United States: Commercial Tenant Debtors In Chapter 11: Fundamentals Of Landlord Creditor Protection In Bankruptcy

Commercial landlords have unique protections in bankruptcy, but can lose these rights if they do not assert them. When a commercial tenant files bankruptcy under Chapter 11, the landlord must carefully monitor filings and proceedings from the first day to be sure that the debtor properly budgets for payment of rent, and does not otherwise seek to modify the landlord's rights and remedies. The fundamental rule of bankruptcy is that creditors have certain rights unless they give them away. The Bankruptcy Code (i.e., Title 11 of the U.S. Code) won't protect a sleepy creditor who fails to object to motions, sale orders, a plan, or a confirmation order that strikes a creditor's claim, modifies the lease or otherwise eliminates the landlord's protections. Consequently, commercial landlord creditors must carefully monitor bankruptcy proceedings to enforce their rights and maximize their recovery.

365 – Assumption, rejection and the obligation to pay rent commencing 60 days after the petition date

Section 365 of the Bankruptcy Code is the primary statute addressing unexpired leases. The same Code section also deals with "executory contracts." Among its virtues, § 365 is long and confusing; has different rules for different chapters and for different types of leases; is replete with terms defined elsewhere and cross-references to multiple other statutes; and is subject to alteration by a number of other statutes that aren't referenced. It's a challenging statute.

Commercial rent rule

Debtors are supposed to "timely perform all the obligations of the debtor" arising after the petition date under a commercial lease within 60 days of the petition date. 11 U.S.C. § 365(d)(3). The plain meaning of the statute is that the debtor must pay all post-petition rent when it is due.

Notwithstanding the apparently unequivocal statutory text, debtor attorneys have found room to equivocate. One issue is that § 365(d)(3) does not set forth a consequence if the debtor fails to "timely" perform. Enforcement differs from judge to judge, with a spectrum from conversion or dismissal of the case to a shrug. Another issue is the question of "stub rent." If rent is due on the first of the month and the debtor files bankruptcy any day later in the month, the rent for the remainder of the month from the petition date is colloquially called "stub rent." Since the debtor filed after the due date, debtors' attorneys have argued that § 365(d)(3) does not apply to stub rent, since it cannot be paid "timely." Consequently, notwithstanding the apparent sword of § 365(d)(3) for landlords, they still find themselves in the frustrating position of having to spend attorney's fees to get post-petition rent paid. As with all aspects of bankruptcy, if the landlord does not insist on rent payments, it's as likely as not the debtor will not pay, despite the text of § 365(d)(3).

Assumption vs. rejection – the all-or-nothing game

Among the basics of unexpired leases in bankruptcy is the distinction between "assumption" and "rejection." Section 365 lays out the process for a debtor to exercise its basic right in bankruptcy to choose whether it wants to keep a lease because it is desirable ("assume it") or terminate it because it is not beneficial ("reject it").

The simple math for landlords in bankruptcy is that "assumption" of the lease is generally very good, relative to the other possible outcomes. It means the landlord gets "everything" compared with how other creditors in the case are likely to be treated: The debtor must cure all monetary defaults and comply with the lease terms, generally before most other creditors get paid anything. "Rejection" means the landlord gets "nothing," other than a claim for unpaid rent and other losses that will most likely receive pennies on the dollar in a distribution that occurs years after the case is filed. Even with rejection, the landlord must take affirmative steps, such as filing a motion for relief from stay, just to be able to pursue eviction in state court to recover possession from a holdover debtor tenant. If the debtor assumes the lease, it is because the debtor wants to continue to occupy the space or assign it to a prospective buyer, either of which a commercial landlord typically prefers to having a vacant space. Consequently, a significant issue to monitor when representing a landlord in bankruptcy is whether the debtor will assume or reject the lease.

Timing?

In Chapter 11 cases, debtor-tenants have until confirmation of a plan to assume or reject leases. See 11 U.S.C. § 365(d)(1) & (2). This can occur more than a year after the case is filed, leaving the landlord in a state of limbo and uncertainty. The landlord can file a motion requesting assumption or rejection prior to confirmation; however, once again, the landlord is spending money on attorney's fees just trying to find out if it is going to be in the "all" camp or the "nothing" camp.

Possession?

As noted above, neither rejection nor anything else in § 365 addresses how the landlord might regain possession or evict the debtor. Bankruptcy courts regard the issue of possession as a state court matter. Unless the landlord can negotiate a consensual deal with the debtor for possession under acceptable terms (e.g., "broom-swept condition" by a certain date), the landlord must obtain relief from the automatic stay (11 U.S.C. § 362(a)) and then proceed with a state court unlawful detainer action. The whole process is wildly unsatisfying for a landlord who has likely gone without rent payments for some time and is merely trying to retake possession so that it can find a replacement tenant and hopefully abate some of the losses it has incurred from its bankrupt tenant.

First-Day Motions:

When a bankruptcy case is filed, particularly in a case of any meaningful size, the debtor will file a number of motions on the first day to establish procedures for the case. Any motion for use of cash collateral is critical for landlords, who must monitor to see if (a) the debtor has any money to pay rent; (b) the debtor will actually be spending some of that money paying rent; and (c) what new and additional protections the secured creditor or "DIP [debtor in possession] lender" will receive in return for letting the debtor, i.e., the captain of the Titanic, continue to steer the ship in bankruptcy. "Cash collateral" or DIP motions are frequently used opportunities for a secured creditor, or the debtor, to ratchet up its own protections to the detriment of other creditors, including landlords. Consequently, it is vital for landlords to object to these motions when necessary, and otherwise get involved in the negotiations for the debtor's use of cash collateral to ensure proper and timely rent payments.

Sale Motions – the notorious "363 Sale" (asset sales in bankruptcy):

Many debtors in Chapter 11 are conducting a structured liquidation, with no real goal of reorganizing and continuing in business. An asset sale in bankruptcy can provide an asset purchaser with court-ordered protections against successor liability claims, while giving a debtor and its creditors a public, due-process-supported proceeding to obtain the best price for the assets. The process isn't foolproof, however. The additional expense of bankruptcy on all parties, plus the additional scrutiny, objection rights and delay, can depress the net recovery or even implode a debtor who is struggling to preserve its going-concern value and continue operations before a sale. Most important for landlords, the "363 Sale," named after the Bankruptcy Code section under which it is authorized, 11 U.S.C. § 363, can force a day of reckoning for debtors who have been delaying lease acceptance or rejection, as well as delaying paying rent. This can force the all-or-nothing decision the landlord has been either waiting for or dreading, because an undesired lease that a 363 Sale buyer does not want is likely to be rejected, and the landlord is back in line with the hapless general unsecured creditors. Meanwhile, if a buyer wants the lease, or even just a new lease at the same space, the 363 Sale can force the cure payment that must precede assumption of the lease and assignment to the buyer. The landlord still gets a veto right, and can evaluate whether it wants to be in a lease with the buyer. Even if the prospective buyer only wants to renegotiate the lease, the landlord will typically prefer having a prospective tenant on its doorstep over having to proceed down the path of evicting the debtor.

Preference Risks:

Landlords frequently find themselves the target of a preference demand or suit, i.e., being compelled to return rent payments made in the 90 days before the debtor filed, because the payments were preferential to other creditors, who received nothing in the same period.

It is crucial to monitor any agreements with the debtor for cure, payment of rent, or other lease modifications that include court-approved waivers of these preference claims. While landlords may have strong defenses to any preference suit, the expense of defending these claims is almost always unrecoverable to the client. Consequently, it is far preferable to resolve the issues and obtain a waiver of any preference claims if possible, such as through the process of negotiating a cure payment for defaults.

Plan Confirmation:

Plan confirmation presents another opportunity for the debtor or creditor plan sponsors to modify or eliminate a creditor's rights and protections. Consequently, a landlord must carefully review all disclosure statements and plans, and be prepared to object to the extent they unfairly discriminate against the landlord. These filings can be voluminous and challenging reads, with poison pills buried in small print. Nevertheless, to the extent the landlord has not resolved questions about possession, acceptance or rejection, payment of post-petition rent, payment of the landlord's claim, or other issues related to the lease, the plan will be the last stand for these issues.

Administrative Claims:

Administrative claims, i.e., claims arising after the bankruptcy is filed and that benefit the estate and bankruptcy effort, receive a higher payment priority than do general unsecured claims. Allowed administrative claims must be paid in full. However, this priority protection does not guarantee payment. If the debtor runs out of money, including if the case is converted to Chapter 7, being first in line to receive nothing is small comfort. Consequently, while the ability to file an administrative claim can provide an alternative path to recovery for unpaid post-petition rent, it follows the general math of bankruptcy for creditors – having to spend money to enforce rights, while reducing the net overall recovery.

Claims Bar Date:

It is essential to monitor the deadline to file a proof of claim, and to file a proof of claim for unpaid amounts owed under the lease before the backdate expires. If the landlord fails to do so, its claim will be banned.

If the debtor has not assumed or rejected the lease by the bar date, the landlord may not know the full amount of the claim by the bar date deadline. Typically, the bar date notice will have a separate bar date (generally 30 days from the date of rejection) within which to assert claims arising out of rejection.

Claim Objections:

It is not uncommon for a landlord to participate actively in a bankruptcy case for more than a year, go through plan confirmation and engage in various key stages of the case, only to receive an objection to its claim after the plan is confirmed. This necessitates a new round of expense and litigation defending the claim. If there is an opportunity to obtain a stipulation to the allowance of a claim prior to confirmation, it can avoid this unwelcome fight when the creditor has gotten to the brink of a distribution.

Other issues include a statutory cap on future rent claims that creates more math than most lawyers care to do. Under 11 U.S.C. § 502(b)(6), landlords are entitled to no more than:

  1. 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, following the earlier of—

    1. the date of the filing of the petition; and
    2. the date on which such lessor repossessed, or the lessee surrendered, the leased property; plus
  2. any unpaid rent due under such lease, without acceleration, on the earlier of such dates[.]

It's just that simple. This confusing language breaks down as follows: If the rent is $10,000/month ($120,000/year) and the remaining term is 10 years ($1.2 million), the future rent claim is capped at either $180,000 (if the landlord hasn't recovered possession by the petition day) or less (if the landlord recovered possession by the petition date), plus any unpaid prepetition rent. The key takeaway is that if the debtor rejects the lease, a landlord's future rent claim will be capped at less than three years of future rent, regardless of the remaining lease term.

Joining Forces With Other Landlords – Pros and Cons:

Depending on the number of similarly situated commercial landlord creditors in the case (retail debtors may have multiple locations and landlord creditors), it may be possible for the landlords to form an informal faction, or even a formal committee, to increase collective bargaining leverage with the debtor and other creditor constituencies. However, notwithstanding common issues, it may be preferable for individual landlords to pursue their own rights and remedies, which may contradict the goals of other landlords. It is common for debtors with multiple landlord creditors to choose favored leases over undesirable ones, and focus limited resources on those leases that might be sold.

Conclusion:

The section of code that governs unexpired leases, 11 U.S.C. § 365, is one of the more challenging sections of the Bankruptcy Code. Different rules for Chapter 7 and Chapter 11 contrast with different rules for residential leases and commercial leases. Meanwhile, debtors and other creditors in a Chapter 11 case can modify these rights and restrictions by agreement, "consent" or waiver, often through dense, page-intensive, complex motions for use of cash collateral, motions to sell assets and plan confirmation orders. It is strongly recommended that you work with a bankruptcy attorney on the specific strategic considerations to maximize your landlord client's recovery.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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