Treatment of Commercial Leases in Bankruptcy

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Commercial landlords are increasingly finding themselves thrust into bankruptcy courts when a tenant files for bankruptcy protection.

One of the hottest trends in 2009 is declaring bankruptcy. On April 30, 2009, Chrysler became the first major American automaker to seek bankruptcy protection since Studebaker did so in 1933. General Motors followed close behind, filing for protection on June 1, 2009. Other national retailers to recently file include Circuit City, S&K Menswear, and Eddie Bauer. As for the small to medium sized retailers that make up the heart and soul of the retail market in Pennsylvania, bankruptcy filings increased over 75% in the last two years and this surge is likely to continue. In this volatile market it is essential that all business professionals, including commercial landlords, have a basic understanding of the Bankruptcy Code.

1.  Chapters.

There are two chapters of the Bankruptcy Code under which a commercial tenant is most likely to file: Chapter 7, the liquidation bankruptcy, and Chapter 11, the reorganization chapter most often used by businesses. When a business files for Chapter 7 protection it must dissolve.  It is less likely that a corporation will file a Chapter 7 because doing so would allow a creditor to file a creditor suit against the officers and shareholders personally once the corporate shield no longer exists. A corporation wishing to liquidate will typically file for Chapter 11 and allow the corporation to just wind down.

2.  Creditor/Debtor.

The bankruptcy code uses the term “debtor” to refer to the entity filing the bankruptcy petition (here the commercial tenant). The code also uses the term “creditor” to refer to an entity that has a claim against the debtor that arose at or before the bankruptcy petition was filed (here the commercial landlord).

3.  Things that Happen Upon Filing Bankruptcy.

Most bankruptcy petitions are voluntary. In some instances creditors can file an involuntary petition.  Once the petition is filed by the debtor, an estate is created and an automatic stay goes into effect.  The estate includes all the property, legal and equitable interests of the debtor. Unexpired leases are considered to be assets of the bankruptcy estate. The automatic stay prevents landlords from evicting a defaulting tenant or collecting on past due rent without permission of the Bankruptcy Court.

4.  Trustee or Debtor in Possession.

In all Chapter 7 cases, a trustee is appointed. Trustees are paid a percentage of what is distributed from the estate. The percentage depends on the value of the estate, but can be as high as 25%.  In a Chapter 11 case, unless a trustee is appointed, the debtor itself, as Debtor in Possession (“DIP”) has the duties of the trustee. The trustee or DIP has the power to collect and sell the estate property; investigate the debtor’s financial affairs, examine claims; and object to/avoid any improper claims. According to U. S. Bankruptcy Court statistics, 18,932 total cases were filed in 2006 in the eastern, western, and middle district courts, 29,962 were filed in 2007, and 33,150 were filed in 2008. These statistics are based on the total number of bankruptcies filed.

(211 U.S.C. § 727(a)(1), 311 U.S.C. § 541, 411 U.S.C. § 362)

5. Assume/Reject/Assign an Unexpired Lease.

The bankruptcy petition does not terminate the lease agreement. Once the petition is filed the lease may be assumed and even assigned.  In a Chapter 7 case a trustee must expressly assume or reject an unexpired lease within 60 days following the filing of the bankruptcy petition, otherwise the lease is deemed to be rejected.  In a Chapter 11 case, as a general rule, the DIP or trustee may assume or reject an unexpired lease at any time prior to the confirmation of the plan.  Obviously, the trustee or DIP will quantify the benefit of assuming, assigning or rejecting the unexpired lease based on whether the lease is integral or advantageous to the business or whether assigning the lease will net any proceeds.

6. Avoidance Powers.

The trustee or DIP is given extensive powers to avoid pre-petition transfers of property by the debtor to the extent such transfers are avoidable as preferences or fraudulent transfers. In the commercial lease arena, the most common technique used to avoid pre-petition payments is found in Section 547(b) of the Bankruptcy Code. Under that section an avoidable preference is (i) any transfer of property by the debtor; (ii) to or for the benefit of a creditor; (iii) for or on account of an antecedent debt owed by the debtor before the transfer was made; (iv) made while the debtor was insolvent; (v) made within 90 days of the bankruptcy filing (or one year if the creditor is an insider); and (vi) enables the creditor to receive more than it would have received under a Chapter 7 liquidation.

An example may be helpful.  Assume that a landlord and tenant are three years into a commercial lease and tenant is three months behind on the rent, which is $10,000 per month pursuant to lease. Smothered by an avalanche of debt, tenant requests permission to terminate the lease. Landlord agrees, but requires payment of the three months rent in arrears and a termination fee of one additional month rent. Tenant tenders a $40,000 check to Landlord and vacates the premises. Tenant files for bankruptcy within 90 days of landlord cashing tenant’s check. Provided elements (iv) and (vi) are satisfied, (and they almost always are) and provided there are no applicable defenses under Section 547(c) of the code, the Trustee can set aside this transfer as a preferential payment and sue the landlord in bankruptcy court for the return of the payment. The most likely outcome is that the landlord would have a defense to the current month’s rent or $10,000, which was likely made in the ordinary course of business. However, if the tenant was routinely several months behind on the rent, the landlord could argue that two or three months rents were “made in the ordinary course of business.” This outcome surprises most people. The value to landlords finding themselves in a similar situation of consulting with legal counsel cannot be overstated.

7.  Practical Pointers for Landlords.

  • Cash checks promptly and save copies of all incoming checks to potentially avoid preference litigation.

  • Save envelopes for checks to preserve the postmark dates or routinely record postmarks on all incoming checks.

  • Include an Ipso Facto Clause in the lease agreement. An Ipso Facto Clause is a clause that terminates the agreement upon the filing of bankruptcy by the tenant. While these clauses are unenforceable under the Bankruptcy Code, there are at least two good reasons to include them. First, the confirmation rate for Chapter 11 reorganization is only about 33%.  If the tenant files for bankruptcy and the plan is not confirmed, the tenant is in default and the default can be enforced. Second, if there is a guarantor to the lease, the clause can be used to pursue rent arrearages from any guarantors of the lease.

  • Seek the advice of legal counsel with experience in real estate transactions and representing creditors in bankruptcy proceedings (such as Reager & Adler, PC). Consulting with an attorney to review your commercial lease prior to execution could limit your exposure in the event of a tenant bankruptcy. Consulting with an attorney after the tenant files bankruptcy will allow the attorney to file a notice of appearance and properly monitor the case and receive all pleadings and notices from the court. This can be critical to preserving your legal interest and maximizing your recovery.

(511 U.S.C. § 365(d)(1), 611 U.S.C. § 365(d)(2))

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