A Publication of WTVP

The current economic recession has seen both landlords and tenants of commercial real estate file bankruptcy. All types of restaurants, retailers and shopping centers have sought relief under Chapter 11. These companies are as diverse as Eddie Bauer, Baker’s Square, Circuit City, Linens ‘N Things and Movie Gallery (Hollywood Video). As the economy continues to decline, the list of real estate entities using Chapter 11 will continue to grow.

When the number of Chapter 11 tenants rejecting leases is coupled with the number of successful companies (such as Starbucks Coffee) that are closing store locations to weather the current recession, landlords of decimated shopping centers and strip malls are also seeking relief in bankruptcy. Once distressed landlords file their bankruptcy cases, they will have the same opportunity to assume or reject leases as enjoyed by their debtor-tenants.

Although little known by non-lawyers, there are fundamental rules under the Bankruptcy Code that permit any bankrupt debtor to assume or reject an unexpired lease of real property. The first rule is that a lease cannot be assumed unless all defaults are cured or adequate assurances are provided that all defaults promptly will be cured, other than one relating to the fact of the bankruptcy filing or the insolvency of the debtor. Generally, when a lease is assumed, everyone is happy because the assumption results in a cure of all defaults, or results in negotiated changes of terms between the parties.

Whether the debtor is a landlord or a tenant, the debtor’s duty prior to the decision to assume or reject an unexpired lease of nonresidential real property is the same. The debtor is required to timely perform all the obligations of the debtor (except those relating to the filing of a bankruptcy case or the debtor’s financial condition) until such lease is assumed or rejected. For example, when a landlord files bankruptcy, the debtor-landlord is obligated to timely perform all its duties related to the upkeep and maintenance of the premises prior to the assumption or rejection of the lease.

The Bankruptcy Code also provides a special set of rules where the debtor is the landlord, rather than the tenant. When the debtor-landlord rejects an unexpired lease of commercial real property, the rejection may amount to a breach that would entitle the tenant to treat such lease as terminated. If the tenant treats the lease as terminated, it may file a claim for any damages for breach of lease.

Alternatively, if the lease term has already begun, tenants can keep their rights under such lease, including those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment or hypothecation. In short, rejection of a lease by the landlord or its trustee does not divest tenants of their interest in the lease and the tenant’s interest cannot be modified or changed merely because of a landlord’s pending bankruptcy case.

A landlord may think that the lease has value so that if the lease is assumed, it will benefit the landlord’s unsecured creditors. Obviously, this is not a problem for the tenant, because the landlord’s assumption of the lease requires the landlord to cure (or provide adequate assurance of prompt cure) any of the landlord’s defaults under the lease. On the other hand, if the landlord is going to reject a lease, then the tenant needs to know that fact as soon as possible so that the tenant is in the best possible position to evaluate the impact of lease rejection on the tenant’s continued use of the premises.

What are the tenant’s options if the debtor-landlord rejects the lease? As noted above, the landlord’s rejection constitutes a breach of the lease. Even so, rejection does not constitute a termination of the lease unless the lease terms, applicable non-bankruptcy law or an agreement between landlord and tenant treat the landlord’s rejection as a lease termination. Thus, any tenant who learns that the debtor-landlord is rejecting the lease must first determine if the lease, or any other agreement or applicable law, enable the tenant to treat the lease as terminated once the landlord rejects that lease. Alternatively, if the lease term has already commenced when the debtor-landlord rejects the lease, then tenants may retain their rights under the lease for the balance of the term and any renewal or extension.

Rejection permits the debtor-lessor to escape the burden of continuing to provide services to the tenant under the lease, such as common area maintenance. When the tenant decides to remain in possession after the debtor-landlord rejects the lease, the tenant is permitted to offset against the rent due any damage that the tenant incurs that was caused by the landlord’s nonperformance. In other words, the tenant has the right to reduce future rent payments to the extent that the tenant spends the money to make repairs, improvements or perform maintenance that was the landlord’s obligation under the (now rejected) lease.

Although beyond the scope of this article, tenants must be careful to review any proposed sale of the real estate by the landlord pursuant to the Bankruptcy Code. All parties should be involved in the sale negotiations. However, tenants should be especially attentive to any efforts to sell the real estate "free and clear" of all interests in the property, including their leases.

Landlords and tenants must be diligent in protecting their rights under commercial real property leases. Each party must remain vigilant throughout the bankruptcy case. Pending the assumption or rejection of the lease, one party can insist that the other comply with all the terms of the lease and perform all of their related duties. iBi