Legal Corner: Landlord Rights when a Tenant Files for Bankruptcy

June 25, 2012 at 10:05 am

hand with keysBy Christopher Huntley, Attorney

You’ve executed a lease, got your security deposit, confirmed the financials of your tenant, expended thousands of dollars worth of tenant improvements, and finally your tenant moves in.  All is well…until your tenant declares bankruptcy and your secure source of rent disappears.  The landlord’s rights in connection with a tenant bankruptcy are limited, but the landlord is not completely subject to the mercy of the bankruptcy court.  And, a landlord may be able to minimize or even completely remove its exposure if it plays the bankruptcy game correctly.

The Landlord’s Rights During a Tenant Bankruptcy
When landlords hear the word “bankruptcy,” most believe that they are facing an uphill battle that will rarely result in them retrieving what is rightfully theirs along with a long line of administrative hurdles that will cause them headaches for months or years to come.  The truth is that most landlords fare better than other unsecured creditors when their tenants declare bankruptcy.  It is true that a landlord is prohibited from suing the tenant for past due rent or other past due amounts during the bankruptcy proceeding if such amounts accrued prior to the tenant filing the bankruptcy petition, and any eviction proceedings will be put on hold once the bankruptcy petition is filed, but that is not the whole story. 

A landlord is generally compensated for all obligations that accrue under the lease during the bankruptcy proceeding as the bankrupt tenant or the bankruptcy trustee is obligated to continue to perform under the lease including paying all amounts that become due while the bankruptcy is ongoing.  And, the landlord is entitled to make a claim, and usually obtain compensation, for any defaults that arise during the bankruptcy. If the bankruptcy trustee assumes the lease (only applicable to reorganizations), the lease will continue as if no bankruptcy occurred, the tenant will need to either cure or provide adequate assurances that it will cure in the near future any existing defaults (including defaults that arise prior to the bankruptcy), and the tenant will be forced to demonstrate adequate assurances of future performance under the lease before the bankruptcy court will allow the tenant to assume the lease.  The landlord will essentially be made whole in such a situation.

The downside to a bankruptcy is that the bankruptcy trustee may end up rejecting the lease, which terminates the lease.  The landlord will still receive all amounts that are due under the lease for the period commencing with the filing of the bankruptcy petition and ending with the rejection of the lease, but the landlord will likely not receive other amounts due to it.  The landlord’s right to future rents is severely capped, and the landlord will be treated like any other unsecured creditor if it seeks any such future rent amounts or any other amounts due to the landlord prior to the initiation of the bankruptcy. Luckily, the landlord will be entitled to evict the tenant once the bankruptcy trustee rejects the lease.

Another potential disadvantage for the landlord is that the bankrupt tenant may be replaced with a new solvent tenant by the bankruptcy court.  If the bankruptcy trustee determines that the lease has value, the trustee will attempt to assign the lease to a new tenant. If the bankruptcy court determines that such an assignment is in the best interests of the bankrupt tenant’s creditors, the court will approve the assignment, and any anti-assignment language in the lease will not prevent the trustee from doing so.  Luckily, the court will require adequate assurances of the assignee’s future performance under the lease before the court will approve an assignment to any third party, and a landlord may be successful in requiring additional security from the new tenant.  There is also the obvious benefit of an assignment; the new tenant’s solvency will be far superior to that of the bankrupt tenant. However, a landlord may end up with a tenant that it does not want, which is a particular problem with retail spaces.

What To Do if Faced with a Bankruptcy
If you believe that your tenant is contemplating bankruptcy, one option may be to terminate the lease (if you have the right to do so) so that the lease is not subject to the requirements of the bankruptcy. Only leases that are valid as of the moment when the bankruptcy petition is filed are deemed part of the bankruptcy estate so a landlord that manages to terminate a lease and evict its tenant prior to a filing will not have to deal with the bankruptcy court or trustee. Although you may be giving up certain rights, including the right to certain potential damages, you will be free to relet the premises and you do not need to wait around to determine if the bankruptcy court will accept or reject the lease.
Another option is to work with the bankruptcy court.  A landlord will likely not receive any past due amounts or damages in connection with a Chapter 7 liquidation of the tenant’s estate, but a landlord with a tenant that is reorganizing may not be any worse off than if the tenant was solvent.  The bankruptcy trustee will assume any lease that is of value to the tenant or the tenant’s creditors, and the tenant is obligated to cure any default if it does make such an assumption.  Plus, the landlord will be paid rent during the pendency of the trustee’s final decision as to what to do with the lease.  The downside with this approach is that the landlord may have to wait several months before it receives all of the amounts that it is owed if it does at all. 

Regardless of the approach that the landlord takes, the landlord is still entitled to seek past due amounts and damages from any guarantor of the lease unless the guarantor has also filed for bankruptcy.  The landlord may not be so lucky with using other forms of security to cure a default (e.g. prepaid rent, security deposit, or letters of credit) as these forms of security will likely be subject to the stay issued by the bankruptcy proceeding and will likely be distributed to secure creditors.

Note also that any transfer of assets made by a tenant in the 90 day period preceding the filing of the bankruptcy petition may also be deemed to be fraudulent and may be voided by the bankruptcy court.  Although the smart play when faced with an insolvent tenant is to demand additional security or to use security deposits and the like to cure a default, such actions may be reversed after the tenant files for bankruptcy. A landlord should consider this when reaching any decision and when working with its tenant.

If the landlord decides to, or is compelled to, work with the bankruptcy trustee, and the trustee determines that it is in the best interests of the tenant to reject the lease, the landlord should act quickly to evict the tenant.  Tenants are required to vacate any premises leased under a rejected lease, but tenants are not always quick to do so.  A tenant’s obligation to pay rent once the lease is rejected is also no longer governed by the terms of the lease so a landlord will likely not receive what the space is worth.  The landlord should therefore immediately initiate an eviction action to remove any tenant that does not timely vacate.

Finally, a tenant should engage a good bankruptcy attorney.  Such attorneys know how the system works and how to agitate the bankruptcy trustee and the court to get what its client wants.

Negotiating the Lease
A Landlord should add language to its lease form that states that the tenant will be in default, and the landlord may terminate the lease, if the financial health of the tenant deteriorates based on certain objective standards.  Further, a landlord must include language that obligates the tenant to periodically provide financial statements so that the landlord can monitor the financial health of its tenant.  Many lease forms list a declaration of bankruptcy as an event of default, but declaring such a default at this point may be too late as the lease would then be subject to the requirements of the bankruptcy court and the court will likely not recognize the default.  A landlord that terminates prior to the bankruptcy may avoid this if the termination is valid. Note, however, that a landlord should work quickly to evict its tenant as some courts have found that the lease is subject to the bankruptcy proceeding up until a court issues the writ restoring the premises to the tenant so delivering a notice of termination or initiating an eviction action will not be sufficient.
A landlord should also consider obtaining a secured lien on certain assets of its tenants.  Such a requirement is not practical for many tenants as they have already granted a lien in favor of the bank providing them with their business line of credit, and the loan documents that they have executed prohibit them from granting any other liens.  A landlord may still be able to either segregate the assets so that it obtains a first priority lien on the assets located in the rented premises, or the landlord may be able to work out an arrangement with the tenant’s lender for a subordinate lien. The ideal tenant will not have any other liens and would be able to grant its landlord a lien on all of its assets, but such a tenant will be difficult to find.

There is nothing that a landlord can do to avoid tenant bankruptcies altogether at the end of the day, but a landlord can at least minimize its risk by choosing tenants wisely, monitoring their financial health, acting quickly when the tenant’s business goes awry, and working with the bankruptcy trustee to get what the landlord wants.

DISCLAIMER: This article is to be used for general information purposes only, not as a substitute for in-person evaluations. The information contained herein is not legal advice and no attorney-client relationship is formed through this article.

Entry filed under: Featured Articles, Legal Corner.

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