By: Jeffrey A. Krieger
As consumer spending sinks and credit markets crunch, the trickle-over effect is a surge in bankruptcy filings by commercial tenants. That’s not good news for landlords who had been enjoying California’s real estate-driven economy.
Understandably, the prosperous past has dimmed landlords’ recollection of their rights in a tenant’s bankruptcy. More than just forgetting old laws, landlords may also be unaware that bankruptcy law amendments passed in 2005 changed protections available to them. Here are a few of today’s leading issues for commercial landlords seeking to minimize the risks when tenants file for bankruptcy:
1. Eviction Rights - Bankruptcy May Prevent Eviction. Evicting the tenant is usually a top concern of the landlord once a tenant files bankruptcy under a commercial lease. Unfortunately, the bankruptcy filing prevents the landlord from doing so, at least in the short term. Asking the bankruptcy court for permission before commencing or proceeding with an eviction is critical. Failure to do so can result in damages being awarded against the landlord.
2. Rent is Still Due - Tenant Must Keep Paying. In exchange for the privilege of staying in possession of the leased location, a tenant is obligated to pay all of the rent and other charges due under the lease during the bankruptcy. This obligation lasts for as long as the tenant remains in possession of the premises. But for unpaid rent or charges that came due prior to filing, the tenant does not have to pay to stay in possession of the location.
By way of example, in the recent Hollywood Video bankruptcy case, Hollywood Video (the tenant) was able to use the timing of the bankruptcy filing to maximize cash flow. By filing for bankruptcy in the middle of the month, Hollywood Video avoided paying rent for the first half of the month on their various locations, but required them to pay rent for the second half in order to remain in possession. Deferring rent for the first half of the month provided a tremendous benefit in terms of its short-term cash flow needs.
3. The Seven-Month Stretch - Tenant’s Choice. After filing bankruptcy, the tenant has three options - to reject the lease, keep (assume) the lease, or assign the lease.
The court provides the tenant with 120 days to decide, and then can even ask the court for an extension of up to 90 days. That totals up to 210 days, or approximately seven months, from filing bankruptcy as the amount of time a tenant can take to decide the fate of its lease. After that 210-day period expires, the court has no power to grant further extensions unless the landlord agrees to an additional extension. However, the tenant must remain current on its rent during the seven-month period.
Lease is Rejected - If the lease is priced over market, it is likely that the tenant will reject the lease. It is almost impossible to force a tenant to keep a lease that the tenant views as unfavorable. A tenant has to notify the bankruptcy court and the landlord that it wishes to reject the lease. Once the court accepts the tenant’s decision, the tenant must surrender possession and is no longer required to pay rent. The unpaid rent then becomes an unsecured debt of the bankruptcy estate.
Lease is Assumed - A tenant may determine that the lease is important to its ongoing business and choose to keep the lease. In bankruptcy parlance, this is called “assuming” the lease. The tenant must ask the bankruptcy court for permission and must meet previously unmet obligations or provide adequate assurance that it can promptly meet existing obligations, including any contractually required attorneys’ fees incurred by the landlord, with the exception of attorneys’ fees incurred in bankruptcy court litigation. The tenant must also demonstrate to the court that it can actually perform the lease obligations.
Lease Is Assigned - If a lease is under market, yet not critical to the tenant’s ongoing business, the tenant may choose to assign the lease to a new party. In this case, the original tenant must ask the bankruptcy court for permission, and must satisfy all lease obligations, including the payment of past due obligations. In some instances, the new tenant may be willing to satisfy the original tenant’s past due obligations.
Sometimes, the new tenant, or assignee, may be willing to pay the original tenant for the opportunity to take over as tenant. The original tenant is entitled to whatever sums it can negotiate with the new tenant. This holds true regardless of any lease provisions entitling the landlord to capture those sums, or even if the lease provides anti-assignment limitations. The bankruptcy court will normally approve the assignment to a new tenant notwithstanding such lease provisions. However, the original tenant must demonstrate to the court how the assignment will allow it to perform under the lease obligations. There is an important difference here between state law and federal bankruptcy law. Unlike under state regulations, after the assignment, the original tenant is no longer responsible for payments due under the lease.
4. Shopping Center Landlords - Greater Rights Over New Tenants. For shopping center landlords, there are four stronger protections against being stuck with an unfavorable tenant as a result of an assigned lease. First, to replace the original tenant, the new tenant must be at least as financially sound as the original tenant was at the time the lease was originally signed. Secondly, the new tenant must show that percentage rent will not decline substantially. Next, the assignment may not disrupt the tenant mix. Finally, the assignment may not violate any location, use, radius or exclusivity provision of the lease, or of any other leases, at the shopping center.
5. Early Action – Proactive and Pre-Bankruptcy Steps. The best protection against the hassles of dealing with a tenant in bankruptcy is avoiding being on the defense and acting early, at the first sign of trouble.
Past Due Rent - Landlords need to be proactive in managing untimely tenants. Prior to a bankruptcy filing, landlords can file a proper unlawful detainer complaint. If a tenant fails to pay rent, the landlord should serve the tenant with a three-day notice to pay rent or quit and immediately file an unlawful detainer complaint. If the landlord is able to file the complaint before the tenant files for bankruptcy, the lease is deemed terminated as a matter of law. The tenant no longer has rights under the lease, and the landlord can evict the tenant without being subject to bankruptcy laws, which eliminates the problem described at the top of this list.
Therefore, if a landlord suspects that a bankruptcy filing by a tenant may be imminent, acting promptly when rent is not paid timely may be the difference between obtaining immediate possession or being dragged into bankruptcy court.
Secure Bankruptcy Counsel Promptly - Timing is a major factor in how landlords fare in tenant bankruptcy matters. Obtaining strategic professional bankruptcy counsel can be critical for landlords.
In bankruptcy proceedings, tenants obtain rights they would not otherwise have, rights that come at the expense of landlords, including certain rights landlords normally enjoy under state law. Acting before a bankruptcy filing occurs is the ideal scenario. But if that ship has sailed, acting quickly when a bankruptcy does occur is the next best thing. Prompt action allows landlords to help enforce their rights to receive current rent, to protect against an unwanted assumption or assignment, or when acting pre-bankruptcy, to evict the tenant.
In most tenant-landlord bankruptcy issues, early intervention and counsel are wise business moves. Over the decade and a half that I have been representing commercial landlords, it has become clear that those landlords who receive early-stage bankruptcy counsel gain a definite advantage – they are better positioned in bankruptcy court proceedings and can even minimize the legal expenses of managing the insolvency.
Now more than ever, California landlords should keep their eyes and ears open. They need to know their rights and be ready to exercise protections that reduce their risks in tenant bankruptcies, filings that are poised to proliferate statewide in the months ahead.