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What Commercial Landlords and Tenants Should Know About Tenant Bankruptcies Amid Restricted Evictions

Recent COVID-19-related orders from state and local authorities which restrict evictions raise important questions for commercial landlords and tenants. The relationship of these orders to a subsequent tenant bankruptcy is discussed here. The answer may very well depend on the precise language of the orders issued by the particular local jurisdiction in which the real property is located.

First, a little background.

Federal bankruptcy law allows a commercial tenant that files bankruptcy to assume or assign an unexpired lease, regardless of anti-assignment provisions contained in the lease, and even if the tenant is in default. Although the tenant needs to cure the default in order to assume or assign, the right to assign is powerful. It gives leverage to a debtor because it can force a landlord into a relationship with a new unexpected tenant. If the lease is under market, the tenant and its bankruptcy estate, rather than the landlord, can capture that value. This leverage can be used by a tenant to negotiate a better deal with the landlord.

Landlords can seize back that leverage by establishing that at the time of the bankruptcy, the lease is not “an unexpired lease”. If the lease has been terminated prior to the bankruptcy filing, it is no longer “unexpired,” and the bankrupt tenant no longer has rights in the lease. Under California law, the question of when such termination occurs is discussed in a well-known 1988 case called In re Windmill Farms, Inc., 841 F.2d 1467 (9th Cir. 1988).

Unfortunately, Windmill Farms is not perfectly clear on this point.[1] Based on the decision, one could conclude that the expiration of a 3-day notice to pay rent or quit served on the tenant is sufficient for the lease to be deemed terminated under California law. However, the decision leaves open the argument that after the expiration of the 3-day notice, the lease has not terminated until the landlord files an unlawful detainer complaint. Therefore, commercial tenants are advised to take note and respond promptly as soon as the tenant receives a 3-day notice, while commercial landlords should properly serve the 3-day notice and promptly file an unlawful detainer complaint before a bankruptcy can be filed.

As a result of COVID-19, there are many tenants that are unable to pay their rent. Indeed, some of these tenants had already missed payments prior to the recent emergency orders. These state regulations and local orders have now been put in place, temporarily restricting evictions. These orders create confusion as to what landlords can and cannot do in light of these rules. Governor Newsom’s order sets the framework. However, the specifics depend on where the property is located.

On March 16, 2020, Governor Newsom issued Order N-28-20 which stated in relevant part: “the statutory cause of action for unlawful detainer, Code of Civil Procedure section 1161 et seq., and any other cause of action that could be used to evict or otherwise eject a residential or commercial tenant … is suspended only as applied to any tenancy … to which a local government has imposed a limitation on eviction pursuant to this paragraph 2, and only to the extent of the limitation imposed by the local government” (emphasis added).

Later, California’s Judicial Council, the state court’s rulemaking body, enacted emergency rules on April 6, 2020. These rules provide, in part: “A court may not issue a summons on a complaint for unlawful detainer unless the court finds, in its discretion and on the record, that the action is necessary to protect public health and safety.”

Meanwhile, the City of Los Angeles, in Ordinance No. 186585 dated March 31, 2019, provided as follows: “No Owner shall evict a tenant of Commercial Real Property during the Local Emergency Period if the tenant is unable to pay rent due to circumstances related to the COVID-19 pandemic.”

Based on the foregoing, for real property in Los Angeles, a landlord does not appear to be restricted from serving a 3-day notice or from filing a subsequent unlawful detainer complaint based upon a pre-emergency failure to pay. Note that while the landlord can file the unlawful detainer complaint, the court will not issue a summons at this time. Although no eviction can occur until after the emergency orders have expired, under Windmill Farms, these actions will impact the rights of the landlord and tenant if the tenant does end up in a bankruptcy.

However, some jurisdictions prohibit even serving a 3-day notice in some circumstances. For instance, the City of Santa Monica issued an updated order dated April 8, 2020, as follows: “No landlord shall endeavor to evict a residential or commercial tenant in either of the following situations: (1) for nonpayment of rent if the tenant demonstrates that the tenant is unable to pay rent due to financial impacts related to COVID-19 or (2) for a no-fault eviction if any member of the household is sick, in isolation, or under quarantine. A landlord who knows that a tenant cannot pay some or all of the rent temporarily for the reasons set forth above shall not serve a notice pursuant to CCP 1161(2), file or prosecute an unlawful detainer action based on a 3-day pay or quit notice, or otherwise seek to evict for nonpayment of rent.”

Other municipalities in California have their own rules. As a result, both landlords and tenants should consult with counsel familiar with the interplay between these rules to fully protect their rights and put themselves in the strongest possible position when the present crisis begins to ease.

[1] The opinion states: “[a]fter the three-days' notice period has expired, if the lessee has failed to pay the rent in default, the lessee from that point forward is unlawfully detaining the premises if he remains in possession. See Cal.Civ.Proc.Code Sec. 1161(2). Because his detention is ‘unlawful,’ he has lost his right to possession. His right to possession has been "terminated by the lessor because of a breach of the lease [and] the lease termination. “ Later, the opinion states: [w]e hold that under California law a lease terminates for nonpayment of rent at least by the time the lessor files an unlawful detainer action, provided that a proper three-days' notice to pay rent or quit has been given, and the lessee has failed to pay the rent in default within the three-day period.”

Categories: Coronavirus, Real Property