"Leasing Review - Tenant Rights in a Landlord Bankruptcy" originally published on the NAIOP Minnesota online blog.
A tenant that faces a landlord bankruptcy is put into the precarious situation that it does not know what its fate is. If the bankruptcy trustee accepts the tenant’s lease, the tenant must continue to satisfy its obligations under the lease as if no bankruptcy has occurred. If the trustee determines that it is in the best interests of the debtor’s estate to reject the lease, the landlord will no longer have an obligation to perform under the lease and the tenant will be deprived of essential services, its leasehold interest, and potentially very expensive tenant improvements. This type of situation makes it difficult for a tenant to plan its future and may be financially ruinous for tenants without deep pockets. A tenant is put into the position where it must decide if it should risk defaulting on its lease and enter into a new lease so that it will have a place of business if the lease is rejected, or should it wait around until the bankruptcy court determines the fate of the existing lease and risk having to find a premises in a shortened timeframe. Neither scenario is desired.
Rejecting the Lease
Generally, the bankruptcy trustee handling the landlord’s bankruptcy has the option to either accept or reject the tenant’s lease, but the court will only accept the lease rejection if the trustee demonstrates that that the rejection of the lease reflects a proper business judgment. Absent such a showing, the debtor must accept the lease.
The amount of time in which this decision must be made depends on the type of bankruptcy that the landlord has filed. For Chapter 7 liquidation cases involving residential property, the bankruptcy trustee must accept the lease within 60 days (or longer if the court orders a longer period) or the lease will be deemed rejected, and the trustee will generally allow the lease to be rejected unless the trustee believes that there is value in the lease. Tenants under Chapter 7 cases will at least know their fate fairly soon.
Residential tenants in Chapter 11 reorganizations are not in a better position as the trustee has no obligation to reject the lease until the point at which the reorganization plan has been adopted. This process can take months or years. A tenant, however, does not need to wait idly by while the bankruptcy trustee decides its fate. A tenant can request that the trustee make a determination regarding the status of the tenant’s lease within a specific time period, and many bankruptcy courts will grant the tenant’s request.
There is no general deadline for rejecting a lease of commercial property and therefore there is nothing compelling the trustee to make any speedy decisions. Some courts, however, have granted a tenant’s motion that requests the court to adopt a specific timeframe.
Note, however, that the trustee’s right to accept or reject a lease only applies to leases entered into prior to the bankruptcy. The trustee has no right to reject leases that were entered into subsequent to the commencement of the bankruptcy, and the landlord must perform according to the terms of the lease. If the landlord fails to perform under such a scenario, the tenant will have a damage claim against the landlord that will be entitled to an administrative priority expense status in the bankruptcy, meaning that the tenant will likely receive the full amount of its claim.
Accepting the Lease
An assumption of a lease can only be done through a court order. Before the bankrupt landlord can assume an unexpired lease, the landlord must obtain court permission for the assumption, cure any pre-filing and post-filing default, compensate the tenant for any losses arising from the breach, and provide adequate assurance of future performance.
Rights and Obligations of a Tenant Prior to a Rejection
A landlord that has declared bankruptcy cannot be compelled to perform under a lease even if the lease has not yet been rejected or accepted in connection with the bankruptcy proceeding. The landlord is not even obligated to provide the basic essential services, repairs, and maintenance services. Conversely, the tenant in such a proceeding is obligated to continue to perform under the lease until the trustee and the bankruptcy court determines the status of the lease. The tenant is even obligated to perform if the landlord had breached the lease prior to the commencement of the bankruptcy, and language in the lease that would allow the tenant to avoid its obligations when such a default occurs will not be enforced by the bankruptcy court, nor will a clause that allows the tenant to declare an event of default under the lease if the landlord declares bankruptcy.
A tenant, however, is not without rights. A tenant can still enforce its statutorily protected rights against its landlord until the lease is rejected or accepted by the bankruptcy trustee, and the tenant has the right to offset many of the costs that it incurs in connection with providing these services against future rent payments. The tenant will also have a claim against the landlord’s bankruptcy estate if the tenant continues to perform under the lease and does not receive the corresponding benefits under the lease. The problem with the tenant’s claim is that it may only make a claim for the fair market value of the services and not for the value as set forth in the lease or for the costs the tenant actually incurs so the tenant may still not be made whole.
Rights and Obligations of the Tenant After Acceptance
Once the lease is accepted by the trustee, the landlord is once again obligated to perform under the lease, and any failure to perform will entitle the tenant to a claim against the bankruptcy estate that has priority over most other claims. A landlord must also cure prior defaults and compensate the tenant for losses that it suffered as a result of the defaults.
Rights and Obligations of the Tenant After Rejection
A tenant under a rejected lease has two options. First, it can treat the lease as terminated and assert a claim for damages against the landlord. This right, however, is limited to circumstances where the lease language would treat the landlord’s rejection of the lease as a default that allows the tenant to terminate the lease. Most leases will allow this.
Second, the tenant can remain in possession of its premises and retain some of its rights it has under the lease including the right to possession, although the tenant’s rights are fairly limited under this scenario. Some of the rights that the tenant may still be able to enforce are statutory rights granted to it, radius clauses contained in the lease, and certain use restrictions. The tenant will also have the right to offset most of the damages that it suffers as a result of the landlord’s defaults against future rent payments, but the types of damages applicable to this right are fairly limited (some of the damages that would be included are the basic landlord services normally provided under a lease like general repairs and maintenance).
Note also that a tenant may be dispossessed of its premises if the trustee sells or conveys the property where the tenant’s premises is located. The most common conveyance would be in connection with a conveyance to a secured creditor that held a mortgage lien against the property. The mortgage should be able to terminate the tenant’s leasehold interest under such a scenario if the mortgage predates the lease. The Bankruptcy Code also allows the trustee to sell the property to a third party free and clear of any interests in the property, which some bankruptcy courts have found to include any leasehold interests.
How to Protect Your Rights
Unfortunately, most tenant rights are subservient to the rights of the bankruptcy trustee, and there is not much that a tenant can do to preserve its leasehold interest if the trustee determines that it is against the business interests of the landlord. At a minimum a tenant should engage an aggressive and competent bankruptcy attorney that can work with the trustee and the court. The attorney may be able to preserve the tenant’s rights and negotiate a solution that works for all parties. As there is value in most tenant leases out there, an aggressive attorney can frustrate the court to the point that the court is more willing to work out a favorable settlement then to reject a lease outright.
DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.