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The bankrupt bankruptcy clause.

(The following is part 12 of a 14-part series examining the REBNY form lease and how it has been interpreted in recent court decisions. Parts 1 through 12 are available by sending $10 to Real Estate Weekly at 122 East 25th Street, New York, NY 10010).

The REBNY (1994) standard form commercial leases (office, store and loft) all contain the same form bankruptcy clause. That clause, however, is largely unenforceable, and fails to effectively address many of the problems arising when a tenant files for bankruptcy. (We do not consider here whether that clause is effective where a tenant files for a state-law arrangement or receivership.)

The clause provides, first, that "this lease may be canceled by Owner by the sending of a written notice to Tenant within a reasonable time after... the commencement of a case in bankruptcy." Don't do this: a landlord is barred from sending any such notice by the "automatic stay" provision of Bankruptcy Code [section] 362(a)(3).

Second, the REBNY standard form purports to calculate landlord's "liquidated damages" upon such a termination. The liquidated damages amount is stipulated to be the difference between the rent stream due under the lease for the balance of its term, less the current rental value, discounted back at a rate of 4 percent.

Leaving aside that there are circumstances when this formula is not favorable to landlords (e.g., if the lease rate is not above the market rate, and the real problem facing the landlord is that it will take time and effort to re-let), this effort to accelerate the rents due is probably barred by Bankruptcy Code [section] 502(b)(6), and in any event is subject to the cap specified in that provision (which we discuss further below).

In short, the forms' bankruptcy clause needs to be re-written. The balance of this article will pose some of the questions and concerns that arise when a tenant files for bankruptcy, review quickly the applicable law, and suggest drafting solutions, when possible. (Drafting solutions are not always available because, as will be seen, the Bankruptcy Code simply governs certain issues in ways that drafting cannot avoid.)

How Can Landlord Maximize Allowed Claim in Bankruptcy Case?

The key point here is that Bankruptcy Code [section] 502(b)(6) provides a statutory cap on the landlord's 'allowed claim' in the bankruptcy case where the tenant abandons the premises. (The actual monetary recovery is then typically only some 'cents on the dollar' of all the creditors' allowed claims, except that the landlord can collect the full dollar amount of his claim to the extent he holds a security deposit.) The statute says that a landlord's ordinary state-law claim for damages for breach of lease is disallowed, to the following extent:

'If such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds:

(A) The rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease, following the earlier of: (i) the date of the filing of the petition; and (ii) the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus

(B) Any unpaid rent due under such lease, without acceleration, on the earlier of such dates."

Consider the following case: A landlord gives a tenant a 10-year lease, with 10 months' free rent, two years of a somewhat discounted rent, and thereafter a stepped-up, full rent.

Six months after signing the lease, however, the tenant files for bankruptcy.

Under the one-year alternative cap under Bankruptcy 502(b)(6), which is measured from the date of the petition - which is ordinarily deemed to be the "rejection" date - the debtor here in effect still gets the benefit of the four remaining months of free rent: landlord's recovery is capped at 8 months of discounted rent.

Under the alternative, "15 percent not to exceed three years" test, things will be better for the landlord, but there is an ambiguity in the statute: Does 15 percent refer to the time remaining on the lease, or to the rent stream due under the lease? If 15 percent means the first 15 percent of the duration of the lease, this means, again, that the tenant gets the benefit of the free-rent months and the initial discounted rent period. If 15 percent refers to the total rent stream, then the landlord is not penalized for back-loading the lease rental stream.

The majority of the reported cases favor landlord. See, e.g., In re Gantos, 176 B.R. 793 (Bankr. W.D. Mich. 1995); In re Today's Woman of Florida, Inc., 195 B.R. 506 (Bankr. M.D. Fla. 1996); and see generally In re Financial News Network, Inc., 149 B.R. 348 (Bankr. S.D.N.Y. 1993). However, there is some case-law favoring debtor. In re Allegheny Int'l, Inc., 136 B.R. 396 (Bankr. WD Pa. 1991), aff'd, 145 B.R. 823 (W.D. Pa. 1992).

What this means, as a practical matter, is that a debtor will usually insist on litigating this issue, unless the landlord is prepared to settle.

At least until the statute is clarified, accordingly, we suggest trying to address this problem by including in the lease some language like the following:

"All rent concessions - i.e., amounts by which the lease rent for any month hereunder is less than the highest monthly base rent due under this lease; and all amounts of any free rent or reduced rent and all amounts of any landlord's work, or payments for tenant's work required hereunder (altogether, 'Landlord's Costs'); are made based on tenant's representation that it is in sound financial condition and will be able to fulfill all its obligations hereunder, and conditioned on tenant being current on all its rent obligations. In the event of bankruptcy or other breach of this representation and condition, then the rent due for each month hereunder shall be deemed to be the higher of (i) the rent otherwise due under this lease; or (ii) the average monthly rent due under this lease, without any credits to tenant for free rent or discounted rent, and requiring tenant to fully amortize, at the then-current prime rate, all of Landlord's Costs."

We also note that it may be possible to avoid the cap of [section] 502(b)(6), in the following circumstance: suppose the landlord leased a premises to a publicly-traded corporation, based on a review of the company's financials. It is then revealed that those financials were materially misstated. In such a case, we argued that landlord's fraud claim would not be subject to [section] 502(b)(6); debtor-tenant moved to dismiss; and the Court denied the debtor-tenant's motion. In re Leslie Fay Companies, Inc., 93-B-41724 (Bankr. S.D.N.Y.) (May 27, 1997).

Can Landlord Recover in Full Against Any Lease Guarantors?

Suppose that, even though the tenant has filed for bankruptcy, there is a solvent guarantor of the lease: can landlord collect in full from the guarantor, or can the guarantor claim the benefit of the "cap" of [section] 502(b)(6), previously discussed? The case-law favors landlord, but again not without some debate. See generally Friedman on Leases [section] 35.3 at 1799-1800; Rapisardi, Landlord's Damage Claims Against Guarantors, 1/15/98 N.Y.L.J. 3. Friedman concludes that "it is prudent to include in any guarantee of a lease an express waiver by the guarantor of any limitation on his obligation that might arise by reason of insolvency of the tenant."

An alternative that may be more effective is to specify that, in the event tenant files for bankruptcy and rejects the lease, guarantor then has an option to step-up and lease the premises, but in any event is liable for damages as if it was at that point the primary tenant.

Can Landlord Limit the Tenant-Debtor's Right to Assume and Assign the Lease?

A debtor-tenant has the right under bankruptcy law, under certain conditions, to "assume" a lease for its ongoing business, or to assume and assign the lease to someone else for the profit of the bankruptcy estate.

We will not discuss here the peculiar concerns of shopping center owners when a major store tenant flies for bankruptcy, and then seeks to assume and assign its lease to a less-desirable type of tenant. See Bankruptcy Code [section] 365(b)(3).

What concerns a typical commercial building owner, in our experience, is the following: if tenant now occupies three floors, can tenant-debtor choose to keep only, e.g., the middle floor, whether for its own continued use or to assign to another?

If a reorganizing tenant can cherry-pick only part of a demised premises, that may leave landlord with remaining pieces that are not as readily rentable.

There is authority permitting a debtor-tenant to keep only one of two floors that it leased under a single lease agreement. In re Brentano's, Inc., 29 B.R. 881 (Bankr. S.D.N.Y. 1983). Similarly, cross-default provisions purporting to link a tenant's compliance under multiple leases may be held ineffective to prevent a tenant from picking and choosing which leases to assume and/or assign. See generally Bienenstock, Bankruptcy Reorganization, p. 462 n. 59.

There is probably nothing that a landlord can draft to bar a debtor-tenant from picking and choosing, to the extent otherwise permitted by bankruptcy law. Nevertheless, a landlord can make things worse for himself than necessary. Suppose you are leasing both the second floor and the top floor of a building to a single tenant, one for back-office use and one for executive offices. If you write a single lease, for a single, blended rental rate, then, if tenant-debtor files, tenant will have a strong incentive to assume and assign solely for the, executive space. Accordingly, if landlord is leasing two floors together, landlord could draft the lease to say, e.g., the rent for floor 17 is $35 per sq. ft.; the rent for the 18th floor is $35.50 per sq. ft.; and the rent due shall only be $34 per sq. ft. for each, but only so long as tenant is current on its rent for both floors. A bankruptcy court, faced with such a clause, might require a debtor-tenant wishing to take just one floor to pay the higher single-unit price.

Can Landlord Collect Rent from Subtenants?

Your tenant has subtenants, who are not in bankruptcy. Now that the tenant is bankrupt, do you have any special claim on the rental stream from those subtenants?

Bankruptcy law probably does not create such a right in favor of a landlord, but neither does bankruptcy law preclude the Possibility of such a right as a contract matter. See Cherkis & King, Collier Real Estate Transactions and the Bankruptcy Code, [paragraph] 3.05. These authors suggest, accordingly, that the landlord require a tenant, as part of any consent to a sublease, to give an assignment in favor of landlord of all sublease rents.

The REBNY forms, e.g., Office Lease [paragraph] 11, contain some helpful language in this regard. They provide: "If the demised premises or any part thereof be underlet... Owner may, after a default by Tenant, collect rent from the... undertenant... and apply the net amount collected to the rent herein reserved."

One recent case has enforced this clause, in the context of a state-court dispute, where a commercial landlord requested a judicial declaration of its rights in this regard. In Longstreet Assoc. v. Gordon Investment New York, Inc., 12/20/95 N.Y.L.J. 26 (col. 4) (Sup. Ct. N.Y. Co.), the court ruled: "Since the lease clearly provides that plaintiff is entitled to collect rent from subtenants once the defendants are in default, plaintiff is entitled to a declaratory judgment that it is entitled to collect rent from the subtenants directly."

There does not appear to be any authority, however, as to whether this form clause is sufficient to constitute an assignment of subrents for purposes of Bankruptcy Code protection.

In one recent case (where we represented landlord), tenant has sub-let its entire space to a major company, for (what turned out to be) an above-market rent. Tenant filed for bankruptcy. Landlord desired to keep the subtenant bound to its sublease.

It is unclear whether a tenant's "rejection" of a lease under the Bankruptcy Code permits a subtenant to deem the sublease also as terminated. As a general matter, termination of a prime lease automatically terminates any subleases. But the courts have struggled with the question whether a "rejection" of a lease constitutes such a termination. See, e.g., In re Tri-Glied, Ltd., 179 B.R. 1014 (Bankr. E.D.N.Y. 1995). To avoid any such issues, an affiliate of Landlord went to debtor-tenant and purchased tenant's interests as sublandlord under its sublease. This was held to be an effective way to keep the subtenant bound to its lease. In re Sanshoe Worldwide Corp., 139 B.R. 585 (S.D.N.Y. 1992), aff'd, 993 F.2d 300 (2d Cir. 1990).

What Can Landlord Do With Letters of Credit Posted by Debtor-Tenant as Security?

As a general matter, a tenant's bankruptcy does not stay a landlord from drawing-down on a letter of credit posted as security to the extent otherwise permitted by the lease, whereas a landlord is stayed, by the filing of bankruptcy, from drawing-down on a cash security deposit. See generally Cherkis & King, supra, [paragraph] 2.05, [paragraph] 3.04. As always, there are refinements, and an attorney should be consulted before anything is done once a tenant has filed. Additional lease language may be useful to clarify landlord's rights to draw against the L/C in the event of a tenant bankruptcy.

Moreover, in our experience, the advantages of a letter of credit versus an ordinary security deposit are often dissipated in the language of the letter of credit itself. Often, the Lease gives the landlord a relatively broad draw-down right, but the terms of the "draft" required by the L/C itself to be submitted to the issuing bank as the condition to a draw may restrict draws to, e.g., only existing rent defaults accruing after expiration of ali applicable grace periods.

Accordingly, landlords should look carefully at the draw-down rights under both the Lease and the letter of credit itself.

Conclusion

The Bankruptcy Code, as amended in 1984, offers some important protections for a commercial landlord: a tenant has to either vacate, or start paying some rent for the space it keeps, relatively quickly. Nevertheless, there are several fine points where a well-written bankruptcy lease clause might substantially assist landlord; and the REBNY form is not sufficient.
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Title Annotation:part 12
Author:Claman, Richard
Publication:Real Estate Weekly
Date:Oct 21, 1998
Words:2463
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