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Lease Defaults and Restructuring: The Impact of a Tenant’s Bankruptcy (Part 2 of 3)

The COVID-19 pandemic has a profound impact on commercial real estate, leaving many commercial tenants with the inability to meet their rent obligations. In our previous article of this bankruptcy series, we covered the principles of the automatic stay, tenant’s pre- and post-petition lease obligations in bankruptcy, suspension of Chapter 11 cases and the unenforceability of bankruptcy termination provisions and anti-assignment clauses. In this article, we will highlight the concepts of lease assumption, assignment and rejection; lease modification; security deposits, letters of credit and personal guarantees; financing issues, and going out of business sales.

l. Assumption, Assignment or Rejection of Leases by the Tenant

In connection with its bankruptcy case, a tenant can make one of three elections with respect to its unexpired leases, subject to the approval of the bankruptcy court and so long as the tenant satisfies certain applicable requirements under the Bankruptcy Code. First, it can assume the lease. Second, it can assume and assign the lease to a third party. Third, it can reject the lease. Although the landlord can file an objection with the bankruptcy court with respect to the tenant’s decision to take any one of these three actions, the tenant does not need to obtain the landlord’s consent.

If the tenant elects to assume the lease, then it will be required to (a) cure virtually all types of outstanding defaults (including unpaid rent) under the lease and (b) provide adequate assurance to the landlord that it can continue performing its future lease obligations. Critically, if the tenant decides to assume the lease, it must assume the entire lease. The tenant cannot pick and choose which provisions of the lease it wants to assume or reject. Any modifications of the lease require the landlord’s consent.

To assume a lease, the tenant must file a motion with the bankruptcy court and provide notice to the landlord. The landlord will then have the opportunity to object to the tenant’s request (including on the basis that the landlord’s calculation of the cure amount is greater than the tenant’s calculation, or on the basis that the tenant is unable to provide adequate assurance of future performance).

If the tenant elects to assume the lease and assign it to a third party assignee, then (a) either the tenant or the assignee will be required to cure virtually all types of outstanding defaults under the lease, and (b) the assignee will need to provide adequate assurance to the landlord that the assignee can continue performing the future lease obligations. Tenants often assume and assign their leases as part of a sale of the tenant’s assets to a third party, or when the rental rate under the lease is below market. To assume and assign a lease, the tenant must file a motion with the bankruptcy court and provide notice to the landlord. The landlord will then have the opportunity to object to the tenant’s request.

If a tenant makes the election to assume and assign its lease, the landlord can try to make a defensive bid to purchase the lease. If the landlord prevails in its bid, it would then be free to terminate the lease, recover the premises and rent it to a new tenant of the landlord’s own choosing (we reviewed this option with respect to retail leasing in a previous client alert. If the landlord does not prevail in its bid, then the tenant can assign the lease to an assignee that the landlord does not approve.

A number of courts have held that a tenant can assume and assign leases without giving effect to any lease clause that requires the tenant to share with the landlord a portion of any net profits that the tenant receives in connection with the assignment. The rationale is that such profit-sharing provisions in a lease are unenforceable in bankruptcy, because they are effectively a restriction on assignment. This is typically the case, even if the profit-sharing provision is a bargained-for exchange in which the landlord had agreed to charge below-market rent.

The Bankruptcy Code includes some additional protections to landlords in shopping centers in the event of a tenant’s assumption and assignment of its lease. It defines “adequate assurance” in this context to include requirements that:

  1. the “financial condition and operating performance” of the proposed assignee and its guarantors are similar to those of the tenant and its guarantors,
  2. the percentage rent due under such lease will not decline substantially,
  3. the assignee’s proposed use of the leased premises will not violate any radius, location, use or exclusivity provisions of the lease or any such provisions contained in any other agreements related to the shopping center, and
  4. the assignee’s proposed use of the lease premises will not disrupt any tenant mix or balance in the shopping center.

If the tenant elects to reject the lease, it will be required to surrender the property to the landlord. Even though the tenant will be required to surrender the property, it is not entirely clear whether any subtenants of the tenant will also be required to vacate the property. There is a provision of the Bankruptcy Code that might be construed to give subtenants the right to remain at the property (or at least be able to raise any available rights under state law), even after the tenant rejects the lease. Although it should be noted that some courts have held that the Bankruptcy Code provision at issue does not protect subtenants who do not have a direct agreement with the landlord. In any event, even if the tenant rejects its lease, a landlord may have to litigate with subtenants in state court.

In addition, once the tenant rejects the lease, it will be deemed to have breached the lease, and the landlord may assert (a) an administrative expense claim for any unpaid post-petition rent relating to the period between the bankruptcy filing date and the rejection date, and (b) a general unsecured claim for damages arising out of that rejection (e.g., lost post-petition rent, the costs of re-letting the premises and attorneys’ fees, all to the extent such amounts are specifically provided under the lease). The claim for rejection damages will be treated as a pre-petition general unsecured claim, even for rejection damages that relate to period of time after rejection. The landlord’s claim for rejection damages is capped at an amount equal to the greater of (a) one year’s rent, or (b) 15% of the remaining rent due under the lease, up to a maximum of three years of rent. If the tenant decides to reject a lease, it must reject the entire lease. In other words, the tenant cannot pick and choose which provisions of the lease it wants to assume or reject. The landlord will be required to file a proof of claim in the bankruptcy court to assert any rejection damages.

ll. Tenant’s Deadline to Decide Whether to Assume or Reject Leases

The tenant has up to 120 days after the bankruptcy case is filed to decide whether to assume, assume and assign, or reject its unexpired commercial leases. That period can be extended by up to 90 additional days if the bankruptcy court approves that extension. Any further extension beyond the first 210 days of the case requires the consent of the landlord. This means that, unless the landlord consents to further extensions, the tenant will have no more than 210 days after its bankruptcy case begins to decide whether to assume, assume and assign, or reject its unexpired lease. If the tenant does not make its decision by that deadline, the lease will be deemed rejected.

lll. Modification of Leases

Although tenants can assume, assume and assign or reject their unexpired commercial leases without the landlord’s consent, tenants cannot modify the terms of their leases without the landlord’s consent. To the extent the landlord and the tenant agree to modify the terms of the lease, the tenant will then request bankruptcy court approval to assume the lease as modified by the parties’ agreement. Bankruptcy court approval of the tenant’s assumption of the lease, as modified, is required.

IV. Credit Support for Landlords: Security Deposits, Letters of Credit and Personal Guarantees

There are several ways for landlords to obtain credit support to reduce their risk of the tenant defaulting under the lease. One method is a traditional cash security deposit. However, because traditional cash security deposits are normally deemed to be property of the tenant’s bankruptcy estate (even though the landlord holds the deposit), it is not the best credit support mechanism from a bankruptcy perspective. This is because the landlord will only be able to set off the deposit against unpaid amounts due under the lease after it obtains relief from the automatic stay or if the tenant’s Chapter 11 plan permits it. This inherent delay in applying the deposit can harm a landlord that relies on the rent payments from its tenants to meet the landlord’s own mortgage obligation on the property. In addition, if the amount of the security deposit exceeds the landlord’s claim amount, the tenant may seek “turnover” of the excess. The landlord only needs to return the security deposit amount that exceeds its allowed claim.

Another form of common credit support is a letter of credit, which the tenant would obtain from a third party issuer (typically a bank). The letter of credit will provide that the third party issuer will pay the landlord directly upon demand; with the landlord being permitted to make such demand if the contractual conditions to payment under the letter of credit (e.g., the tenant’s payment default under the lease) are met. As discussed in Part One, the automatic stay in the tenant’s bankruptcy case should not prevent the landlord from drawing on the letter of credit, so long as the lease and the letter of credit do not obligate the landlord to take any action vis-à-vis the tenant (such as providing notice to the tenant). This is because of the “independence principle,” which provides that a letter of credit is an independent contractual obligation of the issuer. As a result, landlords are well-advised to obtain a third-party letter of credit instead of a cash security deposit, and to ensure that the terms of the lease and the letter of credit do not obligate the landlord to take any action vis-à-vis the tenant before being able to draw on the letter of credit.

Another form of credit support is a guarantee by an entity that is affiliated with the tenant, or by one or more principals of the tenant. If the tenant files bankruptcy, but the guarantor does not, in most cases the landlord will be free to collect on the guarantee. This is because the automatic stay generally only applies to the specific entity or individual that has actually filed bankruptcy. However, in some cases, the tenant will be able to obtain a bankruptcy court order extending the automatic stay to affiliates and principals that have not filed bankruptcy. Additionally, if the guarantor itself files bankruptcy, the automatic stay in the guarantor’s own bankruptcy case will halt the landlord’s efforts to collect on the guaranty.

V. Financing Issues

Once a tenant files bankruptcy, it typically requests bankruptcy court approval to use the “cash collateral” of its lender and/or requests a new loan from a lender (which is called a “DIP loan”). In the first circumstance, the lender will request “adequate protection” and in the second circumstance, the lender will request security for its new loan.

In both circumstances, the lender may request a lien on the tenant’s leasehold interest, or at least a lien on any proceeds that the tenant might receive by assigning its lease. The law is not clear on the question of whether a tenant can grant a DIP lender a lien on its leasehold interest, even if the lease contains a provision that prohibits the tenant from granting a lien on its security interest (commonly known as an anti-hypothecation provision). Bankruptcy courts are more likely to permit the tenant to grant the lender a lien on any proceeds that the tenant might receive by assigning its lease.

The question of whether a tenant may grant a lien on the leasehold interest can be critical. Typically, if the tenant is unable to reorganize and assume it lease, or assign its lease, in Chapter 11, the landlord can regain the premises. However, if the tenant has previously granted a lien on its leasehold interest to a lender, that lender could foreclose on the tenant’s rights under the lease without having to comply with the landlord protections of an assumption and assignment discussed above. Therefore, if the lease contains an anti-hypothecation provision, the landlord should consider filing an objection to the tenant’s cash collateral or DIP motion, on the basis that the tenant should not be permitted to grant a lien on its leasehold interest under the express terms of the lease.

VI. Going Out of Business Sales

Landlords that have retail tenants may also need to contend with “Going Out of Business” (GOB) sales. Despite any lease provisions that prohibit GOB sales, tenants will often seek (and receive) bankruptcy court approval to run GOB sales during the bankruptcy case. A bankrupt tenant’s GOB sale can negatively impact the landlord’s other tenants, because of the extensive (and colorful) signage, and the messiness and poor maintenance of the premises during GOB sales. Unfortunately, however, landlords typically cannot entirely prevent a tenant-debtor from having a GOB sale, because a GOB sale may be the only way for the tenant and the tenant’s creditors to maximize value for themselves.

Even though landlords typically cannot wholly prevent a GOB sale, they can try to minimize the sale’s negative impact on the premises. For example, landlords can (a) negotiate a finite time period for the sale, (b) monitor the signage and advertising to ensure that it does not disrupt other tenants, (c) monitor the sale to ensure compliance with applicable guidelines for the premises, such as noise levels, capacity and cleanliness, and (d) monitor the premises to ensure proper maintenance. If a landlord cannot reach an agreement with its tenant regarding GOB sales or if the tenant does not comply with its agreement, the landlord can seek intervention by the bankruptcy court to force tenant compliance. Indeed, bankruptcy courts have the discretion to condition the time, place and manner of GOB sales to balance the interests of bankrupt tenants and their landlords.

In our last article of the series, we will explore the 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.

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

06.01.2020  |  PUBLICATION: E-Alert  |  TOPICS: Bankruptcy

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