease.

In jurisdictions where this is not permitted, the landlord's sole remedy will be to file a motion to compel the tenant to assume or reject the lease. However, if the tenant wants to remain on the property and can comply with the assumption requirements covered earlier, the landlord may find it difficult to regain possession.

The court also may determine that it is too early in the reorganization for the tenant to be forced to assume or reject its lease(s), particularly if the lease covers the tenant's principal place of business. At this point, the only alternative may be to enter into direct negotiation with the tenant.

A landlord should carefully document any costs or expenses incurred as a result of a tenant filing for bankruptcy, such as attorney's fees or costs of reletting the property. In many cases, these expenses may be allowed as part of a landlord's claim against the bankrupt tenant and will not be included in the damages cap.

Finally, the landlord's attorney should file immediately a "notice of appearance" in the tenant's bankruptcy proceedings so that they both receive copies of all the important papers filed in the case. Specifically, a landlord and its attorney should carefully monitor the bankruptcy proceedings to be aware of any impending "bar date" set by the court--the date by which all claims against the tenant must be filed.

If the landlord or other creditors have not filed a "proof of claim" by the bar date, they may not receive any distribution in the bankruptcy. It generally is wise for a landlord to file a claim in an unliquidated amount which can be supplemented after the bar date to include the exact amount of the landlord's claim.

Clearly, a tenant's bankruptcy filing is disruptive, cutting down on the landlord's income stream and creating instability in its relationship with the tenant. Nonetheless, with proper planning and competent counsel, total disaster can be avoided and the negative impact of the bankruptcy can be greatly reduced.

[Bennett J. Murphy is a partner and Marc A. Rothenberg is an associate in the New York office of Latham & Watkins, an international law firm. Both specialize in bankruptcy issues.]
COPYRIGHT 1992 National Association of Realtors
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Legal Issues
Author:Murphy, Bennett J.; Rothenberg, Marc A.
Publication:Journal of Property Management
Date:Sep 1, 1992
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