Landlord Rights and Tenant Bankruptcy

Summer 2014

For a commercial property lessor, the bankruptcy of a tenant presents unique challenges, especially in the case of a Chapter 11 “reorganization.” Bankruptcy means more than just the inability of the bankrupt tenant — referred to here as the debtor — to pay any arrearage that may have accrued before the bankruptcy. Bankruptcy law gives the debtor the power to unilaterally “reject” the lease, while drastically limiting the landlord’s right to recover damages.

Even when the property is relatively small and the rent modest, a tenant’s bankruptcy may cost the landlord hundreds of thousands of dollars or more in lost rent, and the stakes increase with the size and value of the property. This can be the case even if the tenant successfully reorganizes.

Before making any decisions when a tenant files bankruptcy, the landlord must understand its rights and the tenant’s rights under bankruptcy law, including the countless “exceptions” and “special circumstances” that may affect those rights. Among other things, the landlord and its bankruptcy counsel will need to discuss the effects of the automatic stay, the way that bankruptcy law treats unexpired leases and the landlord’s claim against the tenant for unpaid rent and other obligations.

The Automatic Stay

The automatic stay is a powerful tool, available only in bankruptcy, which shields the debtor from creditor interference while the debtor restructures its debt. The automatic stay gets its name from the fact that the mere filing of the bankruptcy case automatically stays (temporarily stops) any action against the debtor or its property without the consent of the bankruptcy court.

head shot of Ian Bolton

Ian Bolton

The automatic stay prohibits a landlord from taking direct action against a debtor, such as filing a lawsuit to recover rent that became due before the debtor filed bankruptcy or evicting the debtor after it files bankruptcy, with some exceptions. For example, a landlord may evict the debtor despite the automatic stay if the lease expired prior to the tenant filing bankruptcy. (Even then, a landlord may run afoul of the automatic stay if, for example, the debtor claims that it exercised an option to extend the lease in a timely manner). The automatic stay also prohibits a landlord from taking indirect action against the debtor, such as failing to provide services that the landlord is required to provide under the lease.

Penalties for violation of the automatic stay may be severe. The bankruptcy court may order a creditor that violates the stay to pay the debtor’s actual damages and attorney fees, and may even award punitive damages. Therefore, the better practice is always to seek relief from the automatic stay before taking any action against the debtor, even if that action may be permitted by law.

Unexpired Leases

Another powerful tool at the debtor’s disposal is the right to assume or reject an unexpired lease. While the debtor may take months to decide whether to assume or reject the lease, it must pay rent in the meantime. The good news is that the debtor must cure any monetary default, including the payment of back rent, if and when the debtor assumes the lease.

On the other hand, the debtor may reject a lease if the property is no longer useful or profitable, or if the lease calls for above-market rent. If the rent is below market rates, the debtor may assume the lease and then assign it to another tenant for a profit. A debtor leasing multiple properties may, absent special circumstances, assume some leases and reject others. A debtor also may use the threat of rejection to convince landlords to renegotiate the terms of their leases. However, a landlord cannot be forced to renegotiate.

head shot of David Michael

David G. Michael

Bankruptcy law balances the debtor’s option to reject the lease with the landlord’s right to insist that the lease be assumed as written, if at all. If there is an opportunity to raise the rent and lease the property to another tenant, it may be in the landlord’s best interest to recover the property as soon as possible. In that case, the landlord should oppose any attempt by the debtor to extend the time allowed to assume or reject and should consult bankruptcy counsel to determine to what extent that may be possible under the circumstances.

The Landlord’s Claim

If the debtor rejects the lease, the landlord is likely to have a claim against the debtor for both back rent and rent that otherwise would become due for the unexpired term of the lease. The landlord generally is entitled to claim all back rent that became due before the bankruptcy was filed. However, the landlord’s claim for rent for the unexpired term of the lease is drastically limited and may never exceed three years’ rent.

Depending on a variety of factors, including the jurisdiction in which the bankruptcy case was filed, the landlord also may be entitled to assert a claim for the debtor’s other obligations under the lease. This claim may far exceed any claim for rent for the unexpired term of the lease. However, the landlord’s entire claim is likely to be paid on a pro-rated basis along with the claims of the debtor’s other general unsecured creditors, which often recover only pennies for every dollar owed — and sometimes nothing at all. The landlord also must file proof of its claim with the bankruptcy court, or the claim will not be eligible for payment in any amount. Although a landlord may file a proof of claim without an attorney, experienced bankruptcy counsel will ensure that the proof of claim is properly filed in a timely manner — and amended as appropriate — and will help ensure that the landlord recovers every last dollar to which it is entitled.

Debtors enjoy formidable rights against landlords and other creditors under bankruptcy law. However, bankruptcy law is flexible and bankruptcy courts are vested with equitable powers that allow them to fashion a variety of remedies to fit a particular case. In many instances, the remedies available may be limited only by the experience, creativity and negotiating skills of counsel. In any case, counsel should establish a strategy for protecting the landlord’s interests from the start of the bankruptcy case and work diligently throughout the case to execute that strategy.