Your Commercial Tenant Goes Bust – What Happens Next?

Neiman Marcus, Gold’s Gym, JC Penney and Hertz – the list goes on of large American companies that have declared bankruptcy during 2020. If you are a landlord with a commercial tenant that files for bankruptcy protection, what happens next? This article provides a brief overview of the assumption/rejection process for a commercial tenant after the tenant files a voluntary petition under Chapter 11 of the Bankruptcy Code and the landlord’s rights and remedies based on the tenant’s decision to assume or reject. This article solely focuses on the procedures following a Chapter 11 (Reorganization) filing and not a Chapter 7 (Liquidation) bankruptcy.

Assumption or Rejection of Commercial Lease by the Tenant

In a Chapter 11 bankruptcy case, all unexpired leases become property of the bankruptcy estate and the debtor may assume or reject them as part of its reorganization efforts. 11 U.S.C. §541(a)(1), 11 U.S.C. §365(a). If the tenant debtor assumes a lease, the lease will remain in effect. If the debtor rejects a lease, the rejection constitutes a breach immediately before the date of the filing of the bankruptcy petition (unless the lease was previously assumed) and the breach entitles the landlord to a claim for damages. 11 U.S.C. §365(g).

The deadline to assume or reject a lease of nonresidential real property is the earlier of (i) 120 days after the date of the filing of the bankruptcy petition or (ii) entry of the plan confirmation order. 11 U.S.C. §365(d)(4). The debtor, by motion, may request a 90 day extension of this period “for cause.” Any further extensions require the written consent of the lessor. If the debtor does not timely assume or reject the lease, it is deemed rejected. 11 U.S.C. §365(d)(4).

Until the nonresidential real property lease is assumed or rejected, the tenant debtor is required to perform all the obligations under the lease. 11 U.S.C. §365(d)(3). The court may “for cause” extend the time for performance arising within the first 60 days of the case, but the time for performance may not extend beyond the 60-day period.  Prior to assumption or rejection, if the tenant remains in possession of the nonresidential real property and does not pay rent, the landlord can: (i) file a motion to compel immediate assumption or rejection; (ii) file a motion to compel payment of rent; or (iii) move to dismiss the Chapter 11 bankruptcy case, appoint a Chapter 11 trustee, and/or seek to convert the case into a Chapter 7 (Liquidation) case.

Rent Incurred Post-Petition Prior to Assumption or Rejection

As discussed above, if a bankrupt tenant remains in possession of the nonresidential real property, it is required to perform all the obligations under the lease until the lease is assumed or rejected. Until a lease is assumed or rejected (or premises are surrendered), a landlord is entitled to an administrative claim for all amounts arising under the nonresidential real property lease. 11 U.S.C. §365(d)(3). Administrative claims are paid before general unsecured claims.

If the Tenant Assumes a Lease

The assumption of a lease is subject to court approval. 11 U.S.C. §365(a). If there has been a default, at the time of assumption the tenant must “promptly” cure all existing defaults. 11 U.S.C. §365(b)(1). This generally means all monetary defaults must be cured and certain non-monetary defaults will also need to be cured by the debtor (to the extent they are curable). 11 U.S.C. §365(b)(1)(A). Tenant must also compensate the landlord for “any actual pecuniary loss” resulting from the default, and provide “adequate assurance of future performance.” 11 U.S.C. §§365(b)(B)-(C). The lease will continue in full force and effect if (and only if) the tenant assumes the lease, and any claims for subsequent defaults by the tenant will be entitled to administrative priority (i.e., paid before general unsecured claims) and will not be subject to the statutory cap on damages discussed below.

If the Tenant Rejects a Lease

If the debtor tenant rejects a non-residential real property lease (or the lease is deemed rejected), the tenant must “immediately surrender” the property to the lessor. 11 U.S.C. §365(d)(4). The rejection is deemed a breach of the lease immediately before the date of the filing of the petition (unless the lease was previously assumed). 11 U.S.C. §365(g)(1). Once the lease is rejected, the debtor has no ability to reinstate the lease and the landlord is entitled to a claim for damages arising from the rejection of the nonresidential real property lease. The resulting claim is a general unsecured claim with the same priority as the other general unsecured claims (behind priority claims).

The landlord’s rejection damages claim includes two types of damages. First, it includes all unpaid rent due on the earlier of (i) the Petition Date or (ii) the date the nonresidential real property was repossessed or surrendered by the lessee. 11 U.S.C. §502(b)(6)(A). This type includes all rent due for periods before the bankruptcy filing.

Second, the landlord’s rejection damages claim includes all “rent reserved” (future rent) that would be due under the lease. 11 U.S.C. §502(b)(6)(A). The Bankruptcy Code caps the “rent reserved” claim to the greater of (i) one year’s rent or (ii) 15% of the rent due for the balance of lease, not to exceed 3 years. 11 U.S.C. §502(b)(6). Like the first type of rejection damages, the “rent reserved” is measured from the earlier of the (i) petition date or (ii) the date the landlord repossessed, or lessee surrendered, the nonresidential real property. 11 U.S.C. §502(b)(6)(A). Parties sometimes litigate what is included in “rent reserved” (e.g., operating expenses, other additional rent, etc.).

Advanced Issues: Letter of Credit and Security Deposits

If the landlord holds a security deposit or letter of credit, it may apply either to all of its claims – although the security deposit or letter of credit should first be applied against the amounts of landlord’s capped general unsecured claim (and not administrative claim unless the bankruptcy estate is insolvent). Both a security deposit and a letter of credit are subject to the capped general unsecured claim. A landlord should not apply a security deposit without court authority. Although a letter of credit can generally be drawn on without court authority, if it requires notice to the debtor the notice can be construed as a violation of the automatic stay.

Process if Tenant Fails to Vacate

If a debtor tenant does not surrender the nonresidential real property after rejecting the lease the landlord will need to seek relief from the bankruptcy court. After a valid rejection, some courts will issue an enforceable order requiring tenant to surrender the premises. Other courts may require a motion for relief from the automatic stay and, after obtaining such relief, the landlord may commence and pursue an unlawful detainer action in state court to regain possession of the premises.

Dan Myers is a partner in the Real Estate Practice Group and Lisa Lenherr and Mark Bostick are partners in the Insolvency, Restructuring and Creditors’ Rights Practice Group at Wendel Rosen LLP in Oakland, California.  They can be reached by phone at (510) 834-6600 and by email at dmyers@wendel.com, llenherr@wendel.com and mbostick@wendel.com.