Bankruptcy Issues a Landlord Should Know Prior to Workouts with Defaulting Tenants

Commercial tenants are expected to temper the impact of rapid inflation, but experts believe that evolving market trends will play a role in future tenant defaults. Landlords contemplating terminating or renegotiating a tenant’s lease should consider the Bankruptcy Code’s impact on such decisions.

Terminating the Lease. In general, a landlord may terminate the lease prior to the tenant filing for bankruptcy. If done correctly, the lease does not become property of the estate, and is thus not subject to assumption or rejection, allowing the landlord to market and relet the property. If the landlord does not terminate the lease prior to the petition date, the debtor has 120 days (currently 210 days under the CARES Act) to assume or reject the lease. Even if the debtor intends to reject the lease, until it is rejected, a landlord may not relet the property. The landlord can market the property and condition any lease on the debtor’s formal rejection, but such contingency may make it difficult to relet the property. By terminating the lease prior to bankruptcy, a landlord can avoid waiting on the debtor to make a decision with respect to the lease, and will be in a better position to relet the property.

If a landlord decides to terminate the lease prior to bankruptcy, the landlord should be aware of two things. First, a landlord must strictly comply with applicable law and the terms of the lease. With strict compliance, a landlord can better situate itself in the event a debtor considers challenging the termination. Second, termination and eviction proceedings can be lengthy events, and a debtor often files for bankruptcy on the eve of such events. If this happens, the “automatic stay” will prevent the landlord from taking further action against the debtor. Although a landlord can seek relief from the automatic stay, this can be difficult. Therefore, a landlord should terminate the lease when the tenant still has other options available to it, and is not boxed into a corner.

Lease Amendments or Entering into a New Lease. Rather than terminate the lease, a landlord may wish to press the reset button with the tenant, and amend the lease or enter into a new lease. This, too, should be done with an eye toward bankruptcy.

As an initial matter, in connection with any lease amendments or new lease, the landlord should obtain comprehensive financial information from the tenant. Not only will this allow the landlord to make an informed decision, but it may allow the landlord to argue that its claim is nondischargeable in a future bankruptcy case.

A landlord should be hesitant about accepting any payment from the tenant to satisfy past debt. On its face, this could constitute a “preference” that the debtor may attempt to claw-back in bankruptcy. Although a new defense affords a landlord new protections to account for arrearage payments, the landlord should strictly complies with such provision. Another option is to “forgive” the old debt and enter into a new lease, whereby the new rent payments are increased to account for the past-due amounts.

In connection with a new lease, the landlord should also consider the form and amount of any security. Most landlords take a security deposit from their tenants, which renders a portion of the landlord’s allowed claim as a secured claim. However, even though the security deposit is often in the possession of the landlord, the deposit is considered the debtor’s property. In order to apply the deposit to amounts owed, a landlord must work with the debtor or seek court approval. A better option is using a letter of credit in lieu of a security deposit. A letter of credit is not property of the estate, because it allows the landlord to seek payment directly from the financial institution. A landlord can thus bypass the bankruptcy process, and immediately satisfy a portion of the tenant’s past-due rents. A landlord should also consider the amount of the security, and take into account the tenant’s business and the cost of any cleanup. In most bankruptcies, cleanup costs are borne by the landlord.

A landlord should explore obtaining a guaranty from a third party. If a tenant defaults on its rent obligations and files for bankruptcy, the automatic stay does not prevent the landlord from collecting past-due rents against the nondebtor third party. 

A landlord should also ensure that the tenant’s rental obligations are properly characterized to maximize the amount of any “allowed” claim in bankruptcy. While a tenant’s fixed monthly payments are certainly allowed claims, other obligations, such as CAM charges and insurance premiums, may not be. The Bankruptcy Code contains a number of undefined terms, and courts have taken different approaches as to what is included in these terms. The amount a landlord can claim depends largely on the terms of the lease and the applicable law. Any new lease or lease amendment should take into account these differences to ensure it maximizes the amount of any allowed claim in bankruptcy.

Short of obtaining an astronomically large security deposit, a landlord cannot safe-proof itself from a tenant’s bankruptcy case. However, amending or entering into a new lease with its tenant with bankruptcy principles in mind, a landlord can protect itself during the process.

This article was originally published in the Colorado Real Estate Journal