TENANT RIGHTS WHEN A COMMERCIAL LANDLORD FILES FOR BANKRUPTCY
In the volatility of today's economic world, more and more commercial landlords may find themselves in dire financial straits and decide to seek the protection of a Chapter 11 bankruptcy filing. If you are a tenant leasing commercial space from such a landlord, it is important for you to understand what you can do to protect your interests during the bankruptcy. Being uninformed and failing to take proper action could cause significant harm to your business. This article provides a brief summary of the process and a tenant's rights in a Chapter 11 bankruptcy filing by a commercial landlord.
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Assumption or Rejection of the Lease
The rights of a tenant and landlord with respect to an "unexpired lease" in a Chapter 11 bankruptcy filing are governed by Section 365 of the U.S. Bankruptcy Code (the "Code"). Pursuant to the Code, a landlord who files bankruptcy has the option to either assume or reject any unexpired lease. If the landlord elects to assume the lease and such election is approved by the bankruptcy court, all of the rights and obligations of each party under the lease will remain in effect as if the bankruptcy filing never occurred.
Before a bankruptcy court will allow the landlord to assume a lease, the landlord is required to cure any landlord defaults under the lease, compensate the tenant for any actual pecuniary loss resulting from such default, and provide the tenant with adequate assurance that the landlord will be able to perform all future lease obligations. Accordingly, the act of your landlord filing for bankruptcy but then gaining approval to assume your lease will have a positive effect with respect to any obligations the landlord was failing to perform before the bankruptcy (such as making particular repairs to the premises).
With the high vacancy rates and negative absorption levels currently existing in many commercial markets, a troubled landlord's lease with a good tenant who consistently pays the rent on time is likely to be one of the landlord's most valuable assets. If so, there is a good chance that the landlord will assume rather than reject the tenant's lease. Upon assuming the lease, the Landlord might then desire to assign its rights under the lease to a third party, resulting in a new landlord for the tenant. Subject to a few exceptions, the Code does allow a landlord to assign a lease that has been properly assumed as long as adequate assurance is provided that the assignee will be able to perform its future lease obligations (even if the lease itself has a provision prohibiting assignment of the lease). After the assignment, the bankrupt landlord is released from all liability for any future breach of the lease. A tenant needs to be diligent in investigating the assignee and should properly object to the assignment if the tenant has legitimate concerns about the ability of the assignee, as landlord, to meet future lease obligations.
Termination or Continuation of the Lease
If a bankrupt landlord elects to reject an unexpired lease, the lease is considered breached. The tenant can then choose to either terminate or continue the lease. If the tenant decides to terminate the lease, all parties will be released from any future obligations under the lease and the tenant's right to possession of the premises will end immediately. If the tenant alternatively chooses to continue the lease, the tenant will retain its rights under the lease (possession, rental rate, etc.) for the remainder of the lease term and any renewal periods. During the period of continuation, the tenant is allowed to offset rent by the value of any damage caused by the landlord's failure to perform its obligations under the lease. The amount of offset is limited to the actual amount of rent payable under the lease, and the tenant's right to offset rent is the only recourse against the landlord for any damage caused by the landlord's failure to perform its lease obligations.
High commercial vacancy rates have created a renter's market in many places today. Landlords are frequently offering reduces rates and other incentives to attract new tenants into their buildings. In situations where a tenant is paying above-market rent or can secure enticing incentives to move into an alternative space, such tenant should strongly consider terminating their lease upon the landlord's rejection and moving to a different location. A tenant may, however, determine that their current rent is competitive, really like their current location or simply desire to avoid the hassles of moving their operation. If such tenant is comfortable with the fact that their bankrupt landlord may no longer carry out its maintenance or other obligations under the lease, the tenant may decide that lease continuation is the best option. Either way, a tenant needs to be educated about the local rental market to ensure the best decision is made upon the landlord's rejection of the lease.
Sale of the Property
While Section 365 of the Code gives a bankrupt landlord the option of either assuming or rejecting a commercial lease, Section 363 of the Code allows the landlord to sell the real property in which the leased premises are located to another party. If the landlord has any equity in the property, the landlord may decide to sell in order to raise money to pay off creditors. In certain circumstances, the Code allows the sale of the property to occur free and clear of any interest in the property, including a tenant's leasehold interest. But upon the request of any party having an interest in the property, the bankruptcy court will prohibit or condition the sale of the property to "provide adequate protection" of the party's interest.
This article does not discuss how a tenant's leasehold interest, upon request, might adequately be protected in the event of a sale. But what is important is for a tenant to understand that it needs to request such protection from the bankruptcy court. Otherwise, the tenant runs the risk of having its leasehold interest wiped out in the sale with the inability to recoup the value of any leasehold improvements or relocation costs. Courts have held that a commercial tenant's failure to object to a sale of the property in a bankruptcy case essentially resulted in the tenant's consent to such sale, enabling the purchaser to receive title to the property free and clear of the tenant's leasehold interest.
Conclusion
Even though a tenant's initial reaction upon finding out that the tenant's landlord filed bankruptcy might be one of panic, an informed tenant will know that it has rights and can make certain decisions that will greatly protect its business. If your landlord happens to file for bankruptcy, hire a competent attorney and be ready to take the appropriate action throughout the process.
Disclaimer: The purpose of this article is to provide general information only and does not constitute the rendering of legal advice.
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