- When Red is the Color of the Season: Commercial Property Leases and Bankruptcy
- January 16, 2009 | Author: Richard W. Brunette
- Law Firm: Sheppard, Mullin, Richter & Hampton LLP - Los Angeles Office
Bankruptcy filings are skyrocketing as more and more companies are going deep into the red. For retailers or their landlords holding leases in commercial property, there are special considerations to keep in mind. This post will provide some basic information on the rights of non-debtor tenants and landlords under unexpired non-residential property leases when a debtor–landlord or –tenant, respectively, files a chapter 11 bankruptcy petition.
Assuming or Rejecting the Lease. When a debtor files for bankruptcy and seeks to reorganize its business under chapter 11, the debtor will generally retain possession of its property and continue to manage its business as a debtor in possession. The debtor has broad rights to either assume, assume and assign, or reject commercial leases (and other contracts and leases to which it may be a party), subject only to court approval. By assuming a lease, the debtor is choosing to continue under the terms of the lease and accepts all burdens and obligations related to the lease. If rejected, however, the debtor will be relieved of its obligations under the lease, leaving the non-debtor with an unsecured claim for damages based on a breach of the lease.
When the chapter 11 debtor is the tenant:
- Before a tenant-debtor may assume an unexpired lease of non-residential real property, it must: (1) cure any monetary defaults, or provide adequate assurance that any monetary defaults under the lease will be promptly cured; and (2) provide adequate assurance that all obligations under the lease will be satisfied in the future. For tenant-debtors seeking to assume a lease in a shopping center, additional showings are required for adequate assurance of future performance, including evidence of the source of rent and assurances that any percentage rent due will not decline substantially.
- If the tenant-debtor rejects the lease of non-residential real property, the tenant will be required to immediately vacate the premises. In addition, the rejecting tenant-debtor will still be required to address any claims made against it for past due and unpaid rental and other monetary obligations, and may be exposed to damages for rejection of such lease, including future rent.
When the chapter 11 debtor is the landlord:
- Similarly, if a landlord-debtor assumes an unexpired lease of non-residential real property, it must first: (1) cure any monetary defaults, or provide adequate assurance that any monetary defaults under the lease will be promptly cured; and (2) provide adequate assurance that all obligations under the subject lease will be satisfied in the future.
- However, if a landlord-debtor rejects an unexpired lease of non-residential real property, the non-debtor tenant will have the option to treat the lease as terminated or retain its rights under the lease for the duration of the lease and any renewal or extension periods thereof. The landlord-debtor must allow the tenant to exercise its rights, including with respect to the amount and timing of payment of rent and any other amounts due, and to possession, use, quiet enjoyment, subletting, assignment and hypothecation. If the non-debtor tenant opts to remain, the landlord-debtor is not required or obligated to actively perform their duties and responsibilities under such lease. The tenant, however, is entitled to offset any damages incurred by the tenant by virtue of the landlord-debtor's non-performance of its obligations under the lease against the rental or other payments it is required to make. Rejection of a lease of non-residential real property in a shopping center where the non-debtor tenant opts to continue its use of the premises will not affect the enforceability of any provision pertaining to radius, location, use, exclusivity, tenant mix or balance within the shopping mall.
- In the event that either a tenant-debtor or landlord-debtor seeks to assume and assign a lease of non-residential real property to a third party: (1) the debtor party must still first cure any monetary defaults, or provide adequate assurance that any monetary defaults under the lease will be promptly cured; and (2) the proposed third-party assignee must provide adequate assurance of its future performance under such lease from and after assignment. In addition, before a shopping center lease is assigned to a third party, the proposed assignee must provide adequate assurance that it is able to perform under the lease, including compliance with all restrictive covenants and the ability to maintain the tenant mix or balance within the shopping center will not be disturbed.
Timeframe. In 2005, Congress reduced the time in which a tenant-debtor may assume, assume and assign, or reject an unexpired lease of non-residential real property to 120 days of the bankruptcy filing. The debtor may be granted one 90-day extension of this 120-day period, however, if the tenant-debtor wishes to seek further extensions thereafter, it must first attain written approval of the non-debtor landlord. If assumption has not occurred within the required time period, the unexpired lease is deemed rejected.
This 210 day cap has significant implications for retail debtors. Prior to this change the time to make a decision for assumption or rejection was often virtually unlimited (and remains virtually unlimited for landlord-debtors), allowing a retailer to evaluate sales at a particular store for one, if not two, holiday seasons. Now, the decision must be made within seven months.
Assignment of Leases. Many leases have provisions purporting to restrict or prohibit assignment (as well as provisions which state that the lease will terminate upon bankruptcy). There are, however, specific Bankruptcy Code sections which render such provisions generally unenforceable in the bankruptcy context.
The ability to assign a non-residential real property lease can provide a significant opportunity to retail debtors who hold leases below market rates and are able to find third-party buyers to purchase the rights under, and thereby take over, these leases. This not only provides proposed assignees with an opportunity to step into the shoes of the debtor on below-market unexpired commercial leases, but also provides the retail tenant-debtors with additional capital with which to administer their estates. Note that with respect to shopping center leases, limitations such as radius, location, use, or exclusivity will continue to be enforceable, even in the bankruptcy context.
If the Debtor is a Sublandlord. If you are a tenant under a sublease and the sublandlord files for bankruptcy, your right to occupy the property will likely be terminated if the sublandlord rejects the master lease (the lease between the ultimate landlord and your sublandlord). You may retain your rights to possess the property, however, if you have a non-disturbance agreement with the ultimate landlord or if you are a third party beneficiary of a non-disturbance clause in the master lease.
Get prompt legal advice. Whether the debtor is a tenant or a landlord, commercial leases will be affected by any bankruptcy proceeding. The above discussion provides only a brief snapshot of the complexities involved when a business holding commercial leases as either a landlord or debtor files for bankruptcy. In order to protect your rights, get prompt legal advice any time bankruptcy proceedings are involved.