Tenant bankrupt: Now what?

You rip open a nondescript white envelope and review the single page notification enclosed within entitled “Notice of Bankruptcy Case Filing.” Your commercial tenant has filed bankruptcy. The notice also admonishes that any attempt to collect debts during the pendency of the bankruptcy could be a violation of the Bankruptcy Code’s “automatic stay.”

The automatic stay is imposed immediately upon the filing of a bankruptcy petition to protect debtors from creditor harassment. If a creditor violates the automatic stay by attempting to collect a debt, the creditor could be penalized. Unless you are a seasoned vet when it comes to such notices you undoubtedly have a litany of questions. “Can I just evict the tenant if it is behind on rent?” “If not, why not?” “If I can’t evict the tenant will I ever receive the unpaid rent? “Do I need to go to Bankruptcy Court to protect my lease?” ” Can I still keep the security deposit?” “What do I do now?”

The answer to the last question is a bit self-serving: consult with an experienced bankruptcy attorney. In full-disclosure: I practice bankruptcy. The importance of consulting with an attorney familiar with the effect of bankruptcy on landlord-tenant law cannot be understated.

Not only can the bankruptcy-specific vernacular be a bit overwhelming to the uninitiated, but your lease, and your rights thereunder, are no longer the same from the moment your tenant files bankruptcy. Some provisions of the lease may no longer be enforceable. Actions ranging from eviction to mere communication with the debtor can result in monetary sanctions being imposed on a landlord. On the flip side, the failure to take certain action by a lessor during a tenant’s bankruptcy could result in losses far greater than need be.

In short, whether you like it or not, your rights as landlord have been altered significantly. Do you think you are safe because the lease provides that it is terminated upon the tenant filing bankruptcy? Think again, as such “ipso facto” clauses are impermissible under the Bankruptcy Code.

Sound hopeless? Fear not. The Bankruptcy Code explicitly provides for the treatment of leases in bankruptcy but several factors affect what that treatment may be.

Perhaps the biggest factor affecting leases is the chapter of Bankruptcy Code under which your tenant files. Chapter 7 or “liquidation” bankruptcy results in the court-appointed trustee marshalling a debtor’s non-exempt assets, liquidating them, and distributing the proceeds to claimants in order of priority.

In contrast, Chapter 13 and 11 bankruptcies, typically referred to as “reorganizations,” require the debtor to devise a plan to address, amongst other things, how leases will be treated. An important distinction between liquidation and reorganization is that under the reorganization chapters debtors may still be able to operate as going concerns on or within leased real property. Since a reorganization plan requires ongoing income to fund it, the debtor may derive this income by continuing to operate the business in the premises which is the subject of your lease.

Under the Bankruptcy Code, debtors must continue to perform their obligations under leases after a bankruptcy is filed until the lease is (1) assumed, (2) rejected or (3) assigned. Assumption requires the debtor to agree to be bound by, and to continue to comply with the terms of the lease. Landlords of assumed leases in bankruptcy are given some additional comfort if a lease is assumed because if it is later breached the landlord is given an “administrative” claim which elevates the claim to a higher payment priority, providing a greater likelihood of recovery than if the claim were merely an unsecured claim (the lowest level of the scheme). Additionally, other post-bankruptcy responsibilities of the debtor/tenant such as the payment of insurance, taxes, CAM, utilities, repairs, etc., in most instances, will also be afforded a high-level of treatment (relative to other creditors).

If, on the other hand, a lease is rejected, the lease is deemed to have been breached and the landlord may file a proof of claim for pre-bankruptcy arrearages as well as future damages as a result of the breach. Landlords have an opportunity, for a limited-period of time, to file a proof of claim for damages arising from the tenant’s failure to pay pre-bankruptcy rent and the breach of the lease post-bankruptcy.

The formula for determining a landlord’s claim is complicated and beyond the scope of this article. We go back to the earlier advice: contact an experienced bankruptcy attorney to help you file your proof of claim. The amount you receive on account of your proof of claim depends upon a multitude of factors, the most important of which is the amount of money a trustee has to pay creditors. In Chapter 7 cases distributions to creditors are typically quite small (but full payment is not unheard of).

Finally, the third alternative permits debtors and trustees to assign leases to third-parties if both pre- and post-bankruptcy defaults are cured. In other words, even if your lease has a provision that says it cannot be assigned without your permission, you may be forced to accept a replacement tenant. There is an important safeguard for shopping center leases. If the assignment to the third party would violate any “tenant mix” ratios or covenants for other leased space within the shopping center, the assignment may be prevented. How do you know how to react when assignment is threatened? Consult an experienced bankruptcy attorney.

Regardless of whether the decision is made to assume, reject or assign, as to commercial leases, the decision must be made by the earlier of 120 days after the bankruptcy case is filed or the date of an order confirming the debtor’s plan is entered. This deadline, however, can be extended 90 days upon application to the bankruptcy court.

An often-overlooked issue which arises when a tenant files bankruptcy involves security deposits. All interests, or potential interests of a debtor become property of its bankruptcy “estate” from which the trustee seeks to fund distributions to creditors. The security deposits, which may be in possession of a landlord, are typically deemed to be property of the bankruptcy estate and subject to turnover to the trustee. While a landlord is entitled to maintain a security interest in the deposit, such interest is limited to amount of the actual, allowed claim of the landlord. In other words, if you hold a tenant deposit, the bankruptcy trustee may demand that you deliver it to him.

Landlords of commercial real properties are not without hope if a tenant files bankruptcy. In some instances, the treatment afforded to leases under a bankruptcy plan may be more preferable than proceeding with eviction, etc. However, it is imperative that applicable Bankruptcy Code provisions and deadlines be understood by landlords to preserve their rights and to maximize recovery to the extent possible.

Seth Adams is an associate with Woodburn and Wedge and practices in the areas of bankruptcy, corporate law and real property law. Contact him at 775-688-3000 or sadams@woodburnandwedge.com.