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

This is the third part in a series dealing with the subject of bankruptcy strategies and considerations for commercial landlords, tenants, lenders and real estate investors. These alerts are intended to highlight for our readers some of the key issues they may wish to consider in connection with the subjects discussed.

Strategies for Landlords In Connection with Assumption and/or Assignment of Real Estate Leases

When a commercial tenant files for relief under the Bankruptcy Code, the bankrupt tenant has three choices with respect to its real estate leases. The tenant can: 1) reject the lease; 2) assume the lease; or 3) assume the lease and assign it to a third party. This alert is intended to address the implications of a tenant's decision to assume and/or assign its real estate leases.

Assumption

Under the Bankruptcy Code, a tenant has the option of assuming the lease and once assumed, the further option of assigning the lease to a third party. Assumption is generally a favorable result for the landlord, since it continues the lease and requires the tenant to cure any existing monetary defaults. Furthermore, the lease must be assumed with all its burdens, meaning that the debtor cannot pick and choose which parts of the lease it wishes to assume. Once a lease is assumed, a subsequent breach during the pendency of the bankruptcy case gives rise to an administrative claim for damages.

Timing

In a Chapter 7 or Chapter 11 case, the bankrupt tenant (or the trustee) must generally assume a lease of non-residential real property before the earlier of: 1) 120 days after the filing date of a Chapter 11 proceeding; or 2) the date of the entry of an order confirming a plan. The court may extend this 120-day period prior to its expiration for an additional 90 days on motion by the debtor or trustee for cause but may not grant any further extensions without the written consent of the affected landlord.

Strategy Consideration One

While the debtor-tenant must cure all monetary defaults in connection with the assumption of a lease, ' 365(b)(1)(A) of the Code excuses the debtor from curing certain non-monetary defaults, excepting any defaults that arise from a failure to operate in accordance with the lease terms, which must be cured at the time of assumption or thereafter, together with any associated monetary losses. In order to avoid litigation regarding the value of such non-monetary defaults, a landlord might consider specifying in the lease an amount of liquidated damages that the landlord will suffer from the failure to cure certain identifiable non-monetary defaults.

Strategy Consideration Two

While assumption is generally a positive outcome for a landlord, that is not always the case. If the lease provides for under-market rent, the landlord might be better off if the lease is rejected as opposed to assumed. In such a case, the landlord should not pursue an aggressive strategy of trying to force a decision by the debtor as to whether the debtor will assume or reject the lease. Frequently, the debtor-tenant will seek to assume and assign or sell an under-market lease to bring money into the bankrupt estate. In such a case, the landlord should consider at an early point in the case engaging in negotiation with the tenant to buy back the lease rather than take the chance that the tenant will sell the lease to an undesirable third party.

Strategy Consideration Three

In order for a tenant to assign a lease, the prospective assignee must provide adequate assurance of future performance. Yet, aside from shopping center leases, the Code provides no guidance on what constitutes “adequate assurance.” Moreover, it remains an open question whether provisions of a lease specifying what constitutes adequate assurance are enforceable. While it is unclear whether a court would give effect to a provision requiring a prospective assignee to have a specified net worth (or other financial metric), there is no apparent downside risk in including such provisions.

Strategy Consideration Four

The bankruptcy courts will permit a tenant to assume a lease if, in the tenant's business judgment, it is advantageous to do so. With rare exceptions, the courts will not second-guess the tenant's business judgment. However, the preceding statement does not mean that the landlord should not question that judgment and seek to oppose a lease assumption motion if it can show that such judgment is improvident due to extensive monetary defaults and/or the debtor's prospective inability to comply with the terms of the lease, which would threaten to create a substantial administrative expense burden for the estate.

Strategy Consideration Five

Section 365(h) of the Code generally allows a tenant to remain in possession of leased premises when a debtor-landlord rejects a lease. Section 363(f) of the Code allows a debtor to sell the debtor's interests in assets free and clear of liens and encumbrances. There have been recent decisions that allow a debtor-landlord to sell assets, including the leased real estate, free from the non-debtor tenant's rights under ' 365(h), thus depriving the non-debtor tenant of its rights under ' 365(h). It is important to note that there is diversity of opinion between the circuits as to whether ' 363(f) indeed trumps ' 365(h). Therefore, the non-debtor tenant needs to be mindful of the venue of the bankruptcy proceedings and the applicable law in the related circuit. Since the law in this area is unsettled, the non-debtor should consider filing opposition to an attempt by a debtor-landlord to abrogate the non-debtor tenant's ' 365(h) rights.

Jeffrey 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 third part in a series dealing with the subject of bankruptcy strategies and considerations for commercial landlords, tenants, lenders and real estate investors. These alerts are intended to highlight for our readers some of the key issues they may wish to consider in connection with the subjects discussed.

Strategies for Landlords In Connection with Assumption and/or Assignment of Real Estate Leases

When a commercial tenant files for relief under the Bankruptcy Code, the bankrupt tenant has three choices with respect to its real estate leases. The tenant can: 1) reject the lease; 2) assume the lease; or 3) assume the lease and assign it to a third party. This alert is intended to address the implications of a tenant's decision to assume and/or assign its real estate leases.

Assumption

Under the Bankruptcy Code, a tenant has the option of assuming the lease and once assumed, the further option of assigning the lease to a third party. Assumption is generally a favorable result for the landlord, since it continues the lease and requires the tenant to cure any existing monetary defaults. Furthermore, the lease must be assumed with all its burdens, meaning that the debtor cannot pick and choose which parts of the lease it wishes to assume. Once a lease is assumed, a subsequent breach during the pendency of the bankruptcy case gives rise to an administrative claim for damages.

Timing

In a Chapter 7 or Chapter 11 case, the bankrupt tenant (or the trustee) must generally assume a lease of non-residential real property before the earlier of: 1) 120 days after the filing date of a Chapter 11 proceeding; or 2) the date of the entry of an order confirming a plan. The court may extend this 120-day period prior to its expiration for an additional 90 days on motion by the debtor or trustee for cause but may not grant any further extensions without the written consent of the affected landlord.

Strategy Consideration One

While the debtor-tenant must cure all monetary defaults in connection with the assumption of a lease, ' 365(b)(1)(A) of the Code excuses the debtor from curing certain non-monetary defaults, excepting any defaults that arise from a failure to operate in accordance with the lease terms, which must be cured at the time of assumption or thereafter, together with any associated monetary losses. In order to avoid litigation regarding the value of such non-monetary defaults, a landlord might consider specifying in the lease an amount of liquidated damages that the landlord will suffer from the failure to cure certain identifiable non-monetary defaults.

Strategy Consideration Two

While assumption is generally a positive outcome for a landlord, that is not always the case. If the lease provides for under-market rent, the landlord might be better off if the lease is rejected as opposed to assumed. In such a case, the landlord should not pursue an aggressive strategy of trying to force a decision by the debtor as to whether the debtor will assume or reject the lease. Frequently, the debtor-tenant will seek to assume and assign or sell an under-market lease to bring money into the bankrupt estate. In such a case, the landlord should consider at an early point in the case engaging in negotiation with the tenant to buy back the lease rather than take the chance that the tenant will sell the lease to an undesirable third party.

Strategy Consideration Three

In order for a tenant to assign a lease, the prospective assignee must provide adequate assurance of future performance. Yet, aside from shopping center leases, the Code provides no guidance on what constitutes “adequate assurance.” Moreover, it remains an open question whether provisions of a lease specifying what constitutes adequate assurance are enforceable. While it is unclear whether a court would give effect to a provision requiring a prospective assignee to have a specified net worth (or other financial metric), there is no apparent downside risk in including such provisions.

Strategy Consideration Four

The bankruptcy courts will permit a tenant to assume a lease if, in the tenant's business judgment, it is advantageous to do so. With rare exceptions, the courts will not second-guess the tenant's business judgment. However, the preceding statement does not mean that the landlord should not question that judgment and seek to oppose a lease assumption motion if it can show that such judgment is improvident due to extensive monetary defaults and/or the debtor's prospective inability to comply with the terms of the lease, which would threaten to create a substantial administrative expense burden for the estate.

Strategy Consideration Five

Section 365(h) of the Code generally allows a tenant to remain in possession of leased premises when a debtor-landlord rejects a lease. Section 363(f) of the Code allows a debtor to sell the debtor's interests in assets free and clear of liens and encumbrances. There have been recent decisions that allow a debtor-landlord to sell assets, including the leased real estate, free from the non-debtor tenant's rights under ' 365(h), thus depriving the non-debtor tenant of its rights under ' 365(h). It is important to note that there is diversity of opinion between the circuits as to whether ' 363(f) indeed trumps ' 365(h). Therefore, the non-debtor tenant needs to be mindful of the venue of the bankruptcy proceedings and the applicable law in the related circuit. Since the law in this area is unsettled, the non-debtor should consider filing opposition to an attempt by a debtor-landlord to abrogate the non-debtor tenant's ' 365(h) rights.

Jeffrey 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.