Dealing With Tenant Insolvency
With retailers closing stores at an alarming rate and retail bankruptcies skyrocketing, landlords are finding themselves increasingly pressured to stem their losses. Former mainstays of the American consumer like Payless Shoes, The Limited and RadioShack all filed for bankruptcy relief or closed large numbers of stores since the beginning of 2017. Recently, Credit Suisse issued a report predicting that more than 8,600 stores may be shuttered this year. Even financially healthy companies are following consumer trends and building up their online presence. The shifting landscape has many commercial owners and managers asking what they can do to protect themselves and, by extension, their other tenants.
The good news is a commercial landlord can take steps at several points in its relationship with a tenant to minimize risk. At the outset, landlords can perform due diligence on tenants, including running credit checks, judgment searches, reviewing U.S. Securities and Exchange Commission filings, Uniform Commercial Code financing statements and undertaking other online investigations. For newer companies without an established history, landlords may consider running searches on the tenants’ insiders.
Landlords can protect themselves by including favorable provisions in leases. Contractually requiring security deposits, letters of credit, third-party guaranties and payment of rent by a date certain at the beginning of the month can all reduce economic loss from a tenant’s failure to pay rent, insolvency and even bankruptcy. Most leases contain a provision providing that a tenant’s bankruptcy filing constitutes an event of default. These provisions are usually unenforceable. Landlords’ economic interests are much better served by obtaining a third-party payment source and imposing short cure periods.
Frequently, landlords with tenants who make late payments or miss payments will try to renegotiate the lease rather than begin eviction proceedings. A renegotiated agreement may be advantageous to both landlord and tenant. However, a landlord needs to be cautious because a newly renegotiated agreement may disadvantage the landlord if the tenant files for bankruptcy protection shortly after the agreement is finalized.
If a tenant files for bankruptcy, both the landlord and tenant’s rights will be determined by a combination of the lease, state law, local regulations and the bankruptcy code. The bankruptcy code overrides certain common lease provisions, including provisions prohibiting assignment without landlord consent.
In almost all circumstances, the filing of a voluntary bankruptcy petition by a tenant results in the imposition of the automatic stay. The automatic stay is a freeze of most lawsuits and claims against a debtor, including eviction proceedings and proceedings for breach of lease. Notably, the automatic stay does not freeze actions for recovery of possession where the lease expired by its own terms either before or during the bankruptcy case. However, landlords must be careful when relying on this exception because the law of some states provides that an implied tenancy of a specific term may be created when a landlord continues to accept rent from a holdover tenant.
If the automatic stay applies, a landlord will need to appear before the bankruptcy court before being able to commence or continue state court eviction proceedings. The automatic stay usually does not prevent a landlord from proceeding against a guarantor or another third-party payment source.
Tenants also have the right to assume or reject unexpired leases in bankruptcy. This gives tenants the right to effectively terminate leases or agree to continue in the tenancy. The bankruptcy code places time limits on the amount of time a tenant has to decide whether to assume or reject an unexpired lease. Moreover, the tenant is required to timely perform its obligations under the lease until it rejects the lease and must cure most breaches of the lease, or give assurances of cure, prior to being permitted to assume the lease. Special protections are given to shopping center landlords.
If the tenant rejects the lease, the landlord is entitled to file a claim against the bankruptcy estate for damages. The amount of damages may be capped if the remaining term of the lease exceeds certain time periods. Courts have taken different approaches as to how to calculate damage claims, so a claim amount may depend on the location of the bankruptcy case.
A tenant’s economic difficulties may alter the parties’ respective rights and obligations. However, with careful planning at every stage of the relationship, a landlord can minimize the impact of a tenant’s difficulties.
Elyssa Kates is an attorney with BakerHostetler. Her practice spans multiple areas, including real estate, corporate finance, insolvency and retail. The views expressed in this article are those of Elyssa Kates and not necessarily those of BakerHostetler.