Landlords of nonresidential real property may be left in the lurch if their tenants unexpectedly file for bankruptcy, but careful planning and quick action in the event can help preserve the landlord's interests.

by Christopher A. Camardello

Several large retail chains have filed for bankruptcy protection in the past year, leaving thousands of landlords subject to the strictures of the United States Bankruptcy Code. Though well-versed in real estate law, many practitioners who represent landlords are unfamiliar with their clients' rights when a tenant files a bankruptcy petition. With respect to unexpired leases of real property, debtors in bankruptcy have three options -- assumption, assignment, and rejection. This article provides an overview of the treatment of nonresidential real-property leases under the Bankruptcy Code. The emphasis is on commercial leases, and the rights and limitations of landlords. The article includes a step-by-step approach to calculating landlords' damages when the debtor has rejected the leases, and concludes with practice tips for counsel to commercial landlords. This article assumes that the tenant is the debtor or debtor in possession and will use the terms interchangeably.

The Automatic Stay

Before examining the treatment of unexpired leases of nonresidential real property under the Bankruptcy Code, we must consider §362 -- the automatic stay. Upon the filing of a bankruptcy petition, the Bankruptcy Code imposes a stay on all efforts to collect debts or otherwise take action against the debtor or the debtor's property. As it applies to landlords, the stay prohibits such acts as eviction, collection of unpaid rent, termination of the lease, foreclosure, enforcement of liens, setoff, and any other act to exercise control over the debtor's property. Not only are acts done in violation of the stay of no force or effect, but in some circumstances, the debtor can recover from the violating party any actual damages, including costs and attorneys' fees. And if the violation was willful, the debtor can recover punitive damages in appropriate circumstances.

There are some acts that are not prohibited by the automatic stay. For example, the stay does not prevent a creditor from pursuing the debtor's guarantors, assuming that the guarantors are not in bankruptcy. Further, the stay does not prohibit a landlord from drawing on a letter of credit, as long as the issuer is not in bankruptcy and the landlord need not first demand payment from the debtor. In addition, section 362(d) of the Bankruptcy Code allows a party in interest to request relief from the stay "for cause." Several courts have held that a debtor's failure to meet its postpetition lease obligations constitutes "cause" to allow the landlord relief from the stay. Note, however, that a Minnesota bankruptcy court has opined that, if the debtor defaults postpetition, a lessor may not proceed under section 362(d); instead, the lessor must move for an order requiring the debtor to assume or reject the lease.1 In practice, if a tenant is not performing under the lease during the bankruptcy case, the landlord should request alternatively that the court require the tenant to perform in accordance with the lease, require the debtor to assume or reject the lease, or grant the landlord relief from the automatic stay. In which order these requests are presented will depend on the landlord's goals and objectives.

Assumption

Under §365(d) of the Bankruptcy Code, a debtor may "assume" an unexpired lease of nonresidential real property. "Assuming" a lease, simply means that the debtor agrees to continue to perform its obligations under the lease. Of course, the landlord must continue to perform its obligations as well. A debtor cannot assume parts of a lease; it must assume the entire lease, with all of its burdens and benefits.

Assumption is subject to approval by the bankruptcy court. Under §365(b)(1), before the debtor can assume a lease, the debtor must cure all defaults, or at least provide adequate assurance that defaults will be cured promptly. In addition, the debtor must compensate the landlord for actual pecuniary losses resulting from any default, or, again, provide adequate assurance that such losses will be compensated promptly. Section 365(d)(2) explains that "default" does not include a breach of a provision relating to the debtor's financial condition, the filing of the bankruptcy petition, the appointment of a trustee, the satisfaction of any penalty rate, or the debtor's failure to perform nonmonetary obligations.

Before the debtor may assume a lease, the debtor must also provide adequate assurance of future performance. The Bankruptcy Code does not define "adequate assurance of future performance." But if the debtor is a tenant in a shopping center, "adequate assurance of future performance" includes several specific requirements. For example, the debtor must adequately assure the source of rent and other consideration due under the lease. This includes assurance that percentage rent will not decline substantially. Further, the debtor must show that it will not breach provisions relating to such items as radius, location, use, or exclusivity, and will not breach any similar provisions in any other agreement relating to the shopping center. Finally, the debtor must adequately assure that assuming the contract will not disrupt any tenant mix or balance in the shopping center.

Assignment

The debtor may assign the lease to a third party. Before the assignment, however, the debtor must assume the lease, and therefore must meet all of the obligations discussed above. The difference, of course, is that instead of providing adequate assurance of its own future performance, the debtor must show that the assignee will be able to perform all of the lease obligations. Thus, in the case of a shopping center, the debtor will have to show that the assignee will be able to pay the rent, comply with provisions of contracts relating to the shopping center, and not upset the tenant mix. In addition, the debtor must show that the assignee's financial condition and operating performance, including guarantors, are similar to those of the debtor at the time the debtor became the lessee.

Leases often contain a provision prohibiting or limiting assignment without the landlord's consent. Under §365(f), these provisions are not enforceable in bankruptcy. Moreover, once the debtor has assigned the lease, the debtor is no longer liable for any breach of the lease occurring after the assignment. The landlord must look to the assignee to recover any damages arising from a post-assignment breach of the lease.

A debtor is likely to assign the lease if the monthly rent obligations are below market value. A third party generally pays a lump sum of cash up front to acquire the lease. Unfortunately for the landlord, if the debtor sells the lease at a profit, the proceeds go the estate for distribution to all creditors. Still, assignment of the lease is generally better for the landlord than rejection, which is discussed next.

Rejection

If the debtor does not assume or assign the lease, then the lease will be rejected. In fact, if the debtor does not assume the lease within 60 days after the debtor files for bankruptcy, the lease is deemed rejected under §365(d)(4). In most cases, however, the debtor will seek an extension of time to assume or reject unexpired leases. These extensions are routinely granted and, in some cases, debtors are allowed to assume or reject leases well beyond 60 days after the petition was filed. For example, in Kmart's bankruptcy case, the court allowed the debtor over a year to determine which leases the debtor wanted to assume or reject.

If the debtor rejects the lease, the landlord is entitled to lease-rejection damages, which are deemed to have occurred prior to the petition. Note, however, that if the debtor has unpaid postpetition obligations, those obligations may be administrative expense claims and are in addition to the landlord's lease-rejection damages. Administrative expense claims are given priority ahead of general unsecured claims.

Section 502(b)(6) limits a landlord's lease-rejection damages. It is not a formula for calculating damages; rather, it is a limit on the amount of damages a landlord may claim. If the landlord's actual damages are below the cap, then the cap does not apply and the landlord's claim will be in the amount of the actual damages. Further, if the landlord mitigates its damages by leasing the property to a new tenant, then the actual damages must be reduced by the rent paid by the new tenant.

Under §502(b)(6), the landlord is entitled to rejection damages equal to the greater of one year's rent or 15 percent of the rent reserved, not to exceed three years' rent. Thus, to calculate lease-rejection damages, landlords must compare three numbers: one year's rent, 15 percent of the rent remaining under the lease, and three years' rent. These calculations begin from the time the debtor surrenders the property or the petition date, whichever is earlier.

An example illustrates this concept. Suppose the debtor and landlord have a ten-year lease running from 2000 to 2010. Under the lease, the debtor pays $10,000 per month ($120,000 per year) in rent. In 2002, the debtor files for bankruptcy protection and immediately rejects the lease. The landlord's actual damages would be eight years' rent or $960,000. Under §502(b)(6), however, the landlord's lease-rejection claim will be the greater of one year's rent ($120,000), or 15 percent of the rent reserved ($144,000).2 Since $144,000 is greater than $120,000, and is not more than three years' rent ($360,000), the landlord will have a lease-rejection claim for $144,000.

In addition to the $144,000, the landlord can add any prepetition obligations that the debtor did not pay. Thus, if the debtor owed two months' rent on the day it filed bankruptcy, the landlord could add $20,000 for a total unsecured claim of $164,000. Further, the landlord may be able to add, in addition to the capped amount, claims for obligations other than pure rent, e.g., common area maintenance charges, taxes, utilities, etc.3 If the landlord obtains relief from stay to set off the amount of a security deposit, the landlord must subtract that amount from its allowed claim.

Strategies and Practice Tips

Immediately upon learning that a client's tenant has filed bankruptcy, counsel should warn the client of the automatic stay and the consequences of violating it. Then counsel should learn whether the debtor intends to assume or reject the lease. Often the debtor will not have made a decision, in which case counsel will want to ensure that the debtor continues to meet all of its obligations under the lease until the debtor assumes or rejects the lease. If the debtor is not making payments, counsel should bring a motion to compel the debtor to do so. In the alternative, the motion should seek relief from the automatic stay to allow the landlord to exercise whatever rights it may have under state law to remove the tenant from the building. And if there are unpaid postpetition obligations, counsel should bring a motion for allowance of an administrative expense claim for all unpaid obligations between the petition date and the date of rejection.

Landlords' attorneys should closely monitor the bankruptcy case. Debtors often reject leases on very short notice, e.g., ten days. This gives counsel little time to prepare an objection. Counsel should carefully read all motions that may affect landlords' rights. For example, a motion to reject a lease may be part of a motion to approve store closings. Similarly, a motion to assume a lease may be part of a motion to approve the sale of assets. Thus, motions that may appear innocuous, may in fact substantially affect your clients' rights.

Attorneys should also pay strict attention to claim bar dates. Landlords may have general unsecured claims, which must be filed by a certain date, and administrative expense claims, which are usually subject to a different deadline. If a lease is rejected, often the claim for rejection damages will be due shortly thereafter, e.g., 30 days. Attorneys should monitor these dates carefully and calendar them to ensure timely filing.

Conclusion

From a landlord's perspective, the Bankruptcy Code is not kind to a lessor of nonresidential real property. But if lessors understand their rights, and closely monitor the bankruptcy case to enforce those rights, then landlords can make the best of a bad situation.

Notes
1. In re O-Jay Foods, Inc., 110 B.R. 895, 897 (Bankr. D. Minn. 1987) (considering rights of lessor of personal property).

2 Rent reserved is $960,000, of which 15 percent is $144,000.

3 Cases are divided on whether such charges are subject to the cap, are in addition to the cap, or are not allowed at all. The bankruptcy courts in this district have not ruled on the issue. From a landlord's perspective, such charges should be in addition to the amount capped by §502(b)(6), plus prepetition damages.

CHRIS CAMARDELLO is an associate at Winthrop & Weinstine. His practice is focused in bankruptcy, creditors' rights, and commercial litigation.