We are in the calm before the storm. With the state court system shut down for non-emergency matters, and evictions and foreclosures stayed, businesses have little reason to file for bankruptcy now, even though the Bankruptcy Courts are open and working remotely. However, once the COVID-19 emergency measures ease, and the civil court system resumes operations, it is inevitable that many businesses will file bankruptcy due to Coronavirus-related financial distress.
A commercial tenant entering bankruptcy should be a cause for concern, but not despair, for a landlord. The bankruptcy code provides landlords of commercial property with some significant protections, and, more important, in many cases, a reasonable shot at having the tenant emerge from the process with its business and lease intact. However, there are several things that every landlord should understand about the bankruptcy process in order to maximize the opportunity to achieve the best results possible under the circumstances. The overarching thing to recognize is that commercial bankruptcy is a practical and results-oriented process, where compromise and accommodation are highly encouraged, and that many of the rules and requirements can be modified if the parties agree and the changes make sense.
The information in this article is necessarily general, and each rule discussed is riddled with exceptions and special situations, so there is no substitute for consultation with experienced bankruptcy counsel. This article is also focused on bankruptcies of small and local businesses because there are additional considerations with larger and more complex bankruptcies, though the basic principles are the same. But whatever the size of the tenant, knowing some basic information can help significantly in speeding the process by which a landlord and its counsel respond to a tenant’s bankruptcy and maximizing the landlord’s recovery..
1. Understand What Happens when a Bankruptcy is Filed
Bankruptcies are started by the filing of a bankruptcy petition with the Bankruptcy Court, an act with several immediate consequences to the person or company filing, known after filing as the debtor, and all of the debtor’s creditors.
Most significant is the automatic stay that occurs upon the bankruptcy petition’s filing. At the moment of filing, all creditors, including landlords, are required to stop virtually all efforts to collect debts from the debtor or its property – whether the creditor knows about the filing or not – and any collection activities or judicial proceedings that take place after the filing are void. This means that the filing of a bankruptcy petition just one minute before a Marshal executes an eviction warrant stays the eviction, and if the eviction proceeds, it is both void and contempt of the Bankruptcy Court. Of course, the courts are reasonable when parties act unaware of the bankruptcy filing, but efforts to collect from or otherwise proceed against a debtor with knowledge of its bankruptcy filing can be treated harshly by the Bankruptcy Courts.
The filing of a bankruptcy petition also divides the debtor’s financial affairs into two worlds, pre-petition and post-petition. All debts of the debtor as of the petition date, including rent arrears, are to be addressed through the bankruptcy process (and thus the automatic stay bars their collection outside bankruptcy). However, once the debtor files the bankruptcy petition, it is expected to satisfy all of its ongoing obligations. In particular, debtors are required to pay all post-petition rent when due (unless the Court permits a delay of up to 60 days), though as a practical matter, this may not always occur. However, if post-petition rent is unpaid, the landlord may have cause to lift the automatic stay to resume eviction proceedings, and any unpaid post-petition rent is generally considered to be an “administrative expense,” to be paid before almost all other creditors.
2. Understand the Types of Bankruptcy
Commercial bankruptcies come in several different types, with different objectives. The most straightforward is a Chapter 7 liquidation, in which all of the debtors assets and operations are taken over by an independent bankruptcy trustee, who is tasked with collecting and liquidating those assets, and distributing the proceeds to the creditors in accordance with the bankruptcy code and any security interests the creditors may hold in the assets. For landlords, a Chapter 7 filing will likely mean that the tenant will likely give up its leases fairly promptly, unless the leases are significantly below market or they are used in a business segment that will be sold off as an operating business. In most instances, a Chapter 7 will provide a limited payout for rent arrears, if there is any payout at all.
Chapter 11, in contrast, contemplates that the business will survive, with its finances reorganized so that it can operate long-term after the bankruptcy. The idea is that if a company’s operations are inherently profitable, but it is burdened by excessive debts or other obligations, it can be better for the creditors if the company continues operating with its debts and costs reduced, rather than simply liquidating the business’s assets. A significant feature of Chapter 11 is that instead of a trustee being appointed, the debtor’s management is generally permitted to continue to run its business as “debtor in possession.” In a successful Chapter 11, the Court will confirm a Plan of Reorganization (a Chapter 11 Plan), which sets out how the business will operate and address its debts and obligations on a going-forward basis. Chapter 11 is a process that allows debtors extensive flexibility in structuring a plan that they believe can work for their businesses, particularly where creditors agree to the plan provisions, but it can be a very slow process in which landlords can face significant uncertainty as to how their leases will be affected.
In 2019, Congress amended the Bankruptcy Code to add Subchapter V of Chapter 11 to allow a “small business debtor” to go through a streamlined reorganization process. To be a small business debtor, a company can have total debt of up to approximately $2.7 million, though Congress has temporarily allowed companies with up to $7.5 million in debt to qualify as part of its Coronavirus relief package. Under Subchapter V, Debtors are supposed to file their Plan of Reorganization within 90 days, and can pay their creditors out of projected disposable income over a three to five year period. Because Subchapter V only came into effect in February 2020, on the eve of the COVID-19 crisis, many of the practical aspects of its implementation have yet to be worked out. Still, this will likely be a popular option for small businesses affected by the Coronavirus.
Because many businesses have suffered short-term losses due to the COVID-19 emergency measures, and hope and expect to return to profitable operations when the restrictions ease, reorganization under Chapter 11 or Subchapter V can be an effective strategy to respond to those losses. And the Bankruptcy Courts will undoubtedly seek to help along those COVID-affected businesses in which financial reorganization appears feasible. But landlords should recognize that a significant number of Chapter 11 cases will not succeed, often leaving creditors with little or nothing, and calibrate their response to a tenant bankruptcy accordingly.
3. Understand Bankruptcy’s Treatment of Leases
Because leased premises are critical to many businesses, leases are subject to special provisions in the Bankruptcy Code. In essence, bankruptcy trustees and debtors in possession have three options with respect to each of their leases (all subject to court approval), they can reject, assume, or assume and assign the lease. Each of these options has specific rules, rights and obligations, but most of these can be modified if the landlord agrees. Understanding these options, and when and how to compromise, is critical to a landlord’s response to a tenant’s bankruptcy.
Where a lease is rejected, the tenant is relieved from its lease obligations and must surrender the premises. The landlord has a claim for damages for breach of the lease, but those damages are capped, with the maximum claim typically limited to one year of rent under the lease, but this cap may increase to up to three years for longer lease terms. More important, the landlord’s lease rejection damages are considered an unsecured claim, the lowest priority claim, so in most cases the landlord will receive little or no payment on the claim (other than for the rent from the time of the bankruptcy’s filing through the date of surrender, which should be one of the first claims paid). In essence, this gives the debtor (but not any lease guarantors) the ability to walk away from the lease, with the landlord receiving payment for arrears only if senior creditors are satisfied.
In contrast, Where a lease is assumed, the landlord is made whole, at least in theory. For a lease to be assumed, payment arrears and lease defaults must be cured, or the landlord must be provided with “adequate assurance” of cure, and there must be “adequate assurance of future performance.” Though there is some wiggle room in “adequate assurance,” the idea is that the landlord should be put into as reasonably close to the position that it would have been in had there been no default or bankruptcy, with no modification of the lease, for the lease to be assumed. An important caveat is that in many instances debtors will request lease modifications or arrears waivers to assume a lease, leaving the landlord the choice to negotiate or face the possibility of lease rejection.
Finally, when a lease is assumed, the Bankruptcy Code gives tenants broad authority to assign the lease to other parties notwithstanding lease clauses restricting its assignability. If the assignee’s financial position is such it adequately assures future performance, there are very limited grounds under which the landlord can object to the assignment, and upon a bankruptcy assignment, the debtor tenant is relieved from liability.
The decision on whether to assume or reject a lease must be made within 120 days of the bankruptcy’s filing, though this time can be extended by up to 90 additional days by court order. After 210 days, however, the time to assume or reject can only be extended with the consent of the landlord. If the lease is not assumed by the expiration of this time, it is deemed rejected, and the tenant must immediately surrender the leased premises.
4. Understand When Security Deposits May and May Not Be Used
One of the most important protections a landlord has is the security deposit. Once a tenant enters bankruptcy, however, there are important limits on how the tenant’s security deposit may be applied.
Where a landlord holds a cash security deposit of a tenant in bankruptcy, the deposit is considered to be property of the tenant’s bankruptcy estate. This means that bankruptcy’s automatic stay prohibits the landlord from using the security deposit or applying it to arrears after the bankruptcy is filed without court approval. The landlord, however, is considered to have a perfected security interest in the deposit, meaning, in essence, that the deposit must first be used satisfy arrears to the landlord. If the deposit exceeds what is or could become due to the landlord, it will have to be turned over to the bankruptcy trustee to be used for other purposes.
Though applying a cash security deposit to arrears is restricted once a bankruptcy is commenced, if the landlord actually draws down on the security deposit before the bankruptcy is filed to satisfy arrears, this drawdown should not be affected by the bankruptcy. (There is a small chance that if the drawdown was within the 90 days prior to the bankruptcy filing, it could be considered a preference that can be clawed back, but because of a security deposit must first be applied to offset rent arrears in bankruptcy, this is uncommon).
In contrast, a standby letter of credit held by the landlord as security is considered to be a contract between the landlord and issuing bank that does not involve the tenant. As such, the letter of credit is not considered part of the bankruptcy estate, so even if the tenant is in bankruptcy, the landlord is permitted to draw down on the letter of credit to offset rent arrears. If the landlord does, it must, of course, properly credit the amount applied and reduce any bankruptcy claim by that amount.
As such, where a tenant is in arrears and appears to be headed toward bankruptcy, a landlord may wish to draw down on the tenant’s cash security deposit to the extent of the tenant’s arrears to avoid the security being frozen during the bankruptcy. If the landlord has a letter of credit, it can more safely wait to proceed. In either event, assuming the lease has a clause requiring the tenant to replenish its security deposit when used, a tenant seeking to assume the lease will have to cure both any remaining rent arrears and its obligation to restore the security.
5. Understand Your and Your Tenant’s Objectives and Endgame
The prior sections summarized some important points of bankruptcy law. However, though knowing the law is essential, understanding where you and your tenant want to take the bankruptcy can as important to maximizing the potential bankruptcy result. Particularly in situations where a fundamentally sound business is impacted by non-recurring events – like the COVID-19 crisis – a bankruptcy reorganization can save business and its tenancy.
Landlords are often frustrated when a tenant enters bankruptcy, particularly after the landlord has taken the tenant to the edge of eviction in the civil courts. Although you may think of the filing as an illegitimate effort taken solely to delay the inevitable eviction, be assured that Bankruptcy Judges virtually never see it this way, at least until a filing is shown to have been made for an improper purpose. In other words, it is never an effective strategy to be outraged at a debtor exercising its bankruptcy rights, at least in dealing with the Bankruptcy Courts (but feel free to vent all you want out of court). Instead, you have to carefully consider your rights and options.
Depending on the type of business and bankruptcy, a landlord may have tremendous control over the outcome. A single location business has a very strong incentive to come to accommodation with its landlord if it wants to survive. On the other hand, in a bankruptcy of a large, national company, with many locations, the debtor’s counsel and consultants will assess each lease and decide whether it is to be assumed or rejected, and the landlord may have little to do other than to wait to see how the decision plays out. To fashion an appropriate response, the landlord has to understand how and the landlord’s particular lease is in the tenant’s bankruptcy, and what the tenant’s options are if it cannot assume the lease.
If the tenant has the financial wherewithal to assume the lease by paying any rent arrears and all ongoing rent, it will be able to do so, but the landlord will be made whole. On the other hand, if the tenant wants to reject the lease, the landlord usually has little option but to acquiesce. It is in the substantial middle ground where the landlord’s choices matter.
Landlords face the question of whether they want to retain the tenant, and under what circumstances. Because the already-weak rental market will likely be even weaker after COVID-19, many landlords should be willing to make concessions to keep paying tenants. This would dovetail with the strong inclination of most Bankruptcy Judges to push for a negotiated settlement. Indeed, unless it is plainly obvious that a tenant will be unable to assume its lease, Bankruptcy Courts tend to give the tenant the opportunity to seek an agreement with the landlord, and may delay resolution to give this time to happen. So, it is helpful for you to consider in advance under what circumstances you would allow the tenancy to continue, recognizing that keeping even a weak tenant who may well collapse even after bankruptcy may be better than a vacancy now.
The calculus changes slightly if there is a lease guarantee. A tenant’s bankruptcy will not eliminate the guarantor’s liability, though the court does have the ability, in appropriate cases, to temporarily stay actions on the guarantee that might adversely impact the tenant’s ability to complete a reorganization. However, landlords must recognize that the guarantor may file for bankruptcy, likely eliminating the landlord’s ability to collect on the guarantee. Indeed, because many small company owners have most of their assets tied up in their businesses, the personal bankruptcy of the guarantor can be a very credible threat that the landlord must consider in deciding whether to grant lease concesssions.
As a landlord, by carefully considering the tenant’s motivations and your own interest, you can use the bankruptcy of a tenant as an opportunity for a restructured tenant to have stronger operations and retain the tenancy on a long term basis. With the economic disruptions caused by COVID-19, and the impact that they will have on the commercial real estate market, it is important for landlords to face commercial tenant bankruptcies flexibly and knowledgably in order to make the best of a bad situation.