More Tenant Bankruptcies Are Coming in 2018, and Landlords Need to Be Prepared

February 2018

Recent years have seen many prominent retailers filing for bankruptcy, such as The Sports Authority, Toys “R” Us, The Limited, Coldwater Creek, Radio Shack, and Charming Charlie. This wave is expected to continue into 2018, and commercial landlords need to know their rights (and obligations) when their tenants file for relief in bankruptcy. The rules governing leases in bankruptcy are lengthy and complex, but landlords should pay particular attention to the main issues that typically arise in a tenant bankruptcy.

A tenant bankruptcy filing (like any bankruptcy filing) imposes an automatic stay immediately, which prohibits landlords and other parties from taking any action against the debtor or the debtor’s property unless approved by the bankruptcy court. A tenant bankruptcy filing requires landlords to cease any demand, collection, or other activity to recover amounts due from their debtor tenant. And landlords cannot cite a bankruptcy filing as cause to terminate a lease. If a tenant is in default prior to the bankruptcy filing, and the landlord takes all steps necessary to terminate the lease under state law before the tenant files for bankruptcy, the lease will not be subject to the tenant’s subsequent bankruptcy case. Otherwise, the landlord will be subject to all rules governing a tenant’s lease in bankruptcy.

After learning of its tenant’s bankruptcy, a landlord’s initial thoughts typically turn to whether and when it can expect rent payments. The debtor tenant must pay all rent that accrues after the bankruptcy filing, and it must do so timely. However, rent that accrued prior to the bankruptcy filing is a general unsecured claim, which might not be paid until much later in the bankruptcy case if at all. Landlords should closely monitor a debtor tenant’s post-petition rent obligations; if the tenant defaults on these obligations, the landlord can file a motion seeking permission to pursue default and eviction remedies against the tenant.

One of the primary reasons that large retailers file bankruptcy petitions is to take advantage of the significant right accorded tenants in bankruptcy to assume or reject any lease. If the tenant assumes a lease, it can seek to assign the lease to a third party, subject to certain limitations. A landlord thus could find itself with a new tenant not necessarily of the landlord’s choosing.

Generally, a tenant will assume a lease if (a) it wants to remain in the property as part of its long-term reorganization plan, or (b) the lease is a below-market lease that the tenant can assign to a third party, with the third party paying the debtor’s estate for the opportunity to be the lease assignee. The debtor can assume and assign a lease regardless of any restrictions on assignment that might be specified in the lease itself. To assume a lease, the tenant must cure all defaults that exist under the lease at the time of the assumption, including all rent that has accrued, both before and after the bankruptcy filing. The tenant also must obtain court approval for the assumption and assignment. Landlords are given the opportunity to raise objections, particularly in shopping center leases if a proposed new assignee-tenant does not fit the existing tenant mix. To assign a lease, the debtor must demonstrate “adequate assurance” that the assignee will be able to perform under the lease.

If the lease is an above-market lease or the debtor no longer wants to lease the space, the debtor can reject the lease. The bankruptcy court must approve the rejection, but lease rejections are almost always approved because the court generally defers to the debtor’s business judgment as to the value of and need for the lease. After rejection, the debtor must surrender the property and will no longer pay rent. All unpaid rent is an unsecured claim against the bankruptcy estate.

Assumption or rejection of a lease in bankruptcy requires assumption or rejection of the entire lease; a debtor cannot assume or reject parts of a lease. However, some debtors in recent retail cases have sought to modify terms of the leases they wish to assume, such as reducing rent, adjusting the term, or changing the amount of leased space. Debtors can accomplish these changes only with the consent of the landlord; if the landlord agrees, the parties can execute a lease amendment, which generally would be approved by the bankruptcy court. Then the debtor can assume the lease as modified.

Landlords should be vigilant for any signs of financial distress of a tenant. If the tenant misses a rent payment, a landlord should provide all notices of default required under the lease and applicable law. As noted above, if the landlord takes all steps to terminate a lease before the tenant files a bankruptcy case, the lease will not become part of the debtor’s bankruptcy case. The landlord then can take steps under state law to evict the tenant without having to navigate the automatic stay in bankruptcy or any other bankruptcy issues.

If the landlord is not able to terminate the lease prior to bankruptcy, the landlord nevertheless should be proactive in the bankruptcy case at its inception. The bankruptcy code provides a number of rights to commercial landlords, and the sooner a landlord exercises these rights, the closer the landlord will be to regaining the property or a paying tenant.