The Quiet Before the Storm: Fortifying the Landlord's Position Before the Tidal Wave of Tenant Bankruptcy

After the signing of the lease, the last thought entering the landlord's consciousness is that its new tenant is going to file for bankruptcy protection during its tenancy. In the beginning stages of the relationship between landlord and tenant, there is a brief period of shared optimism about the future and the joint prosperity that the new union is bound to offer.

This period may represent the quiet before the storm ' when the landlord's optimism soon gives way to the unfortunate reality that the tenant is in dire financial distress. Financial crisis can turn, very quickly, to the filing for bankruptcy protection in the form of reorganization under Chapter 11 or liquidation under Chapter 7. Once the landlord becomes a creditor in bankruptcy, it is powerless to change the terms of the lease and the respective rights of the parties without the approval of the bankruptcy court. The retail landlord is in a considerably better position and is more likely to maximize its value proposition as a creditor in the tenant's bankruptcy proceeding when it employs foresight and prevention, careful monitoring, and decisive action.

Foresight and Prevention

Shopping Center Leases. Bankruptcy law offers special protections to shopping center landlords. The issue of whether a lease is in a “shopping center” can be a difficult question in today's world of retail development and the increasing number of “lifestyle centers.” One tip for the landlord during tenant lease negotiations is to insist that the lease specify that the leased space is within a “shopping center.” This may be sufficient evidence of the parties' intent should the tenant later file for bankruptcy protection, although the bankruptcy court can overlook this statement as form over substance. A shopping center need not be an enclosed mall, but can be a cluster of relatively contiguous buildings. Not all contiguous buildings, however, will be considered a shopping center. The most important characteristic will be a combination of leases held by a single landlord, leased to retail distributors of goods, and with the presence of common parking. The landlord should also take some basic steps after the lease is signed, eg, perfect a contractual lien as soon as the lease is signed in order to prepare for a possible tenant bankruptcy.

Landlord's Liens. Most commercial leases have both contractual and statutory landlord's liens. Although a statutory landlord's lien is not enforceable in bankruptcy, a properly perfected contractual lien under the applicable state Uniform Commercial Code will give a landlord a security interest in the tenant's property. It may be difficult for a landlord to obtain a first lien on the tenant's property because the tenant will usually have some bank financing in place; however, a landlord with a junior lien may be able to use the lien as leverage to gain an advantage in any subsequent bankruptcy or to receive a greater distribution on a secured claim. If a landlord waits until a tenant has financial problems to perfect its interest in the tenant's collateral, it may be too late. The interest can potentially be set aside as an avoidable transfer – known as a preference by the bankruptcy court. Requiring security deposits and letters of credit may provide additional security, but timing is the key.

Security Deposits. There is a strategic advantage to requesting a security deposit as part of the lease negotiation rather than after it becomes apparent the tenant is in financial crisis. In the latter scenario, the tenant may not have the funds available when the landlord finally makes the request. Even if the funds are available ' and assuming the tenant is willing to cooperate ' there is the added risk that the court could set aside the security deposit as a preference should the tenant subsequently file for bankruptcy protection within 90 days of posting the deposit. Security deposits are applied against the maximum statutory claim the landlord can assert under bankruptcy law; this application will reduce the dollar value of the landlord's claim. The loss in the value of the claim as a result of the application of the security deposit is, however, acceptable because claims are typically paid at substantially less than dollar for dollar, if at all, and it is better to have the money rather than the claim.

Letters of Credit. Letters of credit are an even better tool to maximize the landlord's recovery. As a general rule, the landlord may draw on the letter of credit if it is so entitled under the terms of the applicable documents, even if the tenant is in bankruptcy. A letter of credit and its proceeds are not property of the estate, but are property of the issuing bank paid on account of an independent obligation to the beneficiary of the letter of credit under bankruptcy law. Some legal authority exists in support of an injunction to, at least, delay the landlord from drawing on a letter of credit. The majority of bankruptcy courts, however, have refused to enjoin a draw on a letter of credit because they do not want to upset the principles underlying the general rule. To foreclose any opportunity for the tenant even to seek injunctive relief, the letter of credit should be carefully drafted to ensure that the landlord has the ability to draw on it without notice to or cooperation from the tenant. As in the case of security deposits, there is some case authority holding that the proceeds of the letter of credit are to be applied against the landlord's maximum statutory claim.

If the tenant posts a letter of credit to secure its outstanding obligations, the posting of the letter of credit can create a preference in favor of the landlord, provided such posting is within 90 days of the tenant's bankruptcy filing. For this reason, the letter of credit should be obtained at the time the lease is signed. It creates a defense to any subsequent preference attack because it would relate back to the time that the lease was signed and the letter of credit was issued, and not the date that past-due obligations had accrued.

Careful Monitoring

Careful monitoring of the financial condition of its tenant is another basic step the landlord should take in order to maximize its position should it become a creditor in the tenant's bankruptcy proceeding. Although public companies usually have public reporting requirements that make it easier for a landlord to monitor the tenant's financial condition, a landlord can still monitor private companies by requiring the tenant to comply with financial reporting requirements. Landlords should review the information on a regular basis, and not merely toss it into the file. Early signs of a tenant's deteriorating financial condition include the obvious, such as a tenant's habitual late payment of monthly rent and other obligations due under a lease, and the less obvious, such as negative financial information reported on public filings. When careful monitoring is used in conjunction with lease default provisions for failing to maintain minimum net worth requirements and minimum financial conditions, the landlord is in the best position to act quickly and decisively at the first signs of financial distress. Waiting until a tenant has a significant accrued balance on the books may be too late for the landlord to take decisive action.

Quick and Decisive Action

By exercising its remedies in strict compliance with the lease and applicable law, however, a landlord may be situated to negotiate with the tenant from a leveraged position when careful monitoring of the tenant's financial condition has given the landlord advance warning of financial distress. An analysis of the available state law remedies under a lease is outside the scope of this article, but, if available, the termination of the lease is the remedy with the most teeth. It is important to note that even a lease termination is not foolproof within a bankruptcy proceeding. Some case authority suggests that such a termination can be set aside as a preference or fraudulent transfer. While the state of bankruptcy law is unsettled on the issue, it may be better for the landlord to take that risk and get control of its space with the knowledge that it may have to defend itself in subsequent litigation. The landlord that aggressively exercises its remedies, within the confines of the law, is in a better position to negotiate if and when the filing occurs. The termination of the lease can be unilateral or bilateral, at least from the landlord and tenant's perspective.

When the landlord's objective is to obtain control of the space and it anticipates that the defaulting tenant will not go quietly, it should exercise unilaterally (once again, if available under the lease or applicable state law) the right to terminate the lease in its entirety and not just terminate the tenant's right of possession. The bankruptcy court will look to state law to determine if the lease has been properly terminated and will enforce termination provisions within leases that are properly drafted. The tenant or bankruptcy trustee may nevertheless try to avoid the lease termination as a preference and recover the premises or value thereof from the landlord if the lease was below market and had value that can be realized through an assignment of the lease to a third party. One possible way to reduce the risk that the involuntary lease termination will be held to constitute a preference is to include a lease provision stating that the term of the lease will be deemed to expire on the landlord's termination of the lease for a tenant default.

According to applicable bankruptcy law, a lease does not become property of the estate, and the landlord is not subject to the automatic stay, if the lease has terminated by the expiration of its stated term before the bankruptcy filing. In this scenario, the landlord can obtain possession of the premises without first seeking bankruptcy court approval, without violating the provisions of the automatic stay, and without the risk of the termination being found to be a preference. This safe-harbor provision under bankruptcy law probably does not apply if the landlord has terminated the lease because of a tenant default, but the landlord may attempt to draft itself within the safe-harbor provision by crafting language in the default and termination provision of the lease. It is important to note that a bankruptcy court may very well view such a provision as form over substance and, as such, a landlord is still well advised to seek relief from the automatic stay to avoid any question of what, if any, rights under the lease or applicable state law a landlord may exercise after a bankruptcy filing.

An agreed lease termination or bilateral termination between the landlord and tenant may be an option with a cooperative tenant, and another workable solution for the landlord that wants to recapture the lease space and avoid being engulfed in a subsequent tenant bankruptcy. A bilateral termination is subject to challenge in bankruptcy court on preference or fraudulent transfer grounds, and the landlord exercising a unilateral termination right may be in a better position to avoid a subsequent attack on such grounds. The two options, however, are not mutually exclusive and may in fact work best when used in conjunction with one another. A landlord must pay “reasonably equivalent” value for the lease termination to guard against a preference or fraudulent transfer challenge. If the landlord as a result of a tenant default had already unilaterally terminated the lease, then, presumably, the tenant would not be entitled to “reasonably equivalent” value. Following the unilateral termination, the landlord's use of an agreed or bilateral termination has the additional benefit of minimizing the risk of a state court lawsuit possibly being brought by the tenant. A justification for the subsequent bilateral termination in this scenario, if ever brought into question, is that the landlord was merely facilitating the tenant's move-out from the premises.

Conclusion

Through the use of foresight and prevention, careful monitoring, and quick and decisive action, the retail landlord has the opportunity to fortify its position before the tenant's bankruptcy tidal wave hits. Retail landlords are well advised to engage competent counsel experienced in this area upon the first signs of the tenant's financial distress. The combination of strategic thinking and advance preparation provides the landlord with the best chance to minimize its exposure to potential loss and to prevent being washed out to sea in the event of a tenant bankruptcy.

After the signing of the lease, the last thought entering the landlord's consciousness is that its new tenant is going to file for bankruptcy protection during its tenancy. In the beginning stages of the relationship between landlord and tenant, there is a brief period of shared optimism about the future and the joint prosperity that the new union is bound to offer.

This period may represent the quiet before the storm ' when the landlord's optimism soon gives way to the unfortunate reality that the tenant is in dire financial distress. Financial crisis can turn, very quickly, to the filing for bankruptcy protection in the form of reorganization under Chapter 11 or liquidation under Chapter 7. Once the landlord becomes a creditor in bankruptcy, it is powerless to change the terms of the lease and the respective rights of the parties without the approval of the bankruptcy court. The retail landlord is in a considerably better position and is more likely to maximize its value proposition as a creditor in the tenant's bankruptcy proceeding when it employs foresight and prevention, careful monitoring, and decisive action.

Foresight and Prevention

Shopping Center Leases. Bankruptcy law offers special protections to shopping center landlords. The issue of whether a lease is in a “shopping center” can be a difficult question in today's world of retail development and the increasing number of “lifestyle centers.” One tip for the landlord during tenant lease negotiations is to insist that the lease specify that the leased space is within a “shopping center.” This may be sufficient evidence of the parties' intent should the tenant later file for bankruptcy protection, although the bankruptcy court can overlook this statement as form over substance. A shopping center need not be an enclosed mall, but can be a cluster of relatively contiguous buildings. Not all contiguous buildings, however, will be considered a shopping center. The most important characteristic will be a combination of leases held by a single landlord, leased to retail distributors of goods, and with the presence of common parking. The landlord should also take some basic steps after the lease is signed, eg, perfect a contractual lien as soon as the lease is signed in order to prepare for a possible tenant bankruptcy.

Landlord's Liens. Most commercial leases have both contractual and statutory landlord's liens. Although a statutory landlord's lien is not enforceable in bankruptcy, a properly perfected contractual lien under the applicable state Uniform Commercial Code will give a landlord a security interest in the tenant's property. It may be difficult for a landlord to obtain a first lien on the tenant's property because the tenant will usually have some bank financing in place; however, a landlord with a junior lien may be able to use the lien as leverage to gain an advantage in any subsequent bankruptcy or to receive a greater distribution on a secured claim. If a landlord waits until a tenant has financial problems to perfect its interest in the tenant's collateral, it may be too late. The interest can potentially be set aside as an avoidable transfer – known as a preference by the bankruptcy court. Requiring security deposits and letters of credit may provide additional security, but timing is the key.

Security Deposits. There is a strategic advantage to requesting a security deposit as part of the lease negotiation rather than after it becomes apparent the tenant is in financial crisis. In the latter scenario, the tenant may not have the funds available when the landlord finally makes the request. Even if the funds are available ' and assuming the tenant is willing to cooperate ' there is the added risk that the court could set aside the security deposit as a preference should the tenant subsequently file for bankruptcy protection within 90 days of posting the deposit. Security deposits are applied against the maximum statutory claim the landlord can assert under bankruptcy law; this application will reduce the dollar value of the landlord's claim. The loss in the value of the claim as a result of the application of the security deposit is, however, acceptable because claims are typically paid at substantially less than dollar for dollar, if at all, and it is better to have the money rather than the claim.

Letters of Credit. Letters of credit are an even better tool to maximize the landlord's recovery. As a general rule, the landlord may draw on the letter of credit if it is so entitled under the terms of the applicable documents, even if the tenant is in bankruptcy. A letter of credit and its proceeds are not property of the estate, but are property of the issuing bank paid on account of an independent obligation to the beneficiary of the letter of credit under bankruptcy law. Some legal authority exists in support of an injunction to, at least, delay the landlord from drawing on a letter of credit. The majority of bankruptcy courts, however, have refused to enjoin a draw on a letter of credit because they do not want to upset the principles underlying the general rule. To foreclose any opportunity for the tenant even to seek injunctive relief, the letter of credit should be carefully drafted to ensure that the landlord has the ability to draw on it without notice to or cooperation from the tenant. As in the case of security deposits, there is some case authority holding that the proceeds of the letter of credit are to be applied against the landlord's maximum statutory claim.

If the tenant posts a letter of credit to secure its outstanding obligations, the posting of the letter of credit can create a preference in favor of the landlord, provided such posting is within 90 days of the tenant's bankruptcy filing. For this reason, the letter of credit should be obtained at the time the lease is signed. It creates a defense to any subsequent preference attack because it would relate back to the time that the lease was signed and the letter of credit was issued, and not the date that past-due obligations had accrued.

Careful Monitoring

Careful monitoring of the financial condition of its tenant is another basic step the landlord should take in order to maximize its position should it become a creditor in the tenant's bankruptcy proceeding. Although public companies usually have public reporting requirements that make it easier for a landlord to monitor the tenant's financial condition, a landlord can still monitor private companies by requiring the tenant to comply with financial reporting requirements. Landlords should review the information on a regular basis, and not merely toss it into the file. Early signs of a tenant's deteriorating financial condition include the obvious, such as a tenant's habitual late payment of monthly rent and other obligations due under a lease, and the less obvious, such as negative financial information reported on public filings. When careful monitoring is used in conjunction with lease default provisions for failing to maintain minimum net worth requirements and minimum financial conditions, the landlord is in the best position to act quickly and decisively at the first signs of financial distress. Waiting until a tenant has a significant accrued balance on the books may be too late for the landlord to take decisive action.

Quick and Decisive Action

By exercising its remedies in strict compliance with the lease and applicable law, however, a landlord may be situated to negotiate with the tenant from a leveraged position when careful monitoring of the tenant's financial condition has given the landlord advance warning of financial distress. An analysis of the available state law remedies under a lease is outside the scope of this article, but, if available, the termination of the lease is the remedy with the most teeth. It is important to note that even a lease termination is not foolproof within a bankruptcy proceeding. Some case authority suggests that such a termination can be set aside as a preference or fraudulent transfer. While the state of bankruptcy law is unsettled on the issue, it may be better for the landlord to take that risk and get control of its space with the knowledge that it may have to defend itself in subsequent litigation. The landlord that aggressively exercises its remedies, within the confines of the law, is in a better position to negotiate if and when the filing occurs. The termination of the lease can be unilateral or bilateral, at least from the landlord and tenant's perspective.

When the landlord's objective is to obtain control of the space and it anticipates that the defaulting tenant will not go quietly, it should exercise unilaterally (once again, if available under the lease or applicable state law) the right to terminate the lease in its entirety and not just terminate the tenant's right of possession. The bankruptcy court will look to state law to determine if the lease has been properly terminated and will enforce termination provisions within leases that are properly drafted. The tenant or bankruptcy trustee may nevertheless try to avoid the lease termination as a preference and recover the premises or value thereof from the landlord if the lease was below market and had value that can be realized through an assignment of the lease to a third party. One possible way to reduce the risk that the involuntary lease termination will be held to constitute a preference is to include a lease provision stating that the term of the lease will be deemed to expire on the landlord's termination of the lease for a tenant default.

According to applicable bankruptcy law, a lease does not become property of the estate, and the landlord is not subject to the automatic stay, if the lease has terminated by the expiration of its stated term before the bankruptcy filing. In this scenario, the landlord can obtain possession of the premises without first seeking bankruptcy court approval, without violating the provisions of the automatic stay, and without the risk of the termination being found to be a preference. This safe-harbor provision under bankruptcy law probably does not apply if the landlord has terminated the lease because of a tenant default, but the landlord may attempt to draft itself within the safe-harbor provision by crafting language in the default and termination provision of the lease. It is important to note that a bankruptcy court may very well view such a provision as form over substance and, as such, a landlord is still well advised to seek relief from the automatic stay to avoid any question of what, if any, rights under the lease or applicable state law a landlord may exercise after a bankruptcy filing.

An agreed lease termination or bilateral termination between the landlord and tenant may be an option with a cooperative tenant, and another workable solution for the landlord that wants to recapture the lease space and avoid being engulfed in a subsequent tenant bankruptcy. A bilateral termination is subject to challenge in bankruptcy court on preference or fraudulent transfer grounds, and the landlord exercising a unilateral termination right may be in a better position to avoid a subsequent attack on such grounds. The two options, however, are not mutually exclusive and may in fact work best when used in conjunction with one another. A landlord must pay “reasonably equivalent” value for the lease termination to guard against a preference or fraudulent transfer challenge. If the landlord as a result of a tenant default had already unilaterally terminated the lease, then, presumably, the tenant would not be entitled to “reasonably equivalent” value. Following the unilateral termination, the landlord's use of an agreed or bilateral termination has the additional benefit of minimizing the risk of a state court lawsuit possibly being brought by the tenant. A justification for the subsequent bilateral termination in this scenario, if ever brought into question, is that the landlord was merely facilitating the tenant's move-out from the premises.

Conclusion

Through the use of foresight and prevention, careful monitoring, and quick and decisive action, the retail landlord has the opportunity to fortify its position before the tenant's bankruptcy tidal wave hits. Retail landlords are well advised to engage competent counsel experienced in this area upon the first signs of the tenant's financial distress. The combination of strategic thinking and advance preparation provides the landlord with the best chance to minimize its exposure to potential loss and to prevent being washed out to sea in the event of a tenant bankruptcy.