Treatment of Commercial Leases in Tenant Bankruptcy - The Basics

July 7, 2020 Articles

As the COVID-19 pandemic continues to wreak havoc with the nation’s economy, we have started to see bankruptcy filings by well-known companies such as GNC, J. Crew, Neiman Marcus, Modell’s, 24 Hour Fitness, Gold’s Gym, and J.C. Penney. Unfortunately, it is highly likely that these will be only the earliest victims of the crisis, and that more companies, both large and small, will be filing for bankruptcy protection in the coming months. For landlords of commercial real estate, these bankruptcies can have significant effects on their rights and remedies under their leases. When confronted with a tenant that has filed for bankruptcy, or may be considering it, it is helpful to understand the basics of what those effects may be.

The treatment of leases in bankruptcy is governed by the United State Bankruptcy Code (the “Code”). Under the Code, upon filing of a bankruptcy petition, the “automatic stay” kicks in, which prevents all actions against the debtor or their property. This generally means that a landlord cannot thereafter take any actions to enforce its rights under a lease, including sending a notice demanding the payment of prepetition rent or other lease obligations, or pursuing an unlawful detainer action.

Section 365 of the Code governs the assumption, assumption and assignment or rejection of a debtor’s real property leases. The general rule is that the debtor is required to continue to pay post-filing rent and other obligations under a lease, but not delinquent rent and other lease obligations accruing prior to the bankruptcy, from the date of the bankruptcy filing until the rejection of the lease, although the bankruptcy court may permit deferral of such payments until the 60th day after filing.

Generally speaking, a tenant has 120 days after a bankruptcy filing to decide whether to assume, assume and assign, or reject its lease. On the motion of the debtor or the landlord, a bankruptcy court has the discretion to extend this 120 day period by up to 90 days, however, any further extension requires the consent of the landlord. A lease that is not assumed, or assumed and assigned, within the relevant time period (or confirmation of a Chapter 11 plan if earlier) is deemed rejected. 

If the debtor assumes a lease, it is required to cure all lease defaults (with certain narrow exceptions for uncurable nonmonetary defaults), including any delinquent rent and other obligations (both pre and post-petition). It also must provide adequate assurance of future performance under the lease. Once a lease is assumed, any ongoing obligations must be timely paid, with any unpaid amounts treated as an administrative expense of the bankruptcy estate, that generally must be paid in full in order for the debtor to exit bankruptcy.

Note that, so long as it or the assignee satisfies the conditions for lease assumption, a debtor may assign an assumed lease notwithstanding provisions of the applicable lease that restrict or condition the tenant’s ability to assign, with certain exceptions applicable to shopping center leases.

If the debtor rejects a lease, it is a deemed a breach, allowing the landlord to terminate the lease and retake possession of the premises. In addition, the landlord can assert a claim for damages resulting from the lease rejection against the bankruptcy estate, the calculation of which is initially governed by state law. However, the Code caps such damages at an amount equal to the “rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease.” If the landlord’s damages under state law are less than the Code’s cap, then it simply has a claim equal to its state law damages. “Rent reserved” for purposes of calculating the cap generally includes base rent, real estate taxes, insurance, and common area maintenance charges, especially if the latter three categories are described as “rent” or “additional rent.” 

This article is only designed to provide a brief outline of the effects of a tenant bankruptcy, and there are many specific issues that may arise in a particular situation: treatment of “stub rent” when a tenant files mid-month; applicability of security deposits; drawing on letters of credit; recovering on guaranties; and preferential transfers to name a few. Those matters are beyond the scope of this piece, however, on the specific subject of security deposits, please see: Non-Residential Lease Default Workouts, Security Deposits and Bankruptcy.