The Chapter 11 Giveback: Preventing Preferential Transfers When Negotiating Settlement Agreements with Defaulting Tenants

Whenever a landlord enters into a settlement agreement with a tenant that has failed to pay rent, there always exists the potential of subsequent litigation if the tenant files bankruptcy and seeks to recover each payment as a preferential transfer. Set forth below are techniques to avoid such lawsuits or their adverse economic impact. Of course, if the tenant eventually elects to assume (ie, retain) the lease post-petition, the issue becomes moot because those payments would have to have been made anyway.

While the Bankruptcy Code provides certain defenses to creditors, a settlement agreement can be structured such that the payments never qualify as preferential transfers. This can be done in a number of ways.

Structuring the Payments so their Source is Other than the Tenant

In many instances, a tenant is able to make settlement payments from sources other than its own funds. For example, loans may be obtained from affiliated companies or the tenant's principals. Perhaps the simplest solution to avoidance of the preference issue is to require that the funds with which the payments of the antecedent rent are made are from such “other sources.” Thus, the tenant's affiliate and/or the tenant's principal makes the payment directly to the landlord. Because the payments are not from the tenant's assets, they are not subject to avoidance as preferential transfers. (In certain circumstances, however, these transfers may be avoidable as fraudulent transfers if the entity making the transfer files for bankruptcy contemporaneously with the tenant.)

Structuring the Settlement Such that the Payments Are Not Antecedent Debt

Where the landlord has the requisite leverage, and where there remains perhaps several years or more of term, a landlord would be well served to structure the settlement payments so they are not payments of antecedent debt; rather, prepayments of future debt.

For example, assume that the tenant is 3 months in arrears. Under the settlement agreement, the tenant prepays the last 3 months of its lease over the course of the first 3 months of the settlement, ie, “double rent” during that period. To avoid “shrinkage,” one might structure the prepayments so that there is a reasonable estimation of any CAM, real estate taxes, utility charges, and other non-base rent charges. During the last 3 months of the tenant's lease, the settlement would then provide that the tenant must repay the 3 months of payments that were outstanding at the time of the execution of the settlement agreement, preferably together with interest thereon.

This solution works particularly well in those circumstances where there is sufficient term remaining on a tenant's lease. If the tenant were to file bankruptcy shortly after its entry into a settlement agreement, and it thereafter rejected its lease, the Bankruptcy Code provision governing the filing of “rejection claims” ('502(b)(6)) would typically limit a landlord's claim to, simply stated, the greater of 1 year's rent or 15%, not to exceed 3 years, of the remaining term of the lease, plus any unpaid rent on the earlier of the petition date or the date the landlord regained possession of the leased premises. Therefore, in virtually all cases, the last 3 months of the remaining multiyear lease would be unrecoverable. (Once again, the specter of a fraudulent conveyance claim looms, but such claim would likely be more defendable.)

Increase the Security Deposit To Ensure that the Landlord Does Not Receive More Than It Would Have Received Under a Hypothetical Liquidation

One of the requirements for a preferential transfer is that it enables the landlord to receive more than the landlord would have received if the transfer had not been made and the landlord had received its distribution in accordance with the applicable provisions of the Bankruptcy Code. Secured lenders often avoid preferential transfers because they can prove they did not receive more than they would have received if they had not received the pre-petition transfer. Secured lenders do so by showing that the funds they received were subject to their security interest (ie, they would have received the payment in all events because there was sufficient dedicated collateral to assure payment). Interestingly, a landlord can make a similar argument to the extent of the tenant's security deposit. Therefore, when the amount to be paid pursuant to the settlement agreement exceeds the security deposit, the potential for a preferential transfer arises. Thus, a landlord can avoid a preference claim by requiring that the tenant increase its security deposit in an amount equal to the amount to be paid under the settlement agreement. On the 91st day following each settlement payment, a commensurate amount of the security deposit can be refunded to the tenant. Of course, the increased security deposit may also become a preference unless it is obtained from “sources” other than the tenant, such as by way of a letter of credit.

The 'Springing Guaranty'

When the debtor's principals or affiliated companies do not have the funds with which to make the payments, and no “other sources” are available, protection from bankruptcy risk can be created by a guaranty of the payments by the tenant's principals and/or an affiliated company of the tenant. Such a guaranty can be “deferred” so that the guaranty only becomes effective or “springs into life” if the tenant files, or is involuntarily placed into, bankruptcy. For further protection, such a guaranty should be collateralized with property that is not owned by the tenant. On the 91st day following the last settlement payment, the guaranty can be discharged. Normally, the documents are held in escrow to facilitate the discharge of the guaranty.

Conclusion

While settlement discussions with a tenant that has breached its rental obligation often involve myriad issues, the landlord surely should be entitled to as much protection as possible with regard to the receipt of the outstanding payments it negotiates to be repaid. The concepts discussed become particularly apposite when the financial condition of a tenant is precarious, but the tenant, nevertheless, is seeking to rehabilitate its lease and remain in the premises, and perhaps also is seeking nonmonetary concessions as part of the overall settlement. Careful drafting should prevent the landlord's involuntary return of the “old” rent the landlord received during the 90-day “danger” period.

You negotiated a settlement for your landlord client with a tenant that had not paid rent for a number of months, and, as part of the settlement, you recently received all the defaulted payments. Shortly thereafter, however, the tenant commenced bankruptcy proceedings. Moreover, accompanying the notice of commencement of bankruptcy was a summons and complaint against your client in which the debtor/tenant seeks the recovery of every settlement payment made, claiming they were preferential transfers.

You check '547 of the Bankruptcy Code and confirm that a preferential transfer is a pre-petition transfer of property of the debtor's estate, to or for the benefit of a creditor, in the payment of an antecedent debt, made while the debtor was insolvent and within 90 days of the bankruptcy, and which enabled the creditor to receive more than the creditor would have received if the payment had not been made and the creditor received whatever it would have received under a hypothetical Chapter 7 liquidation.

Accordingly, if the settlement payments exceeded your security deposit, the settlement payments may well qualify as a preferential transfer. Moreover, you know from your negotiations with the debtor that it had virtually no free assets, ie, they were all subject to the security interest of its lender; hence, the debtor may well have been insolvent at the time of the settlement payments. Thus, the settlement payments enabled your client to receive more than it would have received in a Chapter 7 liquidation. In such a circumstance, one must then turn to the defenses that are available. The problem exacerbates if none of the defenses are available.

Whenever a landlord enters into a settlement agreement with a tenant that has failed to pay rent, there always exists the potential of subsequent litigation if the tenant files bankruptcy and seeks to recover each payment as a preferential transfer. Set forth below are techniques to avoid such lawsuits or their adverse economic impact. Of course, if the tenant eventually elects to assume (ie, retain) the lease post-petition, the issue becomes moot because those payments would have to have been made anyway.

While the Bankruptcy Code provides certain defenses to creditors, a settlement agreement can be structured such that the payments never qualify as preferential transfers. This can be done in a number of ways.

Structuring the Payments so their Source is Other than the Tenant

In many instances, a tenant is able to make settlement payments from sources other than its own funds. For example, loans may be obtained from affiliated companies or the tenant's principals. Perhaps the simplest solution to avoidance of the preference issue is to require that the funds with which the payments of the antecedent rent are made are from such “other sources.” Thus, the tenant's affiliate and/or the tenant's principal makes the payment directly to the landlord. Because the payments are not from the tenant's assets, they are not subject to avoidance as preferential transfers. (In certain circumstances, however, these transfers may be avoidable as fraudulent transfers if the entity making the transfer files for bankruptcy contemporaneously with the tenant.)

Structuring the Settlement Such that the Payments Are Not Antecedent Debt

Where the landlord has the requisite leverage, and where there remains perhaps several years or more of term, a landlord would be well served to structure the settlement payments so they are not payments of antecedent debt; rather, prepayments of future debt.

For example, assume that the tenant is 3 months in arrears. Under the settlement agreement, the tenant prepays the last 3 months of its lease over the course of the first 3 months of the settlement, ie, “double rent” during that period. To avoid “shrinkage,” one might structure the prepayments so that there is a reasonable estimation of any CAM, real estate taxes, utility charges, and other non-base rent charges. During the last 3 months of the tenant's lease, the settlement would then provide that the tenant must repay the 3 months of payments that were outstanding at the time of the execution of the settlement agreement, preferably together with interest thereon.

This solution works particularly well in those circumstances where there is sufficient term remaining on a tenant's lease. If the tenant were to file bankruptcy shortly after its entry into a settlement agreement, and it thereafter rejected its lease, the Bankruptcy Code provision governing the filing of “rejection claims” ('502(b)(6)) would typically limit a landlord's claim to, simply stated, the greater of 1 year's rent or 15%, not to exceed 3 years, of the remaining term of the lease, plus any unpaid rent on the earlier of the petition date or the date the landlord regained possession of the leased premises. Therefore, in virtually all cases, the last 3 months of the remaining multiyear lease would be unrecoverable. (Once again, the specter of a fraudulent conveyance claim looms, but such claim would likely be more defendable.)

Increase the Security Deposit To Ensure that the Landlord Does Not Receive More Than It Would Have Received Under a Hypothetical Liquidation

One of the requirements for a preferential transfer is that it enables the landlord to receive more than the landlord would have received if the transfer had not been made and the landlord had received its distribution in accordance with the applicable provisions of the Bankruptcy Code. Secured lenders often avoid preferential transfers because they can prove they did not receive more than they would have received if they had not received the pre-petition transfer. Secured lenders do so by showing that the funds they received were subject to their security interest (ie, they would have received the payment in all events because there was sufficient dedicated collateral to assure payment). Interestingly, a landlord can make a similar argument to the extent of the tenant's security deposit. Therefore, when the amount to be paid pursuant to the settlement agreement exceeds the security deposit, the potential for a preferential transfer arises. Thus, a landlord can avoid a preference claim by requiring that the tenant increase its security deposit in an amount equal to the amount to be paid under the settlement agreement. On the 91st day following each settlement payment, a commensurate amount of the security deposit can be refunded to the tenant. Of course, the increased security deposit may also become a preference unless it is obtained from “sources” other than the tenant, such as by way of a letter of credit.

The 'Springing Guaranty'

When the debtor's principals or affiliated companies do not have the funds with which to make the payments, and no “other sources” are available, protection from bankruptcy risk can be created by a guaranty of the payments by the tenant's principals and/or an affiliated company of the tenant. Such a guaranty can be “deferred” so that the guaranty only becomes effective or “springs into life” if the tenant files, or is involuntarily placed into, bankruptcy. For further protection, such a guaranty should be collateralized with property that is not owned by the tenant. On the 91st day following the last settlement payment, the guaranty can be discharged. Normally, the documents are held in escrow to facilitate the discharge of the guaranty.

Conclusion

While settlement discussions with a tenant that has breached its rental obligation often involve myriad issues, the landlord surely should be entitled to as much protection as possible with regard to the receipt of the outstanding payments it negotiates to be repaid. The concepts discussed become particularly apposite when the financial condition of a tenant is precarious, but the tenant, nevertheless, is seeking to rehabilitate its lease and remain in the premises, and perhaps also is seeking nonmonetary concessions as part of the overall settlement. Careful drafting should prevent the landlord's involuntary return of the “old” rent the landlord received during the 90-day “danger” period.