Treatment of Commercial Leases in Bankruptcy

The novel coronavirus pandemic and related government “stay at home” and “shelter in place” orders are causing serious negative financial impacts to business of all types.  Many of the hardest hit industries, such as restaurants and retailers, are industries in which a large portion of the business may be operated in leased locations pursuant to commercial leases, and their ability to continue to stay in business, much less continue to pay rent, through the pandemic restrictions may be in serious doubt.  Even nationwide chains such as Mattress Firm and Subway, for example, have advised their landlords that they intend to withhold or cut rent in the coming months after closing stores to slow the coronavirus.[1]  Commercial landlords are not immune from this crisis either, as many of them have significant debt, and will likely be facing lowered rent income from which to be able to continue to service such debt.

In short, as reported recently in the Wall Street Journal, “a deluge” of bankruptcy filings in the coming months is predicted due to the massive disruption caused by the coronavirus pandemic.[2]   With this backdrop, it is important for both commercial landlords and tenants to understand the basics regarding how commercial leases are treated in bankruptcy in order to be best positioned to use the bankruptcy code to maximize their financial interests or ability to restructure, as the case may be.  This article is intended to provide such an overview of the key legal issues for landlords and tenants regarding the treatment of commercial leases under the Bankruptcy Code.

Treatment of Commercial Leases in Bankruptcy

1. Tenant Bankruptcies

Commercial leases are largely governed by Section 365 of the Bankruptcy Code.  When a commercial tenant files for bankruptcy, Section 365 provides the tenant with three basic routes to potentially take in connection with the lease, depending on the specific circumstances: 1) assume (i.e., accept) the lease; 2) reject the lease; or 3) assume and assign the lease.  The path taken can be critically important for the debtor tenant as well as the creditor landlord.

A. Assumption or Rejection of the Lease

If a debtor is a tenant under an unexpired lease, the tenant must assume or reject the lease within 120 days of the filing of the bankruptcy.  This deadline can be extended for 90 additional days without the consent of the landlord by the bankruptcy court for cause, but no further extensions can be granted without the landlord’s consent.  If the debtor tenant does not assume the lease within this time period, the lease will automatically be deemed rejected. [3]  The debtor tenant must comply with its obligations under the lease pending its assumption or rejection of the lease, including payment of rent, which post-petition rent obligation is entitled to priority as an administrative claim.  This obligation may be temporarily deferred by the bankruptcy court for a maximum of 60 days from the date of the bankruptcy filing.[4]

Assumption of the lease is essentially a decision by the debtor tenant to retain the lease.  In order to assume the lease, the debtor tenant must cure any defaults or provide assurance that it will promptly do so, and establish that it will be able to perform its obligations in the future.[5]  Only an “unexpired lease” may be assumed in bankruptcy.  If a lease has expired or been properly terminated prior to the bankruptcy filing, then there is nothing for the debtor tenant to assume or reject.  The issue of whether a lease is “unexpired” at the time of the bankruptcy filing will be governed by the terms of the lease and applicable state law.

Rejection of the lease by the debtor tenant is essentially a decision to terminate the lease, and the debtor tenant doing so must vacate the leased premises.  The landlord can then take back possession of the premises for purposes of re-leasing the premises, and may also assert a claim in the bankruptcy for damages resulting from the lease termination.  However, the landlord’s claim will be treated as pre-petition unsecured claim sharing pro rata with other general unsecured creditors.  In addition, the landlord’s termination damages claim will be capped in an amount equal to the greater of: (1) one year’s rent; or (2) 15% of the rent for the remaining lease term, not to exceed 3 years.[6]  Thus, by rejecting a lease with a significant remaining term, the debtor tenant may be able to substantially reduce liability for future rent under the lease.  However, this cap applies only to future rent that would have been due under the lease but for the tenant’s rejection of the lease, with the landlord still able to claim unpaid rent prior to the bankruptcy filing as an additional general unsecured claim, and unpaid post-bankruptcy filing rent as an administrative priority claim.

B. Assumption and Assignment

Another potential option available to the debtor tenant may be to assume and assign the lease to a third party, even over the landlord’s objection and notwithstanding anti-assignment language in the lease.  This may be a particularly important option to the debtor’s bankruptcy estate where the lease is a long-term lease at below market rent, making it a potentially valuable asset for the debtor tenant’s bankruptcy trustee to assume and assign, i.e., sell, to a third party to create additional value for the bankruptcy estate.  Further, unlike an assignment outside of bankruptcy, a bankruptcy assignment will relieve the obligation of the debtor tenant and the bankruptcy estate under the assigned lease.[7]

In order to assume and assign a lease, the debtor tenant must cure any defaults under the lease, and the assignee must provide adequate assurance of future performance of the lease obligations.  The landlord may require a deposit or other security from the assignee substantially the same as would have been required by the landlord upon the initial leasing to a similar tenant as the assignee.[8]

C. Special Provisions for Shopping Center Leases

The Bankruptcy Code provides certain additional protections for shopping center landlords related to lease assumptions or assignments by the debtor tenant.  Specifically, Section 365(b)(3) provides that the “adequate assurance of future performance of a lease of real property in a shopping center” must include:

(1) assurance that the reorganized debtor tenant (or assignee in an assumption and assignment situation) will have a financial condition and operating performance similar to that of the debtor tenant at the time of the original commencement of the lease;

(2) assurance that any “percentage rent” due under the lease (i.e., a portion of rent based on the tenant’s sales/revenues) will not decline substantially;

(3) assurance that the assumption or assignment of the lease will be subject to the requirements in the lease regarding radius, location, use, or exclusivity, and will not breach any such provision contained in any other lease, financing agreement, or master agreement relating to the shopping center; and

(4) assurance that assumption or assignment of the lease will not disrupt any tenant mix or balance in the shopping center.

These provisions not only protect the landlord, but also are designed to protect other tenants in the shopping center who may have exclusivity or other provisions in their leases with the landlord, that may be impacted by, for example, an assumption and assignment by the debtor tenant to a competitor in the same business.

2. Landlord Bankruptcies

Many commercial landlords that could also be under significant financial stress due to the coronavirus restrictions may also seek bankruptcy protection.  Like tenant debtors, landlord debtors also have the option to assume or reject unexpired leases.  If the landlord assumes the lease, all of the tenants and landlord’s obligations under the lease remain in place, i.e., the tenant has to continue to pay rent and remains entitled to remain in the leased premises.  The landlord and tenant must also cure all defaults under the lease before the lease can be assumed by the landlord debtor.

However, a landlord may also choose to reject an unexpired lease, which may be more likely in the situation where the tenant has a below-market rental rate.  The Bankruptcy Code does provide certain protections to the tenant when a landlord debtor rejects the lease.  Specifically, under Section 365(h), if the term of the lease has already commenced, the tenant may choose to retain its rights in the premises for the remainder of the lease term, including the right to remain in possession of the premises, and continue to pay rent. [9]  The tenant can also offset the amount of any damage suffered by the tenant due to the landlord’s non-performance after the date of the rejection against the tenant’s rent deposit, but only up to the amount of the deposit.  These protections apply to “any successor, assign or mortgagee” permitted under the terms of the lease.[10]  Alternatively, upon the landlord’s rejection, the tenant may treat the lease as terminated, vacate the property, and assert a general unsecured rejection damages claim against the landlord debtor’s bankruptcy estate.

[1] “Subway and other retailers want to stop payment rent to offset coronavirus closures” Fortune, March 24, 2020 https://fortune.com/2020/03/24/coronavirus-rent-payments-retail-industry-subway-mattress-firm-covid-19/

[2] “Bankruptcy Lawyers Gear Up for Surge in Filings Due to Coronavirus Fallout”  The Wall Street Journal, April 2, 2020 https://www.wsj.com/articles/bankruptcy-lawyers-gear-up-for-surge-in-filings-due-to-coronavirus-fallout-11585853669

[3] 11 U.S.C. § 365(d)(4)

[4] 11 U.S.C. § 365(d)(3)

[5] 11 U.S.C. § 365(b)

[6] 11 U.S.C. 502(b)(6).  Note that the landlord may not be entitled to a claim for all of these amounts, such as for example, if the landlord is able to re-lease the premises and thereby cover all or a portion of its losses caused by the debtor tenant’s rejection of the lease.

[7] 11 U.S.C. § 365(k)

[8] 11 U.S.C. § 365(l)

[9] Although beyond this scope this article, there is a split of authority over whether a debtor landlord can sell real estate free and clear of undesirable leases under 11 U.S.C. § 363(f), which is the minority view, or whether the tenant can prevent extinguishment of its lease pursuant to 11 U.S.C. § 365(h), which is the majority view.  See e.g., Matter of Spanish Peaks Holdings II, LLC, 872 F.3d 892, 898 (9th Cir. 2017) (citing cases taking the “majority” approach and the “minority” approach).

[10] 11 U.S.C. § 365(h)(1)(D).

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