By Joshua Levin-Epstein, Esq.
While the commercial real estate market in the United States has stabilized and improved since the Great Recession, the tepid economic recovery necessitates that commercial landlords’ business planning must still contemplate the prospect of tenant bankruptcies. The recent corporate bankruptcies of retail companies with hundreds of now shuttered retail locations, such as Blockbuster, Brookstone Inc., Coldwater, Creek, Inc., Crumbs, Dots, and Sbarro serve as reminders of the challenges of operating commercial real estate businesses. The purpose of this article is to: (1) provide commercial landlords with an understanding of common real estate issues that arise in a bankruptcy proceeding, and; (2) provide commercial landlords with guidance on best practices for compliance with relevant bankruptcy rules.
The Bankruptcy Code’s Invalidation of “Termination on Bankruptcy” Provisions
The Bankruptcy Code, which is a set of federal laws that govern bankruptcy cases, invalidates the so-called “termination on bankruptcy” contract provisions, known colloquially as ipso facto clauses, which are standard provisions in commercial leases. For example, the Standard Form of Store Lease, in New York City, includes the following provision:
Bankruptcy: (a) Anything elsewhere in this Lease to the contrary notwithstanding, this Lease may be cancelled by Owner by the sending of a written notice to Tenant within a reasonable time after the happening of anyone or more of the following events:
(1) the commencement of a case in bankruptcy or under the laws of any state naming Tenant as the debtor . . .
Section 365(e)(1) of the Bankruptcy Code, however, expressly invalidates “termination on bankruptcy” contract provisions in commercial real estate leases, such as the provision excerpted above, that provide for the termination of the lease solely based on the tenant’s initiation of a bankruptcy proceeding. Section 365(e)(1) of the Bankruptcy Code provides in relevant part:
Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—
(A) the insolvency or financial condition of the debtor at any time before the closing of the case; (B) the commencement of a case under this title . . .
Since the Bankruptcy Code invalidates the standard “termination on bankruptcy” provisions in commercial lease agreements, it is vital for commercial landlords to understand the bankruptcy implications of tenant bankruptcies.
Best Practices Guide: The Bankruptcy Code’s invalidation of “termination on bankruptcy” contract provisions means that landlords should negotiate for the greatest amount of security, such as a letter of credit, increased cash security deposits, and third-party guarantees, as a precautionary measure. Upon a tenant bankruptcy, landlords should consult an attorney on the proper completion of the proof of claim for amounts accrued in the pre-bankruptcy period. The failure to timely submit a proof of claim form may result in the landlord’s loss of any rent or charges the bankrupt tenant incurred in the pre-bankruptcy period.
The Bankruptcy Code’s “Automatic Stay” of Legal Action Against the Bankrupt Tenant
To further aggravate matters for landlords, the Bankruptcy Code’s “automatic stay” provision automatically precludes and suspends all legal actions against a bankrupt tenant. The “automatic stay” is a legal mechanism that springs into effect immediately upon the tenant’s commencement of bankruptcy. The scope of the automatic stay is extremely broad and encompasses virtually all legal actions, including eviction proceedings, rent collection and enforcement actions, and lien enforcement actions. Upon the tenant’s initiation of a bankruptcy, landlords must be careful to avoid violations of the automatic stay.
The nature and comprehensiveness of the automatic stay invites violations for the uninitiated landlord. Section 362(a) of the Bankruptcy Code “stay[s]” “any act to obtain possession of property of the estate”, which the Bankruptcy Courts interpret very broadly to include seemingly innocuous acts related to the enforcement of lease terms. For example, the automatic stay prohibits landlords’ issuance of demand notices for pre-petition rent. The automatic stay arises by operation of law and prohibits a broad range of acts that are otherwise legal in a non-bankruptcy setting. Therefore, landlords must be prepared to immediately comply with the Bankruptcy Code’s automatic stay provisions.
For the uninitiated landlord, the automatic stay is a legal minefield. The automatic stay enjoins all legal proceedings against the bankrupt-tenant without the Bankruptcy Courts’ permission. The scope and breadth of the automatic stay even includes set-offs of bankrupt-tenants’ security deposits. The key to operating within the confines of the Bankruptcy Code is to submit all appropriate motions on time. Landlords’ non-compliance with the automatic stay may result in sanctions, including monetary fines, for willful violations of the automatic stay.
Best Practices Guide: The Bankruptcy Code’s automatic stay provisions requires that a landlord seek the approval of the Bankruptcy Court to enforce its rights and interests under the lease. Landlords should proceed cautiously and obtain the services of legal counsel to ensure compliance with the automatic stay. It should be noted that, in bankruptcy, a tenant is obligated to pay rent in accordance with the terms of the lease.
The Bankruptcy Code’s Timeline for the Tenant’s Assumption, Assignment, or Rejection of a Lease
The purpose of the Bankruptcy Code’s regulation of the relationship between the bankrupt tenant and the landlord is to provide the bankrupt tenant with “breathing room” and a meaningful opportunity for reorganization. To this end, the Bankruptcy Code purposefully slows down the legal process and provides the bankrupt tenant with the option of the assumption, assignment, or rejection of a lease.
The Bankruptcy Code provides the bankrupt tenant with a timeline of 210 days from the date of the bankruptcy filing for the election of the lease’s assumption, assignment, or rejection. During the 210-day period, section 365(d)(3) of the Bankruptcy Code requires the bankrupt tenant to perform all lease obligations that accrue in the post-petition period. The bankrupt tenants’ options include the following:
Assumption. The assumption of the lease requires performance under all the terms of the lease and the cure of defaults or the bankruptcy tenants’ “adequate assurance” of the prompt cure of all defaults.
Assignment. The assignment of the lease to a third party is enforceable notwithstanding anti-assignment provisions in a lease. In an assignment, the bankrupt tenant must demonstrate “adequate assurance of future performance” by the third-party assignee, which is determined on a case-by-case basis.
Rejection. The rejection of the lease terminates the bankrupt tenant’s possessory interest in the lease.
Best Practices Guide: The tenant-friendly provisions of the Bankruptcy Code limit landlords’ enforcement options within the initial 210 days of a bankruptcy case. During the 210-day period, however, the landlord should carefully monitor the bankruptcy filings in the event the bankrupt-tenants’ filings include pertinent information about the status of the lease and rent payments, such as a restructuring plan, financial schedules, and monthly operating reports.
The Bankruptcy Code’s Provisions for the Satisfaction of Landlords’ Claims
The Bankruptcy Code provides a statutory framework for the determination of landlords’ claims and damages. The date of the bankrupt tenant’s bankruptcy demarcates landlords’ damages claims into two types of claim classifications: claims that arose in the pre-bankruptcy period, which are generally classified as “unsecured” claims, and claims arising in the post-bankruptcy period, which are generally classified as “administrative” claims. The type of classification bears significantly on whether a landlord’s damages are paid in whole dollars or in bankruptcy dollars.
In the post-bankruptcy period, bankrupt tenants are obligated to comport with all of the obligations under a lease until the lease is deemed rejected. The financial obligations of a bankrupt tenant desirous of maintaining a lease requires the timely payment of all rent and charges that arise in the post-bankruptcy period. For landlords’ claims that arise in the post-bankruptcy period, the Bankruptcy Code affords such claims “administrative” priority, which provides for payment ahead of lower classified claims. The classification of a claim as “administrative” generally provides for full payment in a successful Chapter 11 bankruptcy case or, at the very least, a greater recovery than a lower ranking claim.
In the pre-bankruptcy period, tenants contemplating bankruptcy may plan on purposefully defaulting on lease payment obligations in order to create cash reserves for operation in the post-bankruptcy period. For tenants contemplating a lease rejection, the purposeful payment default in the pre-bankruptcy period is also a strategy to lessen the amount of payments owed to landlords in the claims distribution process. By defaulting on the leases’ payment terms in the pre-bankruptcy period, the tenant locks the landlords’ claim into an “unsecured” designation, which affords a low-ranking priority of payment that is generally paid out in bankruptcy dollars.
Best Practices Guide: The key to landlords’ maximization of payments in the bankruptcy setting is the immediate and timely filing of proofs of claims for unpaid rent and charges in the pre-bankruptcy period, and for unpaid rent and charges in the post-bankruptcy period. The following are some general tips for accurately completing the proof of claim forms: (1) the proof of claim form for amounts accrued in the pre-bankruptcy period should include a description of the security deposit in order to qualify the claims as partially secured; (2) the landlord should refrain from setting-off the security deposit which may trigger a violation of the automatic stay; (3) the proof of claim form should include all amounts due, including taxes, common and maintenance charges, etc.; (4) the deadlines for the submission of proof of claim forms are extremely important, as the failure to timely file a proof of claim generally excludes the landlord’s claim; (5) the landlord should consult with an attorney about possible legal actions against non-bankrupt guarantors.
To prevent a difficult situation from turning into a catastrophe, landlords must put in place a contingency plan for the possibility of tenant bankruptcies. The relatively fast pace of bankruptcy proceedings require that landlords act promptly and decisively to avoid the pitfalls of untimely submissions of proof of claim forms, violations of the automatic stay, and untimely objections to the bankrupt tenant’s election in its decision to assume, assign, or reject a lease. With proper planning, landlords can mitigate problems and salvage the greatest possible recovery in a tenant bankruptcy. As the immemorial cliché goes, “an ounce of prevention is worth a pound of cure.”