What are the Rights and Obligations of Tenants and Landlords in Bankruptcy?
by Rachael Smiley, Attorney/Shareholder
Tenant bankruptcy is always a risk for landlords – and that will never change. In light of the recent wave of retail closures and bankruptcies, however, parties on both sides may be wondering about their rights and obligations.
The following five takeaways will help both tenants and landlords navigate the bankruptcy process by understanding the rights of all involved.
- The tenant can gain control and some breathing room by filing for bankruptcy
- The tenant is obligated to perform on the lease after it files for bankruptcy
- Assumption/assignment or rejection – the choice is up to the tenant
- If the tenant wants to assume or assign the lease, it first has to “cure” the lease
- Flexibility on both sides is in everyone’s interest
A common reason for a tenant to seek bankruptcy protection is that it is trapped in one or more burdensome or undesirable leases. Filing a bankruptcy petition has the immediate effect of preventing a landlord from trying to collect any past-due rent or other leasehold obligations. The tenant will also have the opportunity to unilaterally elect whether or not it wants to “assume” the lease (and potentially assign it to another party) or whether it wants to “reject” the lease and no longer have to perform its obligations under the lease. The tenant effectively gains a breathing spell to determine which leases are favorable to it and which leases it wants out of. However, the breathing spell does not mean that the tenant is now exempt from paying rent.
Although a landlord cannot take action to collect any past-due rent from a tenant in bankruptcy, the Bankruptcy Code requires a tenant to continue to fully and timely perform a lease after filing for bankruptcy, unless and until the tenant decides to reject the lease. In certain circumstances, the bankruptcy court can extend the tenant’s time to perform on its leases by up to 60 days after filing for bankruptcy, but the law forbids the court from extending the time any further than that.
If the tenant falls behind on rent during its bankruptcy case, any unpaid rent or other leasehold obligations will be given priority payment status as administrative claims, and the tenant will have to be able to pay them in full when it confirms its proposed Chapter 11 plan of reorganization.
The power to decide whether to assume or reject a lease is one of the most powerful tools granted to a tenant in bankruptcy. A favorable or below-market lease can be assumed or assigned to another party under the same terms, whereas an unfavorable lease that is above-market or in a bad location can be rejected. The landlord cannot force the tenant to assume or reject the lease – the landlord can only ask the bankruptcy court to set a shorter deadline for the tenant to make that choice than the law otherwise provides. Likewise, the tenant can ask the court to extend its deadline for assuming or rejecting the lease. If the tenant elects to reject the lease, then the tenant is excused from future performance, and the landlord’s recourse is to assert a claim for “rejection damages.” A rejected lease is legally considered to have been breached as of the date the tenant filed for bankruptcy. A claim for this “breach” and loss of future rent is capped at either one year’s rent or 15% of the remaining term of the lease, not to exceed three years, calculated from date the tenant either filed its bankruptcy petition, or surrendered the property, whichever occurred first.
Although the landlord generally cannot prevent the tenant from assuming (or assigning) a lease in bankruptcy, the Bankruptcy Code requires the tenant to cure the lease before it can assume it or assign it to another party. Specifically, the tenant must cure (or provide assurance that it will cure or promptly cure) any monetary defaults under the lease that have arisen up to the date of assumption, and the tenant must also provide “adequate assurance of future performance” under the lease by providing evidence that the future tenant (whether the same tenant or a party it is assigning the lease to) will have the financial ability to perform under the lease.
The Bankruptcy Code provides a number of tools to tenants to maximize their ability to successfully restructure by keeping only those leases that make business sense. Likewise, the code provides certain protections to landlords to ensure they are not floating the cost of the tenant’s decision to seek bankruptcy protection. However, the treatment provided for landlords and tenants under the Bankruptcy Code is really just a default option that applies if the parties are unable to come to an agreement. Successful outcomes are most likely to be achieved when both the landlord and tenant are flexible with respect to one another’s needs and work together to craft a solution. Bottom line: the bankruptcy process allows for some relief on both sides, as long as the parties are flexible and open to working together.