The bankruptcy of a tenant changes the landlord/tenant relationship – it changes the terms of the lease agreement, and it changes the law that governs it. Although bankruptcy affects all unexpired leases, this discussion applies to unexpired leases of nonresidential real property.

The first change brought by a tenant’s bankruptcy is one that is well known to many landlords. Upon receiving notice of the tenant’s bankruptcy, the landlord must immediately suspend any collection activities, lien enforcement actions or eviction proceedings.^[FN1]

The other changes brought about by a tenant’s bankruptcy can be described as a series of new lease options given to the tenant’s bankruptcy representative.^[FN2] The bankrupt tenant’s exercise of these options is subject to oversight by the bankruptcy judge. The landlord, as a creditor and party in interest to the bankruptcy case, has standing and the right to be heard in the bankruptcy court on issues regarding these tenant options.

The following is an overview of: the options available to the bankrupt tenant; the conditions under which they may be exercised; and the rights and remedies of the landlord that arise when these options are exercised.

The Option to Assume or Reject…, and Everything In Between.

The bankrupt tenant’s most basic option is the option to assume or reject the lease. In the simplest example of these options, the bankrupt tenant is allowed to assume a lease having terms favorable to the bankrupt tenant, and it can reject a lease having terms it considers unfavorable. The terms “assumption” and “rejection” describe all-or-nothing options. As a practical matter, however, the mere existence of these options allows a bankrupt tenant to negotiate over a large range of possibilities that lie between outright “assumption” or outright “rejection.”

The Additional Option to Assign.

The Bankruptcy Code also gives the bankrupt tenant the right to assign, to a third party, the bankrupt tenant’s rights under a lease. As a practical matter, this right expands the bankrupt tenant’s options. If the lease has terms that are unfavorable to the bankrupt tenant but nevertheless favorable in the open market, the bankrupt tenant is allowed to assume and assign the lease rights and keep whatever consideration is paid by the third-party for the privilege of becoming the assignee.

Postpetition Performance of the Unexpired Commercial Lease.

Starting on the date of bankruptcy and continuing until the lease is assumed or rejected, the bankrupt tenant is required to perform virtually all obligations as and when called for under the lease, including payment of rent applicable to this period. The bankruptcy judge is authorized to order a delay in the actual performance of the tenant’s postpetition obligations that arise within sixty days following the effective date of bankruptcy. The Bankruptcy Code does not authorize the bankruptcy judge to extend the date of performance beyond the sixty-day period.

Delay in performance is authorized if there is “cause” for it. Examples of “cause” authorizing a delay are diverse. The landlord’s response to a bankrupt tenant’s request for delay is to ascertain if “cause” exists and to advocate the merits of the tenant’s request in the bankruptcy court.

Administrative Rent.

As part of the Postpetition Obligations, the bankrupt tenant is required to pay rent when due under the terms of the lease as it was in effect on the date of bankruptcy. These rental payments are commonly referred to as “administrative rent” because they are eligible for priority payment in full from available assets as administrative expenses essential to the administrative aspects of the bankruptcy proceeding and the protection and preservation of the bankrupt tenant’s assets.

The amounts payable as administrative rent are those in effect on the date of bankruptcy, including such items as Common Area Maintenance charges, tax escalations and most pass-through items described in the lease. If an installment of rent was due on the date of bankruptcy, then only the amount payable for the period after the date of bankruptcy is included in the computation of administrative rent. If the rent payments were current, then administrative rent is computed on a going-forward basis as of the date of the next ensuing installment. If the exact amount of an item to be included has not yet been determined, then a reasonable estimate of this amount may be used.

Landlord’s remedies for nonpayment of administrative rent or other nonperformance of lease obligations arising after the date of bankruptcy are discussed in Landlord’s Rights if Bankrupt Tenant Does Not Perform Postpetition Lease Obligations.

Landlord’s “Administrative Obligations.”

The bankruptcy code creates landlord obligations that apply during the time the bankrupt tenant is required to perform Postpetition Obligations. These obligations are in the form of prohibitions. As noted in Introduction and footnote 1, a landlord has a duty not to engage in collection activities or pursue eviction proceedings after receiving notice of the tenant’s bankruptcy. Similarly in the form of a restriction on the landlord, the Bankruptcy Code does not allow a landlord to terminate or modify a lease after the date of bankruptcy solely because of a lease clause triggered by the insolvency, bankruptcy or receivership of the bankrupt tenant. For most practical purposes the Bankruptcy Code enforces the landlord’s covenant of quiet enjoyment until such time as the lease is assumed or rejected. We address the circumstances under which a bankrupt tenant may be obligated to compensate landlord for services or supplies incidental to the lease in our materials that address the conditions on tenant’s right to assume.

The Option to Reject.

Discussion of the tenant’s option to reject the lease is simpler than that of the option to assume; discussion of the consequences of rejection are discussed before the more complicated discussion on the option and consequences of assumption.
Consequences of Rejection.

The Bankruptcy Code says that rejection constitutes a breach of lease. The breach so established allows the landlord to invoke landlord’s remedies such as repossession and lease termination. In most cases, the landlord’s damages are determined and treated by the Bankruptcy Code as though the breach occurred “immediately before” the date of bankruptcy. Exceptions to this treatment occur when the lease has been previously assumed in the context of the pending bankruptcy proceeding. Thus, where the lease has not previously been assumed in the bankruptcy case, the damage claim arising upon rejection is not entitled to the priority treatment given to the payment of administrative rent; rather, the damage claim allowed on account of rejection is treated as a general unsecured claim like that of all others for debts owed as of the date of bankruptcy.

Determination of “Rejection Damages”.

Landlord’s damage claim resulting from lease termination is defined and limited by a formula.^[FN3] In most cases, landlord’s rejection damages are capped at the sum of: (1) the rental payments owed as of the date of bankruptcy; and (2) the rent reserved under the lease for the one-year period commencing on the date of bankruptcy.

Timing of Exercise of Tenant’s Options.

The Bankruptcy Code provides that the lease is deemed rejected, and possession must be immediately surrendered if assumption or rejection is not made by the earlier of: expiration of 120 days after the effective date of bankruptcy; or the date of entry of an order confirming a plan. The court may extend this deadline prior to its expiration for up to 90 days if the bankrupt tenant requests the extension and shows that there is “cause” for the extension, but the court may grant a subsequent extension only upon prior written consent of the landlord.
Tenant’s Right to Assume.

The bankrupt tenant’s right to assume or reject an unexpired lease of nonresidential real property is subject to “court approval.” As noted above, the bankrupt tenant’s option to reject, its timing and its consequences, are all relatively straightforward. The bankrupt tenant’s rights to assume the lease or assume and assign it to a third party are more detailed and are summarized below. The Bankruptcy Code requires that the bankrupt tenant meet the requirements of assumption in order to assign its rights to a third party; in addition, assignment requires the bankrupt tenant to meet additional requirements. For those reasons, the topic of assumption will be addressed first, followed by the additional requirements for assignment.

Effect of Default.

When a default under the lease exists, the bankrupt tenant may not assume the lease unless, at the time of assumption, the bankrupt tenant does the following:

1. Cures, or provides adequate assurance that the bankrupt tenant will promptly cure the default;

2. Compensates, or provides adequate assurance that the bankrupt tenant will promptly c0mpensate a non-debtor party to the lease for any acual pecuniary loss resulting from the default; and

3. Provides adequate assurance of future performance under the lease.

As important as the term “adequate assurance” is, the term is not specifically defined and is determined by the bankruptcy judge in the event of dispute.

There are four categories of default that may exist under the lease that do not trigger the above three “adequate assurance” requirements; these requirements need not be met if the default is a breach relating to:

1. The insolvency or financial condition of the bankrupt tenant;

2. The fact of the bankruptcy itself;

3. The prior appointment of a trustee or custodian for the bankrupt tenant; or

4. The satisfaction of any penalty rate or penalty provision relating to a default arising from any failure to perform nonmonetary obligations under the lease.
Additional Requirements If Default Is Under a Lease in a Shopping Center.

The bankrupt tenant’s right to assume a lease in a shopping center carries with it an expanded version of the third “adequate assurance” requirement; “adequate assurance of future performance” of a lease in a shopping center includes adequate assurance:

1. Of the source of rent and other consideration due under the lease;

2. That any percentage rent due under the lease will not decline substantially;

3. That assumption is subject to all lease provisions such as a radius, location, use, or exclusivity provisions and will not breach any such provision contained in any other lease, financing agreement or master agreement relating to the shopping center; and

4. That assumption will not disrupt any tenant mix or balance in the shopping center.

As important as the term “shopping center” is, the term is not specifically defined and is determined by the bankruptcy judge in the event of a dispute.

Effect of Default on Landlord’s Obligation to Provide Services or Supplies Incidental to the Lease.

The bankrupt tenant may not require landlord to provide services or supplies incidental to the lease before assumption unless landlord is compensated per the lease for any services and supplies provided before assumption.

Additional Restrictions on Right to Assume.

The bankrupt tenant may not assume the lease over the objection of a party if governing law excuses the objecting party from accepting performance from, or rendering performance to, anyone other than the bankrupt tenant.

The bankrupt tenant may not assume the lease if it has been terminated under governing law prior to the effective date of the tenant’s bankruptcy.

Restriction on Landlord’s Right to Terminate or Modify.

After tenant has filed for bankruptcy protection, the landlord is not entitled to terminate or modify a lease solely because of a lease provision conditioned on:

1. The insolvency or financial condition of the bankrupt tenant;

2. The fact of the bankruptcy itself; or

3. The appointment of or taking possession by a trustee in a previous bankruptcy case.

However, the above restriction does not apply if governing law excuses a non-debtor party to the lease from accepting performance from or rendering performance to the bankrupt tenant and that party objexts to the assumption.

Bankrupt Tenant’s Right to Assign.

The bankrupt tenant may assign its rights under the lease, even if the lease or governing law prohibits (or restricts or places conditions on) assignment if:

1. The bankrupt tenant assumes the lease; and

2. Adequate assurance of future performance by the assignee is provided.

In the case of assignment, adequate assurance of future performance of a lease of real property in a shopping center includes adequate assurance as required for assumption AND adequate assurance that the financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time the bankrupt tenant became tenant under the lease.

Non-debtor parties are not entitled to enforce rights (whether contained in the lease or in governing law) to terminate or modify the lease upon assignment.

^[1] The bankruptcy filing automatically puts an end to collection or eviction actions and commands a landlord to cease such activities unless the landlord obtains a bankruptcy court order allowing such activities to proceed. These provisions, based on the “automatic stay” in the Bankruptcy Code, are in the form of prohibitions. Other prohibitions taking effect on the date of bankruptcy are discussed in the context of assumption and assignment of the lease.

^[2] For purposes of this discussion, the tenant’s bankruptcy representative will be referred to simply as bankrupt tenant.

^[3] The formula is arbitrary and is based on: (a) the amount of rent reserved under the lease; (b) the term of the lease; (c) the effective date of the bankruptcy and the amount of rent that was unpaid as of that date; and (d) the date on which landlord repossessed the leased property or the tenant surrendered the leased property and the amount of rent that was unpaid as of that date.