Lease Obligations in Bankruptcy

Very few tenants enter into leases without the intent to pay all of the rent when due. But lease defaults are a reality. While nonpayment of the rent is bad enough for a landlord, in a commercial tenancy, a tenant’s default has far reaching consequences that may affect other tenants (by reducing traffic) or affect the project in general (by making a project appear less attractive). Therefore, a quick resolution to lease defaults is always in the landlord’s best interest.

Many times, after falling behind on lease payments and other financial obligations, a tenant will seek protection under the United States Bankruptcy Code in order to try and salvage the business. In recent years we have heard many horror stories about bankruptcies in general, but the good news for a landlord is that a debtor’s options in bankruptcy as toward the landlord are very limited. Below are a few important bankruptcy concepts and tenant alternatives in bankruptcy for a landlord’s use in evaluating and reacting to a tenant bankruptcy.

At the outset, the filing of a bankruptcy case imposes an “automatic stay.” Thus, although the tenant must pay all rent that is due from the date of the bankruptcy going forward, the automatic stay prevents the landlord from taking any action, including, for example, use of the landlord’s “self help” remedies. The automatic stay is designed to preserve the debtor’s estate either for reorganization or liquidation. In general, the debtor’s affairs are supervised by the bankruptcy court, and action cannot be taken against the debtor without permission of the court or obtaining “relief from the automatic stay.” Therefore, even in the circumstance where a tenant stops paying rent after filing bankruptcy, a landlord must first obtain relief from the automatic stay before exercising
any of the landlord’s normal default remedies such as lock out, taking possession of collateral securing the lease for non-payment, or suing the tenant for past due rent.

Of primary importance in a Chapter 11 reorganization bankruptcy, a lease obligation is referred to as an “executory” contract. Executory contracts are a special type of contract wherein the parties have some continuing mutual obligation to one another. So, for example, in a lease, the landlord has a continuing obligation to provide the space to the tenant, and the tenant has a continuing obligation to make rental payments. Executory contracts are subject to special rules under the Bankruptcy Code and present the Bankruptcy Court and the debtor with essentially a “binary” option. The debtor must either “accept” or “reject” an executory contract. Acceptance of an executory contract means just that — the contract is affirmed in all of its respects and the debtor is required to make all payments and perform all the actions that are required under the terms of the contract. Rejection, on the other hand, means that the debtor is refusing to continue the contract and surrendering the space to the landlord. It is important to understand from this discussion that the debtor does not have the opportunity to renegotiate a lease obligation.

With an executory contract, the debtor’s only decision is to accept or reject the lease. If the landlord elects to negotiate a “workout,” then that is the landlord’s choice. But the landlord cannot be ordered to amend or modify the lease on behalf of the debtor.

When confronted with a tenant in bankruptcy, a proper landlord’s strategy is aimed towards forcing the debtor to make the acceptance or rejection decision as early as possible in the bankruptcy process. While the Bankruptcy Code provides set deadlines for this decision to be made, in many bankruptcies, the debtor will attempt to delay the decision for some period of time. In a Chapter 11 Bankruptcy, especially, a debtor may attempt to delay the decision until confirmation of the plan. However, even if delayed for some period of time, the fact remains that at some point the debtor must accept or reject the executory contract. If the
tenant accepts the lease, the tenant must bring the lease obligations current. If the tenant elects to reject the lease, the landlord gets the property back and has an unsecured claim for unpaid rent.

While bankruptcy is often viewed as a negative event, landlords and other property owners in a leased property can take some comfort in the fact that their contracts will largely survive as is or be rejected. Bankruptcy can actually be a good event in a landlord-tenant context, because it requires the tenant to either bring the account current or give the property back. And ultimately, this is what landlords are looking for — some “closure” for a defaulted obligation.

By Cliff Wade and Barry Johnson

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