With several significant recent bankruptcy filings such as RadioShack and Saladworks, tenant bankruptcies become a greater risk for commercial landlords. Yet some landlords are not familiar with the rights provided to them under the Bankruptcy Code, nor are they aware of the protections provided to a tenant in bankruptcy. For example, certain lease provisions are unenforceable once a tenant files for bankruptcy. Should a landlord attempt to exercise its rights under the lease without first seeking approval from the bankruptcy court, the landlord may be subject to strong sanctions. The purpose of this article is to provide landlords with the questions and answers they should consider when a commercial tenant files for bankruptcy.

1. What effect does a tenant’s bankruptcy have on the lease?

Once a tenant files for bankruptcy, it has three options regarding the lease: it can assume the lease and continue performing all obligations, or assume and assign the lease to a third party, or reject the lease and surrender the premises and terminate performance. The Bankruptcy Code gives the debtor-tenant 120 days to decide whether to assume or reject the lease. During this period, the tenant can request one 90 day extension to decide what to do with the lease.

If the debtor-tenant fails to assume or reject the lease within the 120 day period, and no extension is granted, the lease is deemed rejected. This is a significant provision for landlords. To be proactive, landlords should review all pleadings filed in the tenant’s bankruptcy proceeding to see if the debtor-tenant sought an extension of time to assume or reject. Additionally, landlords should review the tenant’s motions to assume, motions to assume and assign, as well as motions to reject leases. The exhibits to these motions often contain schedules identifying the leases affected by the motion.

2. How does the “automatic stay” of the Bankruptcy Code apply to landlords?

The automatic stay is one of the most powerful protections provided to debtors in a bankruptcy proceeding. The stay acts as an injunction that prohibits creditors (including landlords) from commencing or continuing any proceeding against the debtor which could have been commenced prior to the bankruptcy. Before a landlord seeks to enforce its rights under the lease (such as through eviction, termination or foreclosure), the landlord should seek “relief” from the automatic stay by filing a motion with the bankruptcy court.

It is important for landlords to realize that the automatic stay becomes effective without notice or a hearing. Were a landlord to be found in violation of the automatic stay, the debtor-tenant may be able to recover actual damages from the landlord, including attorneys’ fees. If the violation is found to be intentional, the debtor-tenant may recover punitive damages.

3. What is the status of the tenant’s rental obligations while in bankruptcy?

While in bankruptcy, the Bankruptcy Code requires the debtor-tenant to satisfy all terms under the lease until the tenant either rejects the lease, or assumes and assigns it to a third-party. The landlord’s claim for unpaid rent receives “administrative claim” status, which is a higher priority of claim than many of the other claims against the debtor. Creditors holding an administrative claim against the debtor will receive payment on their claims before “unsecured creditors,” to the extent funds are available.

Should the debtor-tenant fail to pay the rent as provided under the lease, the landlord should file a motion for payment of administrative rent with the bankruptcy court. The rent motion in some instances can be heard within thirty to sixty days from the date in which it was filed. However, if an evidentiary hearing is needed to resolve the motion, several months could pass before the court issues a decision.

4. What are the landlord’s “rejection damages”?

If the debtor-tenant seeks to terminate and surrender the lease, that is “reject it”, the landlord may be entitled to a “rejection damage” claim. A landlord is not entitled to the full amount of unpaid rent due under the lease. Instead, the Bankruptcy Code limits the recovery a landlord may receive for rejection damages. The landlord’s rejection damage claim is capped at the greater of one year’s rent, or 15% of the rent due under the lease, not to exceed three years’ rent.

To determine the amount of the rejection damage claim, the landlord should first determine the amount of damages it is entitled to under lease, regardless of the Bankruptcy Code’s cap on rejection damages. If the total amount of the landlord’s claim is less than the amount of the cap, the Code’s limitation on damages does not apply.

5. What are the landlord’s rights when the debtor-tenant decides to assume the lease?

Assumption of the lease is permissible even if the terms of the lease expressly prohibit assumption. Before a debtor-tenant can “assume” a lease, the tenant must cure all monetary and non-monetary defaults. Additionally, the debtor-tenant must provide the landlord with adequate assurance that the tenant will be able to perform under the lease going forward.

A debtor-tenant must serve the landlord with notice of its intention to assume the lease. The debtor may provide notice of its intent to assume in either a motion to assume, or a plan of reorganization. Regardless of the method, under either approach the landlord has only a limited amount of time to review and file an objection to the assumption of its lease and/or the proposed cure amount. If the landlord chooses to object to the assumption of its lease, it needs to file a written objection with the court.

6. What are the landlord’s rights when the tenant assumes and assigns the lease to a third-party?

In conjunction with assuming the lease, the Bankruptcy Code allows the debtor- tenant to assign the lease to a third party. The party who is assigned the lease must provide the landlord with adequate assurance that it can meet the financial obligations of the lease. If the party who is assuming the lease cannot provide the landlord with adequate assurance, the landlord can object to the assignment.

Bankruptcy courts often apply the “business judgment” standard when considering whether to allow a tenant to assume and assign a lease. Under this standard, a debtor-tenant can assign a lease provided it can show the transfer of the lease is a reasonable business decision. Although courts provide debtor-tenants with broad discretion on the decision of whether to assume and assign a lease, the debtor-tenant must still demonstrate the assigned party’s ability to cure defaults under the lease and make future payments.

7. How does a landlord recover its administrative rent claim?

The Bankruptcy Code requires the debtor-tenant to timely perform all obligations under the lease until such time that the tenant assumes or rejects the lease. If a tenant files for bankruptcy and maintains possession and use of the property, yet fails to pay rent, the landlord should consider filing a motion for an administrative claim.

Although the landlord is entitled to the fair market value for purposes of determining the amount of its claim, the rental amount provided in the lease is presumed to be the fair market value. If the tenant believes it is entitled to pay an amount less than the rate provided for in the lease, the tenant must show why the contract rate is not fair market value.

8. When can a landlord recover attorneys’ fees from a tenant in bankruptcy?

Landlords may be able to recover attorneys’ fees incurred when a debtor-tenant seeks to assume the lease, or assume and assign the lease to a third party. To recover attorneys fees, however, the landlord must meet several criteria. First, the lease must expressly state that the landlord is entitled to recover attorneys’ fees as additional rent or in connection with the collection of rent. Next, the landlord must have prevailed in the proceedings in which it seeks to recover attorneys’ fees. “Prevailing” in a bankruptcy proceeding may include filing an objection to a motion of the debtor-tenant and receiving a favorable decision (i.e., objecting to the cure amount proposed by the tenant).

The matter in which the landlord seeks attorneys’ fees must be in pursuit or enforcement of the landlord’s rights under the lease, not matters where the landlord challenges the debtor-tenant’s rights under the Bankruptcy Code. Finally, the attorneys’ fees must be reasonable. To determine whether fees are reasonable, courts will consider factors such as the amount in dispute relative to the fees requested, the debtor-tenant’s good faith efforts to resolve the dispute and compliance with the Bankruptcy Code.

9. Can the landlord apply the tenant’s security deposit to the landlord’s claims?

Security deposits are considered property of the bankruptcy estate, and as such, are generally required to be returned to the debtor. Even so, landlords are permitted in some instances to setoff their claim against the security deposit. This benefits a landlord in two ways. First, instead of returning the deposit to the debtor-tenant, a landlord can setoff its claim against the deposit, and thus reduce the amount of the deposit that must be returned. Second, the landlord’s rejection damage claim is a general unsecured claim, meaning it gets paid after all other types of claims under the Bankruptcy Code. However, by applying the security deposit, the landlord is more likely to receive payment ahead of other unsecured creditors.

Landlords should not setoff any claims they have against a debtor-tenant’s deposit without first seeking permission from the bankruptcy court. If the parties reach an agreement as to the amount of the claim to be applied to the deposit, the debtor-tenant may consent to the landlord’s use of the deposit.

10. How can a landlord protect itself prior to and during a bankruptcy?

Requiring a third-party guarantor is one way in which a landlord may obtain better creditor protection when entering into a lease. The Bankruptcy Code does not prevent a landlord from taking action against a guarantor to a corporate debtor-tenants’ lease, provided the lease guarantor is not in bankruptcy.

Landlords can also seek protection through letters of credit. Using a properly drafted letter of credit allows a landlord to draw on the proceeds of the letter of credit should the tenant default under the lease. Letters of credit are generally not considered property of the tenant’s bankruptcy estate.

Once a tenant files for bankruptcy, it is important that the landlord stay informed regarding the status of the proceedings. This is especially true regarding claims bar dates and objection deadlines. If a landlord misses the deadline in which to file a claim, it may be barred from recovering on its claim. Similarly, if the debtor files a motion to assume the lease and assign it to a third party, landlords have a very limited amount of time to file an objection to the assumption. This deadline is also significant as a landlord may dispute whether the party assigned to the lease is capable of complying with the terms of the lease.