In this economy, it would be unusual if a landlord has not had to address a tenant’s bankruptcy. Landlords’ rights and obligations in bankruptcy are complicated and require case-specific review and analysis. However, here are five useful “rules of thumb” to help both residential and commercial landlords get properly acclimated with bankruptcy if their tenants have or are preparing to file.
Rule No. 1: When possible, negotiate a pre-bankruptcy resolution with a tenant in financial distress.
A tenant’s bankruptcy will potentially be costly to the landlord, i.e., nonpayment of rent, delays caused by the bankruptcy, the stay of eviction proceedings and the loss of rents from a more financially stable replacement tenant. Once the tenant’s financial predicament has been confirmed, the landlord ought to consider working with the a tenant for a lease modification or negotiate a settlement that terminates the lease and allows the landlord to regain possession of the premises on acceptable terms. In the current economic environment, the overall financial outcome for the landlord will likely be better than taking a hard line with the tenant.
Rule No. 2: As soon as you know that the tenant has filed bankruptcy – STOP!
Once a tenant files for bankruptcy, the automatic stay provisions of the Bankruptcy Code take effect and require that all efforts by creditors to collect on pre-petition debt immediately cease, unless authorized by the Court or subject to statutory exception. Section 362. This means that after a petition is filed, the landlord may not serve a three-day notice on the tenant or continue an unlawful detainer proceeding or setoff against a security deposit. Doing so will likely result in the landlord’s actions being voided and the landlord could be sanctioned by the Bankruptcy Court. This prohibition also includes the enforcement of a judgment for possession for both residential and commercial tenants with one exception. Recent changes to the Bankruptcy Code now allows a residential landlord in California to enforce a judgment for possession if the pre-petition judgment is based on a non-monetary breach of the lease. Section 362(b)(22). In any case, if there is any doubt whether the automatic stay applies, assume that it does unless there is a clear basis to assert otherwise.
Rule No. 3: Make certain the tenant makes a timely decision to assume or reject its lease.
Assuming that the tenant’s lease has not already expired by its terms or terminated before the petition (then there might be some residual possessory rights to still consider), there are time limits for the tenant’s decision to continue with or reject the landlord’s lease. With respect to a residential lease, tenants have 60 days in a Chapter 7 liquidation case or up until a plan is confirmed in a Chapter 13 case, to decide whether to assume or reject their lease. Section 365(d)(1) and (2). With regards to commercial tenants, they have 120 days to make such a decision, which can be extended with cause for an additional 90 days. Section 365(d)(4). Any further extensions on commercial leases require the consent of the landlord. These deadlines arrive quickly in a bankruptcy case and often times are subject to extensive negotiations between the parties. As a general rule, leases that are assumed must be assumed with all terms and conditions in place (unless the landlord otherwise consents) and that as a condition for the assumption of the lease, the tenant must promptly cure all pre-petition defaults and provide adequate assurance that it will be able to perform future obligations required under the lease. Therefore the landlord may be able to successfully oppose an assumption (and/or an assignment of the lease to a new third party proposed by the debtor-tenant). Depending on the nature of the lease and the tenant’s financial standing, this is often a critical juncture for the landlord’s premises requiring consideration of many factors before deciding how best to proceed. In the meantime, while these time periods are running, the tenant is statutorily required to keep current on post-petition rent payments that the landlord should closely monitor.
Rule No. 4: The landlord should assert all bankruptcy claims on rejected leases.
Under Section 365 of the Bankruptcy Code, the tenant also has the option to reject a lease. Typically in a Chapter 7 case, the bankruptcy trustee files such a motion, in a Chapter 13 case, the debtor address assumption/rejection of a lease in its Chapter 13 Plan, or in a Chapter 11 case, the debtor in possession usually files the motion for rejection. Upon the Court’s order allowing rejection of the lease, the landlord will have essentially three possible claims against the bankruptcy estate:
- damages for all pre-petition arrearages under the lease;
- amounts for any unpaid post-petition obligations (typically rent, but may include other items); and
- lease rejection damages that typically allow for one year’s worth of additional future rent, subject to mitigation offsets. Recent favorable developments in case law allows landlords to assert their attorneys’ fees as part of these claims. See, In re Qmect, Inc. v. Burlingame Capital Partners II, LP, 368 BR 882 (Bkrtcy. ND Cal 2007).
Pre-petition damages and damages for future rent are generally classified as unsecured claims in the tenant’s bankruptcy case, while any unpaid post-petition obligations are usually treated as an administrative claim that are paid before unsecured claims against the estate.
Rule No. 5: Challenge a tenant that files a bankruptcy in bad faith.
If a Court determines that a bankruptcy has not been filed to reorganize, but instead used simply to gain a litigation advantage or frustrate a particular creditor, that case may be dismissed for bad faith and sanctions imposed against the debtor. Although a difficult burden for a creditor to satisfy, here are some possible situations that have:
- solvent debtor filed for bankruptcy for the purpose of obtaining the limit on a landlord’s claim for breach of lease, See, In re Liberate Technologies, 314 BR 206 (Bkrtcy. ND Cal 2004);
- tenant filed a petition in bankruptcy only to avoid a possible eviction, See, National Home Equity Corp. v. Villareal, 46 BR 284 (Bkrtcy. CD Cal 1984); or
- a bankruptcy petition was filed to frustrate an ongoing eviction, See, Norwest Mortgage, Inc. v Waters, 60 BR 339 (Bkrtcy. ED Wis 1986).
Armed with these rules of thumb in hand, the landlord can better negotiate the dangerous waters of the tenant’s bankruptcy.