In the Spotlight: Bankruptcy Strategies for Commercial Landlords, Tenants, Lenders, and Real Estate Investors

This is the first part in a series dealing with the subject of bankruptcy strategies and considerations for commercial landlords, tenants, lenders and real estate investors. The subject matter of each part of this series of brief alerts is complex and what is intended is to highlight some of the key issues the reader should consider in connection with the subjects discussed. Since these issues are complex, readers are encouraged to contact a bankruptcy attorney to discuss the subject matter and any issues that they may have.

Strategies for Landlords and Owners Prior to a Bankruptcy Filing

Pre-filing Lease Termination

When a commercial tenant is in financial distress or a chapter filing appears imminent and, assuming the tenant is in default under the lease, the landlord/owner should consider whether and to what extent it has the right to terminate the tenant's lease. For the most part, a bankruptcy filing only affects “property of the bankruptcy estate.” Thus, if a lease is effectively terminated before a filing, the tenant no longer has rights under the lease, and the lease does not become property of the estate of the debtor/bankrupt entity. Consequently, the landlord is free to do as it wishes with the vacant tenancy and is not affected by provisions of the Bankruptcy Code such as the automatic stay imposed by Code Section 362. Obviously, the decision to terminate a lease is driven by business considerations, but we have identified several strategic considerations that the owner/landlord should take into account in making that decision.

Strategy Consideration One

The date on which a lease is effectively terminated is a matter of the lease contract and state law. If the lease contains a grace period within which to cure a default and the lessee files for bankruptcy prior to its expiration, the lease will become property of the estate and, therefore, the owner/landlord will be caught up in the bankruptcy process. It should be noted that if a bankruptcy intervenes during the grace period and the tenant has a right to cure, then the lease has not been effectively terminated on the filing date. Similarly, if under applicable state law the tenant has a right to revive the lease, the lease might not be effectively terminated. In order to avoid these sorts of entanglements, the landlord might consider obtaining a state court judgment terminating the lease. The landlord also should consider having the lease provide for shorter cure periods or even the possibility of automatic termination of the lease on the occurrence of certain types of default.

Strategy Consideration Two

Under the Bankruptcy Code there is a statutory cap on the damages an owner/landlord may recover following the rejection of the lease. That cap is basically the greater of: 1) one year's rental; or 2) 15% of the remaining rental due under the lease not to exceed a total of three years' rent. A pre-petition termination of the lease would permit the owner/landlord to file a claim for the total amount of rental due as of the filing date and to become due thereafter, but the statutory cap would still apply to the amount of future rent that can be claimed. Whether the owner/landlord determines to make a motion to the bankruptcy court to have the lease rejected or the debtor determines to do so, until the lease is rejected, the debtor/tenant is required to pay its obligations under the lease. Therefore, a landlord that prefers to have the rental stream for the period of time before rejection or who hopes the lease will
be assumed and/or assumed and assigned may not wish to move the court to reject the lease. If the lease is rejected during the bankruptcy proceedings, the owner/landlord would have a claim for accrued and unpaid pre-petition rental and an administrative claim for any unpaid rental that accrues during the period in which the debtor occupied the premises after the filing but prior to rejection or the landlord's regaining possession.

Strategy Consideration Three

If the landlord holds a letter of credit as security for the tenant's obligations under the lease, except in exceptional circumstances, the landlord will not be stayed by the filing from claiming under the letter of credit. This is an important point for landlords to consider when taking a security deposit. Since a drawdown on a letter of credit is not stayed by the Bankruptcy Code, they are a better form of security deposit than, for example, cash. It should be noted, however, that the proceeds of the letter of credit would be credited against the statutory cap on damages set forth above so that the amount of the rejection claim will be affected. Of course, since the letter of credit will pay 100 cent dollars, such a result may be, and usually is, better than having an unsecured claim in lower percentage dollars. The anticipated amount that the debtor will pay on unsecured claims is almost always impossible to tell before a case is filed or in the immediate period thereafter, but the anticipated return on an unsecured claim will also be a factor in the landlord's decision.

Strategy Consideration Four

The Bankruptcy Code permits a debtor or trustee to assume and assign a nonresidential real estate lease. A later part of this series will separately discuss strategy considerations involved in assignment and assumption issues. Some of the consequences of rejection are discussed above. If the lease is assumed or assigned, all defaults must be cured or adequate assurances must be provided that such defaults will be cured. The important point to be made here is that the landlord will have greater control over the disposition of its property if the lease is terminated prior to a bankruptcy filing.

Strategy Consideration Five

If the lease provides for a significant below-market rental, the landlord may be quick to find any excuse to effect a termination because of the possibility that during the bankruptcy the lease may be assumed or, in other words, retained by the debtor/tenant or assumed and assigned by the debtor/tenant to a third party at a lower rent than the landlord might have obtained if the lease had been terminated prior to filing. However, the debtor or bankruptcy trustee might seek to revive the lease on a theory that the pre-petition lease termination was a fraudulent conveyance. Although such arguments have been made and have been sustained in several cases, the risk that such a claim would be successful, while a consideration, should not be a significant determining factor in the landlord's decision making process.

Jeffrey N. Rich is a partner in the New York office of K & L Gates LLP. He has more than 35 years' experience in the areas of creditors' rights, restructurings and bankruptcy representing financially distressed companies and individual debtors, trustees, lenders, asset purchasers, landlords, creditors, and creditors' committees.

This is the first part in a series dealing with the subject of bankruptcy strategies and considerations for commercial landlords, tenants, lenders and real estate investors. The subject matter of each part of this series of brief alerts is complex and what is intended is to highlight some of the key issues the reader should consider in connection with the subjects discussed. Since these issues are complex, readers are encouraged to contact a bankruptcy attorney to discuss the subject matter and any issues that they may have.

Strategies for Landlords and Owners Prior to a Bankruptcy Filing

Pre-filing Lease Termination

When a commercial tenant is in financial distress or a chapter filing appears imminent and, assuming the tenant is in default under the lease, the landlord/owner should consider whether and to what extent it has the right to terminate the tenant's lease. For the most part, a bankruptcy filing only affects “property of the bankruptcy estate.” Thus, if a lease is effectively terminated before a filing, the tenant no longer has rights under the lease, and the lease does not become property of the estate of the debtor/bankrupt entity. Consequently, the landlord is free to do as it wishes with the vacant tenancy and is not affected by provisions of the Bankruptcy Code such as the automatic stay imposed by Code Section 362. Obviously, the decision to terminate a lease is driven by business considerations, but we have identified several strategic considerations that the owner/landlord should take into account in making that decision.

Strategy Consideration One

The date on which a lease is effectively terminated is a matter of the lease contract and state law. If the lease contains a grace period within which to cure a default and the lessee files for bankruptcy prior to its expiration, the lease will become property of the estate and, therefore, the owner/landlord will be caught up in the bankruptcy process. It should be noted that if a bankruptcy intervenes during the grace period and the tenant has a right to cure, then the lease has not been effectively terminated on the filing date. Similarly, if under applicable state law the tenant has a right to revive the lease, the lease might not be effectively terminated. In order to avoid these sorts of entanglements, the landlord might consider obtaining a state court judgment terminating the lease. The landlord also should consider having the lease provide for shorter cure periods or even the possibility of automatic termination of the lease on the occurrence of certain types of default.

Strategy Consideration Two

Under the Bankruptcy Code there is a statutory cap on the damages an owner/landlord may recover following the rejection of the lease. That cap is basically the greater of: 1) one year's rental; or 2) 15% of the remaining rental due under the lease not to exceed a total of three years' rent. A pre-petition termination of the lease would permit the owner/landlord to file a claim for the total amount of rental due as of the filing date and to become due thereafter, but the statutory cap would still apply to the amount of future rent that can be claimed. Whether the owner/landlord determines to make a motion to the bankruptcy court to have the lease rejected or the debtor determines to do so, until the lease is rejected, the debtor/tenant is required to pay its obligations under the lease. Therefore, a landlord that prefers to have the rental stream for the period of time before rejection or who hopes the lease will
be assumed and/or assumed and assigned may not wish to move the court to reject the lease. If the lease is rejected during the bankruptcy proceedings, the owner/landlord would have a claim for accrued and unpaid pre-petition rental and an administrative claim for any unpaid rental that accrues during the period in which the debtor occupied the premises after the filing but prior to rejection or the landlord's regaining possession.

Strategy Consideration Three

If the landlord holds a letter of credit as security for the tenant's obligations under the lease, except in exceptional circumstances, the landlord will not be stayed by the filing from claiming under the letter of credit. This is an important point for landlords to consider when taking a security deposit. Since a drawdown on a letter of credit is not stayed by the Bankruptcy Code, they are a better form of security deposit than, for example, cash. It should be noted, however, that the proceeds of the letter of credit would be credited against the statutory cap on damages set forth above so that the amount of the rejection claim will be affected. Of course, since the letter of credit will pay 100 cent dollars, such a result may be, and usually is, better than having an unsecured claim in lower percentage dollars. The anticipated amount that the debtor will pay on unsecured claims is almost always impossible to tell before a case is filed or in the immediate period thereafter, but the anticipated return on an unsecured claim will also be a factor in the landlord's decision.

Strategy Consideration Four

The Bankruptcy Code permits a debtor or trustee to assume and assign a nonresidential real estate lease. A later part of this series will separately discuss strategy considerations involved in assignment and assumption issues. Some of the consequences of rejection are discussed above. If the lease is assumed or assigned, all defaults must be cured or adequate assurances must be provided that such defaults will be cured. The important point to be made here is that the landlord will have greater control over the disposition of its property if the lease is terminated prior to a bankruptcy filing.

Strategy Consideration Five

If the lease provides for a significant below-market rental, the landlord may be quick to find any excuse to effect a termination because of the possibility that during the bankruptcy the lease may be assumed or, in other words, retained by the debtor/tenant or assumed and assigned by the debtor/tenant to a third party at a lower rent than the landlord might have obtained if the lease had been terminated prior to filing. However, the debtor or bankruptcy trustee might seek to revive the lease on a theory that the pre-petition lease termination was a fraudulent conveyance. Although such arguments have been made and have been sustained in several cases, the risk that such a claim would be successful, while a consideration, should not be a significant determining factor in the landlord's decision making process.

Jeffrey N. Rich is a partner in the New York office of K & L Gates LLP. He has more than 35 years' experience in the areas of creditors' rights, restructurings and bankruptcy representing financially distressed companies and individual debtors, trustees, lenders, asset purchasers, landlords, creditors, and creditors' committees.