Commercial Leasing Issues – When a Tenant Files Bankruptcy

  1. Bankruptcy Commencement
    1. The Petition
    2. Most common filings
    3. The Automatic Stay on Creditor Action
    4. The Scope and Duration of the Stay
  2. Assets and The Bankruptcy Estate
    1. Property of the Estate
    2. Role of Trustee
  3. Debtor’s Obligations
    1. Unexpired Leases
    2. Assumption or Rejection
    3. Assignment
  4. Lessor’s Rights
    1. Motion to Compel Assumption or Rejection
    2. Motion to Compel Surrender
    3. Writ of Possession (Federal remedy)
    4. Motion for Relief
    5. Outright Dismissal
  5. Special Circumstances
    1. Abusive Debtors
    2. Other Tactical Considerations
    3. Sub-lessees
    4. Preferential Transfers

In the context of a commercial lease, once the tenant has filed a bankruptcy—a landlord will learn how well the lease was drafted. Many provisions in the lease, such as use provisions will come into play during the bankruptcy.

I. BANKRUPTCY COMMENCEMENT

A bankruptcy begins in two ways: a) either the debtor has filed a voluntary petition; or b) creditors have forced an involuntary bankruptcy. Either way, a debtor may be eligible if they meet certain criteria—namely that their liabilities exceed their assets. The debtor needs the bankruptcy to provide them with some combination of: 1) discharging their debt; 2) discounting their debt; and 3) the time to accomplish that. The filing date of the petition is a bright-line date that creditors have to be mindful of.

In a commercial lease setting, the most common bankruptcy filings will be a Chapter 11 or a Chapter 7. (In a residential real estate context, the Chapter 13 is the more frequent filing.) When a debtor files a Chapter 11 or 13, this is a re-organization of their debt—it means that the debtor expects to pay some of its creditors. When a debtor files a 7, this is a liquidation of their assets, and unsecured creditors are unlikely to see any recovery of their debt.

Once the petition is filed, it creates an automatic stay on creditor action. [11USC §362] This means that a creditor cannot take collection or enforcement efforts against the debtor. With the stay in effect, even if the tenant is in default on post-petition rent, Lessor can not unilaterally terminate the Lease.

The automatic stay protection is powerful and violation of the stay can trigger damages. If it is found that the violation of the automatic stay was “willful” then punitive damages can be assessed. No specific intent to violate the stay is necessary—ex., computer automated collection is a “willful” violation. [Associated Credit Services v. Campion (In re Campion) 294 B.R. 313 ( (9th Circuit B.A.P. 2003)]

Additionally, a debtor could be entitled to emotional distress damages as well if s(he) can establish significant harm and establish that the cause of the harm is directly related to the violation of the stay. The Debtor doe NOT need to suffer any financial harm to establish emotional distress damages, and they can recover attorney fees. [Dawson v. Washington Mut. Bank (In re Dawson), 390F.3d 1139, 1148-49 (9th Cir. 2004)]

»Lesson to take away – the moment a creditor learns of a petition filing, a company-wide effort must be made to comply with the stay.

11USC§362 (a) Except as provided in subsection (b) of this section, a petition filed under section 301, 302, or 303 of this title, or an application filed under section 5(a)(3) of the Securities Investor Protection Act of 1970, operates as a stay, applicable to all entities, of—

(1) the commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title;

(2) the enforcement, against the debtor or against property of the estate, of a judgment obtained before the commencement of the case under this title;

(3) any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate;

(4) any act to create, perfect, or enforce any lien against property of the estate;

(5) any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title;

(6) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title;

(7) the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor; and

(8) the commencement or continuation of a proceeding before the United States Tax Court concerning a corporate debtor’s tax liability for a taxable period the bankruptcy court may determine or concerning the tax liability of a debtor who is an individual for a taxable period ending before the date of the order for relief under this title.

How long does the stay last? As to creditor action against the debtor, the stay lasts until:

1) An order granting relief from the automatic stay (lifts the stay)

2) dismissal of the case

3) discharge of the debtor

4) case closure

Exception – as to creditor acts against property (as opposed to the debtor) of the estate, the stay lasts until the property is no longer the asset of the estate.

II. Assets and The Bankruptcy Estate

When a debtor files bankruptcy, the bankruptcy Estate is created. [11USC541(b)]

Both Chapter 7 and Chapter 11 relief is available to individuals, partnerships and corporations, without any debt limit. The difference?

In a Chapter 7, all assets of the debtor become assets of the bankruptcy Estate and a Chapter 7 Trustee is appointed to marshall and liquidate the assets. The Trustee is in control of the Estate and makes all decisions as operation, sale, disbursement and is empowered to employ realtors, lawyers, appraisers and other professional to assist him or her in administering the estate. Depending on the size of the Estate, a Chapter 7 with one property for example, could conclude upon sale or abandonment of the asset—many times shorter than a year.

In a Chapter 11, the Debtor is attempting to pay some debt and will propose a Plan that addresses how to reorganize its debt. The duration of the plan could be three years. The Debtor acts as its own trustee to administer its own Plan. This is a “Debtor-in-Possession” scenario. In some cases, a creditor’s committee will be formed and a Trustee appointed when there is fraud, or criminal conduct on the part of the Debtor. [Ex.: Michael Schneider and the California Plan, Inc. multi-million dollar ponzi scheme. Mr. Schneider was indicted and some creditors forced an involuntary Chapter 7 bankruptcy on California Plan. There is a Chapter 11 for his personal assets and a Trustee was appointed, as well as a creditors committee. ]

III. Debtor’s Obligations

A debtor’s bankruptcy protection deals primarily with “unexpired leases” – that is, leases that have not already terminated.

[What about situations where the lease had expired on its own terms and the tenant needs to be evicted? Lessor can bring a motion for relief from the automatic stay which lifts the stay to allow unlawful detainer proceedings.]

In a Chapter 11, a debtor-tenant usually has an ongoing business. This is usually the source of income that is the basis of any Plan the debtor proposes to pay off creditors.

As a landlord, the primary concern is whether the Debtor intends remain in the property. With a Chapter 11, it is more likely that that the Debtor will assume the Lease and remain in the property. In order to do that, the Debtor must assume the unexpired lease.

  1. Unexpired Leases not in default – The debtor must assume or reject an unexpired lease within a statutory timeframe (under the new Code, usually120 days for non-residential real property leases) unless they bring a motion to extend that timeline. Prior to the Bankruptcy Reform Act of 2005, this time period could be dragged out by the debtor for much longer.**Apartment buildings, convalescent homes have been in some cases considered “residential” leases, in which case the time to assume or reject is 60 days in a Chapter 7, but any time before plan confirmation in a Chapter 11.
  2. Unexpired Leases where the tenant is in default – timeline is the same, but the tenant must “promptly” cure the default and give adequate assurance of future payments.

The Court can then approve the assumption. This means that the debtor is essentially reaffirming its debt and agreeing to be bound by the terms of the Lease.

11. USC.365. Executory contracts and unexpired leases

(a) Except as provided in sections 765 and 766 of this title and in subsections (b), (c), and (d) of this section, the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.

(b)

(1) If there has been a default in an executory contract or unexpired lease of the debtor, the trustee may not assume such contract or lease unless, at the time of assumption of such contract or lease, the trustee—

(A) cures, or provides adequate assurance that the trustee will promptly cure, such default other than a default that is a breach of a provision relating to the satisfaction of any provision (other than a penalty rate or penalty provision) relating to a default arising from any failure to perform nonmonetary obligations under an unexpired lease of real property, if it is impossible for the trustee to cure such default by performing nonmonetary acts at and after the time of assumption, except that if such default arises from a failure to operate in accordance with a nonresidential real property lease, then such default shall be cured by performance at and after the time of assumption in accordance with such lease, and pecuniary losses resulting from such default shall be compensated in accordance with the provisions of this paragraph;

(B) compensates, or provides adequate assurance that the trustee will promptly compensate, a party other than the debtor to such contract or lease, for any actual pecuniary loss to such party resulting from such default; and

(C) provides adequate assurance of future performance under such contract or lease.

(2) Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to—

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title;

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement; or

(D) the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.

What is “prompt” in curing the backrent? Could be as long as six months, or as short as one month — it will be on a case by case basis, and could vary by district, courthouse or judge. Assuming the Debtor supplies the back rent or brings the property taxes, and insurance current, the Lessor cannot refuse the tender.

In a Chapter 7, the Trustee has the same rights as the Tenant and would have to observe the same guidelines to assume the unexpired lease. However, the Trustee can bring a motion to assign the lease to a 3rd party. Remember, the Chapter 7 is a liquidation and if there is an ongoing business, the Trustee’s objective may be to sell it to the highest bidder and allow the purchaser of the business assume the Lease.

At this point, the Trustee will need to present evidence that the assignee will be able to perform, and factors the Court will look at are: history of timely payments, additional security, deposit requirement.

Many landlords really want to limit the ability of the Trustee to assign the Lease to the highest bidder, especially if the property is a strip mall or other retail setting. That is when restrictions on use, such as non-compete clauses, open hours, personnel and staffing minimum requirements will factor in on how easily the Trustee can assign the lease to a third party bidder.

IV. Lessor’s Rights

A. Motion to Compel Assumption or Rejection

For a Chapter 11 involving residential real property (apartment building), the Lessor can bring a motion asking the Court to set a stricter deadline for assumption or rejection.

  1. Upon rejection – the Lease has not be rescinded or terminated, it is breach situation so under the Ninth Circuit view, the contract rights survive. Accordingly, upon rejection of a lease, either express or deemed, the Lease has been breached and gives rise to a damages claim against the bankruptcy Estate. [11USC §365(g); In re OneCast Media, Inc. (9th Cir. 2006) 439 F3d 558, 563]
    **Unfortunately, the damages after rejection are an unsecured claim without priority. The likelihood of payout is small.
  2. For non-residential leases – the Debtor-in-Possesion (or Trustee) must immediately surrender the premises. [11USC §365(d)(4)]. This does not generally require further Court order, but when debtors do not cooperate, a motion can be brought.
  3. Rent for residential leases, pending assumption or rejection, the landlord is entitled to the fair rental value (not necessarily the same as the lease amount).
  4. Rent for non-residential leases, pending assumption or rejection, the Debtor-in-Possession or Trustee must make payments as specified in the Lease, even if FMV is lower. [11USC365(d)(3)

B. Motion to Compel Surrender

The Ninth Circuit allows Lessors to bring a motion compelling surrender of the property pursuant to 11USC §365(d)(4).

C. Writ of Possession

As part of the Motion to Compel Surrender, a Lessor can also seek a Writ of Possession to allow eviction without having to go through the state court unlawful detainer.

D. Motion for Relief from the Automatic Stay

This is the remedy most often sought by lenders and lessors. The Lender needs this if they are to foreclose on a property.

For lessors that already have an unlawful detainer going in state court—they need this relief in order to continue the eviction process against a debtor with a terminated lease. Remember, if the lease has not yet expired, the tenant can cure and assume the Lease obligation again which eviscerates your unlawful detainer action.

11USC§362(d) On request of a party in interest and after notice and a hearing, the court shall grant relief from the stay provided under subsection (a) of this section, such as by terminating, annulling, modifying, or conditioning such stay—

(1) for cause, including the lack of adequate protection of an interest in property of such party in interest;

(2) with respect to a stay of an act against property under subsection (a) of this section, if—

(A) the debtor does not have an equity in such property; and

(B) such property is not necessary to an effective reorganization;

E. Post Confirmation, or Assumption

If a Lease has been assumed and Debtor has failed to make post-petition payments, Lessor is entitled to administrative priority. However, there is a cap on damages. [11USC §502(b)(6)]

V. Special Circumstances

A. Abusive Debtors – Motion to Dismiss

When a Lessor has a situation with tenant who has filed successive bankruptcies, or may have done other acts recognized as “bad faith” or abusive, Lessors can seek dismissal of the case.

**Under the New Bankruptcy Reform, the automatic stay lifts after 30 days for debtors have a successive bankruptcy. Creditors may need to seek a “comfort” order to verify this. In the case of a 3rd filing, there is no automatic stay in effect.

Creditors can also seek in rem relief in those circumstances.

B. Other tactical considerations:

a. Objections to venue/jurisdiction

b. Objections to the Plan

c. Objections to Chapter 11 Disclosure Statement

d. Proof of Claim

e. Working with the Trustee

f. Motion to Compel Abandonment of Asset

C. Sub-lessees

The key determination with how sub-lessees are treated starts with determining whether there is a Subordination Non-disturbance and Attornment agreement in place. Without one, after the rejection of the lease by the Debtor (Sub-lessor), the sub-lessees possessory rights terminate as well. [Syufy Enterprises, L.P. v. City of Oakland (2002) 104 CA 4th 869, 882-883.

D. Preferential Transfers

When a Tenant is slow paying, and gets a few months in arrears and makes a lump sum payment—this is ripe for an avoidance claim. If it turns out that the tenant was insolvent when they made this lump sum payment and filed their bankruptcy petition within a short timeframe after—this payment can be clawed back from the Lessor.

>> Lesson to Take Away – negotiate micro-payments (without prejudice to your ability to collect a full payment) from the tenant rather than allowing a delayed lump sum payment.

 


This article written and © Julia M. Wei, Esq.

Julia publishes commentary on issues such as equity purchasing, foreclosure consulting, mechanic’s liens, co-ownership agreements and more on her California Real Estate and Lending Law blog: http://www.dirtblawg.com

Julia is an associate with The Law Office of Peter N. Brewer. The firm serves the legal needs of homeowners, real estate and mortgage brokers and agents, property managers, loan servicers, title companies, developers, investors, other real estate professionals and their clients. Mr. Brewer and his firm also represent clients in debt collection, breach of contract matters, and other litigation and transactional work. The firm’s client range from homeowners, brokers and lenders based in Santa Clara County, San Mateo County, Santa Cruz County, Monterey County, San Francisco County and Alameda County, as well as throughout other counties in California.