What to Do When Commercial Leases End Up in Bankruptcy

The COVID-19 pandemic is forcing many businesses to close, leaving landlords in the lurch.

The COVID-19 pandemic continues to shake up the nation’s economy. Long-standing companies such as JC Penney, J. Crew, Neiman Marcus, Modell’s Sporting Goods, Brooks Brothers, Lord & Taylor, Men’s Wearhouse, GNC, California Pizza Kitchen, 24 Hour Fitness and Gold’s Gym have filed for bankruptcy. Unfortunately, it is highly likely that many more companies, large and small, will file for bankruptcy protection in the coming months.

For landlords of commercial real estate, these bankruptcies can have significant impacts on their rights and remedies under their leases. When confronted with a tenant who has filed for bankruptcy or may be considering it, understanding the basics of those effects is helpful.

Know the Code

The treatment of leases in bankruptcy is governed by the U.S. Bankruptcy Code. When a bankruptcy petition is filed, Section 362 of the code dictates that an “automatic stay” immediately applies. This prevents all actions against the debtor or their property. It also generally means that a landlord cannot take any actions to enforce their rights under a lease, such as sending a notice demanding the payment of rent or other lease obligations incurred before the bankruptcy filing or pursuing an eviction action.

Section 365 of the code governs the assumption, assignment (following assumption), or rejection of a debtor’s real property leases. The general rule is that the debtor must continue to pay rent and other obligations under a lease after petitioning for bankruptcy, until the rejection of the lease, but not delinquent rent and other lease obligations accruing prior to the bankruptcy (which instead are addressed through the bankruptcy claims process). However, the bankruptcy court may permit deferral of such payments until 60 days after filing. 

Indeed, in a number of recent retail bankruptcy cases (including Pier 1, 24 Hour Fitness and Modell’s Sporting Goods), courts have permitted debtors to defer payment of their postbankruptcy lease obligations because they suffered revenue shortfalls following shelter-in-place and similar governmental restrictions related to the COVID-19 pandemic.

Generally speaking, a tenant has 120 days after a bankruptcy filing to decide whether to assume or reject its real property leases. Following a motion by the debtor or the landlord, a bankruptcy court has the discretion to extend this 120-day period by up to 90 days; however, any further extension requires the consent of the landlord. A lease that is not assumed or rejected within the relevant time period (or confirmation of a Chapter 11 plan if earlier), is deemed rejected, and the tenant is required to immediately vacate the premises. 

If the debtor assumes a lease, they are required to cure all lease defaults from before and after the bankruptcy petition, including any delinquent rent and other obligations (with some exceptions for incurable nonmonetary defaults). The debtor also must provide “adequate assurance of future performance” under the lease. There are special requirements if the leased property is in a shopping center, including  assurance that any percentage rent due under the lease will not decline substantially; continued compliance with radius, location, use and exclusivity provisions; and no disruption to the shopping center’s tenant mix or balance.

Once a lease is assumed, any ongoing obligations must be paid in a timely manner, with any unpaid amounts treated as an “administrative expense” of the bankruptcy estate. These generally must be paid in full in order for the debtor to exit bankruptcy under the code.

Importantly, if an assignee satisfies the conditions for lease assumption, a debtor may assign an assumed lease despite provisions of the applicable lease that restrict or condition the tenant’s ability to assign. However, if the leased property is in a shopping center, then the financial condition and operating performance of the proposed assignee must be similar to that of the debtor at the time they became a tenant. 

Into the Breach

If the debtor rejects a lease, it is deemed a breach. This allows the landlord to terminate the lease and retake possession of the premises. In addition, the landlord can assert a claim against the bankruptcy estate for damages resulting from the lease rejection. State laws govern the initial calculation of these figures. 

However, Section 502 of the code caps such damages at an amount equal to the “rent reserved by such lease, without acceleration, for the greater of one year, or 15%, not to exceed three years, of the remaining term of such lease.” If the landlord’s damages under state law are less than the code’s cap, then they simply have a claim equal to damages under state law. “Rent reserved” for purposes of calculating the cap generally includes base rent, percentage rent, real estate taxes, insurance and common area maintenance (CAM) charges, especially if the latter three categories are described as “rent” or “additional rent.” After exhausting any security deposit, the landlord’s claim for rejection damages is treated as a “general unsecured claim” under the code, which typically ends up being paid a fraction of the amount owed. 

Other issues that may arise in a particular situation include treatment of “stub rent,” which is the portion of rent remaining when a tenant files bankruptcy in the middle of the month; application of security deposits; recovering guaranties or letters of credit securing a lease; and preferential transfer claims for lease payments received shortly before bankruptcy. 

Further complicating matters, U.S. bankruptcy courts do not view these issues uniformly. For example, while some courts require debtors to fully pay prorated stub rent, CAM and property taxes attributable to the portion of the month following a bankruptcy filing, other courts only require payments that fall due after the bankruptcy.

Gary M. Kaplan is a partner in Farella Braun + Martel’s San Francisco office and leads its restructuring, insolvency and creditors rights practice. Gregory B. Shean is a partner at Farella and chairs the real estate transactions and development industry group.