Tenant Defaults and Bankruptcies

Fennemore Craig Client Alert

Tenant Defaults and Bankruptcies

With the economic slowdown it is only a matter of time before tenants seek bankruptcy protection to address cash flow issues and to reorganize in the new economic and social world. Bankruptcy is a unique animal for lessors. On one hand it provides substantial leverage for commercial lessors by limiting a tenant’s ability to alter the lease in bankruptcy. However, it provides a tenant that becomes a debtor with substantial powers to clawback preferential payments and reject unfavorable leases. Of prime consideration should be whether the lessor wishes to continue with the current tenant or seek to lease the space to a new entity. Depending on a lessor’s long term plan for the space, a tenant’s default and ultimate bankruptcy can open numerous options.

A. PRE-BANKRUPTCY CONSIDERATIONS

Nearly every tenant that ultimately becomes a debtor will have failed to make at least one (or more) lease payments in the months preceding a bankruptcy filing. At this time a lessor should consider whether it is better to work with the tenant or pursue an aggressive strategy to regain control of the space. Part of this analysis is a consideration of potential preferences claims. To avoid a lockout and other consequences of a lease default, a tenant often offers lump sum catch up payments to entice a deferral of contractual and state law remedies. This would seemingly be a great result for the lessor but bankruptcy filings can ruin even the best of things.

If a tenant makes a payment out of the ordinary course of the parties’ relationship, it can trigger what is known as a preference under the Bankruptcy Code. A preference is the bane of creditors and allows a debtor to claw back payments made to creditors or lessors within a ninety day window before a bankruptcy filing. It is intended to prevent a debtor from favoring or preferring certain creditors over others before a bankruptcy and skewing the equitable distribution of a bankruptcy. The concept is admirable but the result can often be infuriating. Unfortunately creditors and lessors often get caught by the broad preference powers and are forced to return prepetition payments.

By now many are asking how do I avoid this trap? Unfortunately there is not a great way to avoid a preference. Accordingly, the simple truth is that it is often better to take the payments you can from tenants before a bankruptcy and address the potential of a preference claim much later. Preference claims are often the last matters addressed in a bankruptcy case which means claims aren’t pursued for years. Additionally, preferences are subject to numerous defenses that are factually intensive and difficult to prosecute. Preferences are therefore settled for pennies on the dollar which allows a lessor the benefit of having received payment and being able to retain much of it. Additionally, at various points through the bankruptcy process a debtor/tenant may waive any defenses as part of its restructuring and interactions with the lessor. However, if the space is of paramount importance than strict adherence to payment requirements might be more advantageous. By rejecting non-conforming payments, lessors can move forward with lease terminations and eviction proceedings to regain the property before a bankruptcy can be filed. A debtor only has those property rights that it had before filing a bankruptcy. Thus, if a tenant is locked out and its right to possession terminated under the lease, a bankruptcy court cannot resurrect the lease such that the tenant would be entitled to remain in the space. 

Accordingly, as noted above a lessor needs to understand at a fairly early stage whether the tenant is one that might be worth saving or one that needs to be quickly removed and replaced by a performing tenant. This determination will greatly impact the pre-bankruptcy world which will bleed into the ultimate bankruptcy.

B. POST-BANKRUPTCY NOTES

Okay. The tenant has filed – now what does a lessor do and more importantly, what can it not do in the bankruptcy? First and foremost all collection activities must cease. The Bankruptcy Code creates an automatic stay that protects the debtor and its property from any collection activities including demand letters/notices of default, lockouts, and eviction proceedings. Failure to abide by the automatic stay will result in substantial penalties and sanctions from the court.

Once those collection activities are halted, a lessor needs to address whether it wants to cooperate with the debtor or again seek to retake the property. Much of this will depend on the financial strength of the debtor and its ultimate plan for addressing the lease and other debts. Regardless, this early determination will shape the bankruptcy and the lessor’s actions.

Now that a bankruptcy is in place it does not mean that a debtor has a free pass. In fact, the debtor must now comply with the provisions of the lease in a timely manner. That includes the timely payment of rent and other costs as required under the lease. In fact, each rent payment is considered an administrative expense that must be paid ahead of nearly every other creditor. Failure to comply with the terms of the lease post-petition can allow a lessor to retake the property and assert damage claims. Accordingly it is crucial that any budget of the Debtor approved by the court include and require payment of the rent.

Once in a bankruptcy, the debtor needs to decide what it wants to do with the leased space. Here, the Bankruptcy Code gives the debtor the ability to assume or reject the lease. If a debtor wishes to continue in the space, it must cure or provide adequate assurance that it will promptly cure all defaults under the lease as part of the lease assumption. Some defaults that are impossible to cure (eg going dark) are waived. The Bankruptcy Code requires that a debtor make this determination within 120 days after the bankruptcy case is filed or the lease is deemed rejected. This deadline can be extended but requires a debtor demonstrate cause for why it should be excused from this deadline. Again, whether a lessor wants to work with a particular debtor will shape whether it cooperates with the assumption of the lease or pushes for rejection and a return of the property.

The flip side to assumption is rejection of a lease. Here the debtor can essentially terminate the lease and be free of any future obligations. However, the landlord is entitled to damages to the lessor that is the greater of one year of rent or 15% of the rent due under the lease which cannot exceed three years total rent. Such a claim is unsecured which means it gets paid almost last and usually pennies on the dollar if at all. So while  rejection can provide the lessor with immediate possession of the property, its damages are not likely to be paid.

Often debtors sell their assets as part of their reorganization and this includes its leases if there is some value in the terms. To do so, a debtor must assume the lease as described above which includes curing all defaults. In addition, the prospective assignee must provide adequate assurances of future performance before any assumption can occur. Shopping center lessors are entitled to specific protections during assumption including (i) insuring the source of rent and financial condition of the assignee is similar; (ii) any percentage rent due will not substantially decline; (iii) the assignment will comply with all provisions in any other lease, financing agreement or master agreement; and (iv) the assignment will not disrupt the tenant mix/balance of the center. The intent is to ensure the lessor gets a tenant that will be able to financial perform under the lease. Accordingly, assumption and assignment through a sale can provide the landlord with a win-win situation as it requires a full cure of defaults and a qualified tenant.

C. FINAL THOUGHTS

Throughout the process it is crucial that lessors approach the bankruptcy with a clear goal/vision for the leased space. Bankruptcy is a powerful tool for a tenant but a properly prepared lessor can extract considerable concessions through the process, including full payment of any defaults or return of the space with a damages claim for the termination of the lease. A lessor can even avoid a bankruptcy process if it acts quickly enough pre-petition to terminate the lease.  With the current economic environment, lessors will need to quickly evaluate and make these determinations at the first signs of distress in tenants to ensure the lessor’s goals are met and its interests protected.