November 4, 2020
By
Amelia Martin Adams
Attorney, Stoll Keenon Ogden PLLC
(859) 231-3022
amelia.adams@skofirm.com
As the COVID-19 pandemic continues to cause seismic shifts, the economy is preparing to address its long-term effects. Retailers are restructuring to offer consumers curbside pick-up and online shopping, and restaurants are creating new ways to treat customers to dining at home. A multitude of workers have transitioned to telecommuting, and organizations are adjusting to videoconferences for team communications. While these changes have allowed some businesses to adjust to a “new normal” for the foreseeable future, others have been unable to maintain operations and either closed or made difficult decisions to defer large expenses—like rent—to stay afloat.
Facing dramatically reduced revenues, landlords are evaluating what’s to come as business tenants consider reducing spaces to curb expenses or closing their doors. Some of those landlords may consider bankruptcy to address defaults on their own mortgages or other financial shortfalls, leaving commercial tenants wondering what will happen to their leases if the real estate becomes part of a bankruptcy case. This article discusses a nonresidential (“commercial”) tenant’s rights under the United States Bankruptcy Code[1] (“Code”) if its landlord files a chapter 7 or 11 bankruptcy.[2]
Operation of Leases During a Bankruptcy
In a chapter 7 case, a trustee is appointed to wind down the landlord’s operations, liquidate its assets, and distribute proceeds to creditors in the priority set by the Code. In contrast, in a chapter 11, the landlord becomes a debtor in possession (“DIP”) upon filing its bankruptcy petition, meaning that the landlord retains control of its operations and assets except in rare instances where a trustee is appointed. The goal of a chapter 7 is to liquidate the debtor’s assets. The goal of a chapter 11 could be liquidation or reorganization under a sale of assets, a “chapter 11 plan,” or both, approved by the Bankruptcy Court. In either case, the landlord[3] has three options for a lease: assume and retain the lease, assume the lease and assign it to a third party, or reject the lease.
The Code sets a specific deadline for a chapter 7 trustee to assume a residential real property lease or it will be deemed rejected. It also sets a deadline for a chapter 11 DIP to assume or reject a commercial lease where the tenant is the DIP. Yet, the Code does not set a deadline for a chapter 7 trustee or chapter 11 DIP to assume or reject a commercial lease where the landlord is the debtor.[4] The practical impact of that lack of specificity depends on the case. However, because the Code requires landlords to timely perform nearly all obligations under commercial leases during bankruptcy until assumption or rejection,[5] the likelihood of a landlord wholly ignoring a lease is slim.
Requirements for Lease Assumption or Assignment
Before a lease may be assumed, the landlord must cure most defaults and provide adequate assurance of its future performance.[6] When a lease is to be assigned, the Code adds another layer of complexity by requiring the landlord to provide adequate assurance of the assignee’s future performance in addition to satisfying assumption requirements.[7] The Court will often defer to the landlord’s business judgment regarding assumption and/or assignment, but a lease cannot be assigned if the counterparty does not consent and the law excuses the counterparty from accepting performance from or rendering performance to an entity other than the debtor/landlord.[8]
Impact of Lease Rejection
A debtor/landlord’s rejection of a lease does not require a tenant to vacate the premises. Instead, Code § 365(h) allows tenants to choose one of two remedies upon rejection: (a) treat rejection as a breach of the lease and assert a claim for damages in the landlord’s bankruptcy, or (b) retain their rights under the lease and occupy the premises for the remainder of the lease term and any renewal or extension.[9] If the tenant elects to remain, the landlord is effectively excused from post-rejection performance, except to the extent that non-bankruptcy law would require performance by a breaching landlord. Thus, the tenant’s recourse against the landlord would be limited to offsetting rent owed for the remainder of the lease term against damages caused by the landlord’s nonperformance post-rejection.[10] In other words, the tenant may not lose the right to use the space, but may have to scrape the parking lot itself.
Impact of Sale of Leased Premises
One unresolved wrinkle in this process arises when a landlord seeks to sell its property free and clear of the tenant’s lease in bankruptcy. Courts are divided over whether a debtor/landlord may sell its real property free and clear of leases.[11] Still, a leading treatise concluded that “the apparent majority view” is that the protections of Code § 365(h) discussed above prevail over any conflicting application of § 363(f), which authorizes the sale of property free and clear of interests if certain conditions are met.[12] A tenant therefore would not be wholly without support if it objected to a landlord’s attempt to sell its property free of the tenant’s leasehold interest. In fact, the tenant’s right to retain the space is not self-effectuating – in order to be preserved, those rights generally need to be asserted affirmatively if the debtor/landlord proposes a sale or plan contrary to them.
The Code is complex, and bankruptcy cases can move very quickly. To protect itself, a tenant should consult an experienced attorney immediately upon receiving notice of its landlord’s bankruptcy case. Better yet, a tenant concerned about its landlord’s finances should contact counsel before a bankruptcy is filed to establish a plan for the continuity of its business if the landlord seeks bankruptcy relief.
In a separate article, the author discussed a commercial landlord’s rights in its tenant’s bankruptcy.
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[1] 11 U.S.C. §§ 101, et seq.
[2] There are also chapter 9 (governmental), chapter 12 (farmers/fishermen), chapter 13 (individual repayment), and chapter 15 (international) bankruptcy cases. Each is named for the chapter of the Code that primarily governs the case.
[3] For clarity, “landlord” refers equally to a chapter 7 trustee or chapter 11 DIP for the remainder of this article.
[4] “[A]pparently as a result of congressional oversight, the statute sets no time limit for action in a case in which the debtor is the lessor of nonresidential real property.” 3 Collier on Bankruptcy ¶ 365.05 [4] (16th 2020) (citing In re Sae Young Westmont-Chicago, L.L.C., 276 B.R. 888, 893 (Bankr. N.D. Ill. 2002)).
[5] 11 U.S.C. § 365(d)(3).
[6] 11 U.S.C. § 365(b)(1).
[7] 11 U.S.C. § 365(f)(2).
[8] 11 U.S.C. § 365(c)(1).
[9] 11 U.S.C. § 365(h)(1)(A).
[10] 11 U.S.C. § 365(h)(1)(B).
[11] See In re The Great Atlantic & Pac. Tea Co., Inc., 544 B.R. 43, 55-56 (Bankr. S.D.N.Y. 2016) (“[A] fact pattern that continues to divide courts [is] whether a debtor-lessor may sell real property that it owns free and clear under 11 U.S.C. § 363(f) notwithstanding its lessee’s rights under 11 U.S.C. § 365(h)(1).”) (collecting cases).
[12] See 3 Collier on Bankruptcy ¶ 365.11[5] (16th 2020).
