Lease Defaults and Restructuring: The Impact of a Tenant’s Bankruptcy (Part 1 of 3)

The COVID-19 pandemic’s enormous impact on the commercial real estate industry is now evident. For commercial tenants, customers are scarce, demand for goods and services has dried up, and supply chains have been frozen. Additionally, most states have implemented restrictive measures, such as “stay at home” orders, leading to the widespread closure of nonessential businesses. Although governors of a few states are beginning to lift their stay at home orders, the vast majority of American businesses remain under such orders; and even after such orders are lifted, it is difficult to project how long the economy will be depressed.

Accordingly, commercial landlords have been forced to rapidly prepare for and address the inability of tenants to sustain their rental obligations. In order for landlords to formulate their strategy, among other factors, they must be aware of the applicable lease provisions, their available remedies, the short-term and long-term financial viability of the defaulting tenant and the rental market for the leased premises. On the other side of the bargaining table, tenants who are unable to pay their lease obligations need to likewise be aware of these same factors, in order to determine their strategy to request a deferral or abatement of rent, lease termination, or to not to pay the rent due.

Lurking in the background is the potential bankruptcy of the tenant, which may have a material impact on the landlord’s and the tenant’s rights and remedies; and accordingly, a significant impact on the landlord’s and the tenant’s strategy with respect to both the exercise of remedies and lease restructuring negotiations.

In this three-part bankruptcy series on lease defaults and restructuring, we will highlight the relevant principles of bankruptcy law that affect the landlord/tenant relationship if the tenant voluntarily or involuntarily enters bankruptcy. Thereafter, we will address strategic considerations that landlords should consider when a tenant bankruptcy is a real possibility, as well as issues that commercial tenants should consider when contemplating filing bankruptcy. In this article, we will discuss the automatic stay, tenant’s pre and post-petition lease obligations in bankruptcy, possible suspension of Chapter 11 cases, and unenforceability of termination provisions and anti-assignment clauses in bankruptcy.

l. The Automatic Stay

Upon the commencement of the bankruptcy case, an “automatic stay” goes into effect. The automatic stay protects debtors that file bankruptcy by prohibiting any creditor acts to obtain possession of or exercise control over property of the debtor’s bankruptcy estate. Among other consequences, the automatic stay halts the commencement or continuation of any judicial, administrative or other action or proceeding against the debtor that was commenced (or could have been commenced) before the bankruptcy filing date.

Accordingly, absent relief from the automatic stay (which is discussed below), a landlord may not take any action to collect, assess or recover on a claim under a commercial lease that arose before the bankruptcy case, including commencing or continuing an eviction action or attempting to collect pre-petition rent. Even minor actions, such as sending a past-due notice to the tenant, may be enough to violate the automatic stay.

A landlord’s violation of the automatic stay can result in sanctions, including the entry of a court order obligating the landlord to pay the tenant’s actual damages and attorneys’ fees. For this reason, landlords should consult with counsel before taking any actions against tenants, once the tenants enter bankruptcy.

To the extent that a landlord has obtained a cash security deposit from the tenant before the tenant files bankruptcy, the landlord will not be entitled to set off the security deposit against its claims against the tenant, absent relief from the automatic stay or except as set forth in the tenant’s eventual Chapter 11 plan. This presents a timing issue for the landlord, as it may take a long time for the landlord to be able to apply the security deposit.

Alternatively, if the credit support is in the form of a letter of credit from a bank or other third-party issuer (with the landlord as the beneficiary), the automatic stay would generally not prevent the landlord from drawing down on the letter of credit to obtain the proceeds to apply to unpaid lease obligations. This is based on the opinion, held by many courts, that letters of credit and their proceeds are not property of the bankruptcy estate because the issuer of the letter of credit pays the beneficiary with its own funds, not with the debtor's assets. This comes with a caveat, however. If the terms of the lease or the letter of credit require the landlord to first give the tenant notice that it intends to seek payment under the letter of credit, providing that the notice to the tenant may violate the automatic stay; which could delay, or even prevent, the landlord from drawing on the letter of credit. This risk can be mitigated if the letter of credit authorizes the landlord to draw upon it, if it submits a certificate to the issuer that the tenant is in bankruptcy. In addition, if the proceeds realized from the drawing of the letter of credit exceed the amount of the tenant’s then-unpaid obligations under the lease, most leases provide that such excess continues to be held as a cash security deposit; in which event such excess will now be subject to the automatic stay as set forth above (note that this dilemma may be avoided where the letter of credit permits partial draws).

The Bankruptcy Code provides that the bankruptcy court shall lift the automatic stay if (a) “cause” exists, or (b) the debtor does not have equity in the property and the property is not necessary to an effective reorganization, and a landlord may request that the stay be lifted under such rule. However, it is generally difficult for a commercial landlord to obtain relief from the stay to terminate a lease or evict a tenant over the tenant’s objection, particularly early in the bankruptcy case. The bankruptcy court typically will defer to the tenant’s assessment that the lease may have value, or that the lease may be necessary to achieve the tenant’s reorganization. This is particularly true if the lease is “below market” (i.e., the rent amount under the lease is less than the prevailing market rate), as the tenant might be able to assign the lease to a third party and receive value in exchange.

Landlords may find more success in convincing the bankruptcy court to lift the automatic stay to simply permit them to set off their cash security deposits against unpaid pre-petition amounts due under the lease. In addition, if the tenant fails to make its post-petition lease payments to the landlord (which are discussed below), the landlord will likely have a strong basis to request the bankruptcy court to lift the automatic stay to permit the landlord to pursue eviction proceedings.

ll. Treatment of a Tenant’s Pre-Petition and Post-Petition Lease Obligations in Bankruptcy

The Bankruptcy Code provides for different treatment of a landlord’s claim for unpaid amounts that became due before the tenant’s bankruptcy filing date (“pre-petition” claims), and landlord’s claim for amounts that become due after the tenant’s bankruptcy filing date (“post-petition” claims).

As noted above, the automatic stay prevents the landlord from taking actions against the tenant on account of the landlord’s pre-petition claim, including setting off any cash security deposit against unpaid pre-petition amounts due under the lease. In addition, the landlord’s pre-petition claim for unpaid amounts due under the lease will be treated as a secured claim to the extent the landlord holds collateral (such as a cash security deposit), and a general unsecured claim to the extent the amount due from the tenant exceeds the value of the collateral that the landlord holds. In many bankruptcy cases, general unsecured creditors receive little or no distribution in the case. In these cases, the landlord’s only practical sources of recovery may be security deposits and third party guarantees.

If a landlord holds a pre-petition claim, it must make sure to file a proof of claim in the bankruptcy case by the deadline for the filing of such claims (which is called the bar date). If a landlord fails to file a proof of claim, or files one after the bar date, it may be barred from recovering on its pre-petition claim.

On the other hand, post-petition amounts are called “administrative expenses” and are entitled to priority over general unsecured claims. The Bankruptcy Code requires a tenant to pay its lease obligations that arise post-petition in full, until the tenant either assumes or rejects the lease in its bankruptcy case. The landlord’s collection of post-petition lease payments does not violate the automatic stay, and landlords do not need to obtain an order from the bankruptcy court to receive those post-petition payments. Importantly, the tenant ultimately will be required to pay all of its administrative expenses (including its post-petition lease obligations) in full and in cash, to confirm a Chapter 11 plan in its bankruptcy case.

The Bankruptcy Code requires the tenant to pay its post-petition lease obligations on a current basis, but landlords should be aware that the Bankruptcy Code provides that the bankruptcy court may extend the tenant’s deadline to perform the lease obligations that arise during the first 60 days of the bankruptcy filing. Tenants such as J. Crew (In re Chinos Holdings, Inc.) recently have requested the bankruptcy court to grant such a 60-day extension of their deadline to perform their lease obligations, expressly because of the COVID-19 pandemic. Tenants could even try to seek further extensions of that deadline under the bankruptcy court’s equitable powers.

Landlords must also take note of any deadlines that the bankruptcy court may establish for them to file a claim for post-petition administrative expenses. If the court establishes such a deadline, landlords will need to timely file their claims with the bankruptcy court for any unpaid post-petition administrative expenses.

lll. Possible Suspension of Chapter 11 Cases

Because of the exigencies of the COVID-19 pandemic and the stay at home orders that are in effect in many jurisdictions, tenants may ask the bankruptcy court to suspend their bankruptcy case, and thereby also suspend the tenants’ obligation to pay post-petition lease obligations. This recently occurred in the Modell’s Sporting Goods, Inc. bankruptcy case, where the tenant intended to pursue a going-out-of-business sale, which could not be carried out because of the pandemic. In Modell’s, the court suspended the case for approximately 65 days, and permitted the tenant to defer payments of expenses (other than “essential expenses”) during the term of the suspension. Similarly, in the Pier 1 Imports, Inc. case, the bankruptcy court permitted the tenant to temporarily defer making rent payments. Accordingly, landlords that are involved in bankruptcy cases, like Modell’s and Pier 1, that are suspended due to the pandemic, may face delays in receiving post-petition lease payments.

IV. General Unenforceability of Bankruptcy Termination Provisions

Leases commonly include provisions stating that the lease will be terminated or be modified if the tenant commences a bankruptcy case. These provisions, however, are generally unenforceable in bankruptcy (except for very limited exceptions that typically do not apply in the context of a lease that has not expired or been terminated before the bankruptcy case). Specifically, the Bankruptcy Code overrides lease language that provides for termination or modification of the lease based on 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.

The foregoing rule does not apply to the valid termination of a lease before the tenant’s bankruptcy filing (the general rule is that a lease will be deemed terminated if all final hurdles to termination have been satisfied and the lease is not subject to any form of equitable redemption or statutory grace period). The Bankruptcy Code provides that a tenant cannot assume or assign any lease of nonresidential real property that was validly terminated before the commencement of the bankruptcy case. Accordingly, where the lease was validly terminated before the bankruptcy case commenced, the tenant will likely be required to vacate the premises notwithstanding the bankruptcy filing. Note, however, that tenants may try to contest the validity of any pre-bankruptcy lease terminations during their bankruptcy case. In addition, some states have anti-forfeiture statutes that permit a tenant to revive a terminated lease, while other jurisdictions have equitable principles that permit an otherwise-terminated lease to be resurrected.

In the event the landlord terminated the lease before the bankruptcy case commenced, but the tenant continues to inhabit the premises after the case commences, the best practice is for the landlord to first request relief from the automatic stay before taking steps to evict the tenant.

V. General Unenforceability of Anti-Assignment Clauses in Bankruptcy

In addition to termination provisions, leases commonly contain provisions that prohibit the tenant from assigning the lease to a third party or restrict the tenant’s ability to assign the lease. The Bankruptcy Code overrides almost all of these provisions, specifying that notwithstanding any anti-assignment language in the lease, the tenant may assign the lease as long as certain requirements are met.

In part two of this series of articles, we will continue to explore the relevant principles of bankruptcy law that affect the landlord/tenant relationship. That article will cover lease modification, tenant assumption and rejection of lease agreements, financing issues and going out of business sales.

E-Alert is a newsletter that features the latest thinking from Tannenbaum Helpern's various departments.

05.26.2020  |  PUBLICATION: E-Alert  |  TOPICS: Bankruptcy, Real Estate  |  INDUSTRIES: Real Estate

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