Lease Defaults and Restructuring: Strategic Considerations in Light of the Risk of a Tenant’s Bankruptcy (Part 3 of 3)
In our previous articles [Part 1 and Part 2], we discussed certain principles of bankruptcy law that affect the landlord/tenant relationship if the tenant voluntarily or involuntarily enters bankruptcy. This last article of the lease defaults and restructuring series explores the strategic considerations that commercial landlords should consider when the threat of a tenant bankruptcy is a real possibility; as well as, the strategic factors that commercial tenants should consider when contemplating voluntarily entering into bankruptcy.
Given the current market condition, commercial landlords can safely surmise that one or more of its tenants are facing, or may soon be facing, financial stress. Landlords that become aware of a tenant’s potential financial stress (whether through direct communication with the tenant, the tenant’s failure to pay rent or abandonment of its space, or through third-party sources) should attempt, as promptly as possible, to confirm whether the tenant has reached a point where it is (or will be) unable to pay all of its obligations as they become due. As part of that information-gathering exercise, the landlord should consider asking the tenant directly about its current financial condition and its prospects. If the lease provisions contain financial or operational reporting obligations on the part of the tenant, the landlord should press the tenant to deliver the required reporting.
The landlord should not be surprised if, during its discussions with the tenant regarding possible rent relief and lease modifications, the tenant states that it may file bankruptcy if the landlord does not agree to the tenant’s demands. Indeed, the threat of bankruptcy is often a negotiation tactic in many restructuring discussions, as the tenant could file bankruptcy and, without the landlord’s consent, reject the lease, which could leave the landlord with little or no recovery, or take advantage of a below-market rent and assume and assign the lease to a new occupant. This threat of bankruptcy and subsequent lease rejection (or assumption and assignment) could lead the landlord to agree to a negotiated workout to minimize the chances of the tenant filing bankruptcy. Although landlords should not necessarily take the threat of bankruptcy at face value, astute landlords will consider what their likely outcome would be if their tenants ultimately do file.
Below are some steps that a landlord should take when its tenant is facing financial difficulties and there is a possibility of the tenant’s bankruptcy.
A. Familiarize Yourself With Your Lease Documents
Before a landlord makes the determination to place the tenant in default or commences any discussions with a tenant concerning a possible lease modification, the landlord (with the assistance of counsel) must review the existing lease documents. In particular, the landlord should review the default provisions of the lease (and any relevant provisions which may excuse performance) to determine what actions or omissions that have occurred may constitute a default by the tenant, applicable notice and cure periods, and whether any event excuses the tenant’s duties to perform. In addition, the landlord should review applicable remedies for the default under the lease and any obligation to mitigate the damages caused by the tenant’s breach.
B. Default Notices: The Clock is Ticking
Once a landlord determines that a default or an event of default has occurred under the specific terms of the lease, it should send any required default notice to the tenant as soon as possible. With the threat of the tenant’s bankruptcy looming, the landlord needs to be cognizant of the substantial advantage of having the lease terminated prior to the bankruptcy filing. If the lease is not terminated before the tenant’s bankruptcy filing, the tenant will be able to remain in the premises until it either rejects the lease, assumes the lease, assumes and assigns the lease, or the automatic stay is lifted to allow the landlord to terminate the lease (and, until such time, the landlord will be unable to enforce any of its remedies for the tenant’s default and/or re-let the premises to a more palatable tenant). This will be the case even if the landlord has declared a default under the lease prior to the bankruptcy. In fact, once the tenant files bankruptcy, the landlord may be in violation of the automatic stay if it subsequently sends a default notice without first obtaining a lift-stay order from the bankruptcy court.
Accordingly, if the landlord seeks to have the leverage of having the lease terminated prior to the bankruptcy, taking the first step in that process – sending any required default notice – promptly is critical. The timing sensitivity is particularly acute since many leases give the tenant some period of time after the notice is delivered to cure the applicable defaults. Even worse, if the landlord waits too long to send any notice that is required under the lease, the tenant may argue that the landlord has waived the default, or that equitable principles (such as the doctrines of laches or estoppel) preclude the landlord from exercising its remedies.
The landlord is advised to send any required default notice to the tenant, even if it expects to negotiate a workout or does not yet intend to exercise its remedies. By sending the notice as soon as the default is identified, the landlord can maximize flexibility and avoid delays if the landlord needs to terminate the lease before the tenant files bankruptcy. Sending out a notice as soon as possible will also minimize the risk of the landlord inadvertently waiving remedies that are not promptly exercised.
In addition, the lease may permit the landlord to apply the security deposit or to draw a letter of credit against unpaid lease obligations after a default has occurred, so sending out the notice earlier may allow the landlord to exercise its rights to the security more quickly. This is particularly critical if the landlord holds a cash security deposit, because the automatic stay would delay the landlord’s ability to apply the cash security deposit against the outstanding amounts due under the lease. If the landlord is the beneficiary of a letter of credit, the landlord should limit its draws to the amount in default, so that the balance would not be held as a cash security deposit that could be subject to the automatic stay.
C. Possible Termination of the Lease
The proper termination of a lease before the tenant’s bankruptcy filing prevents the lease from becoming property of the tenant’s bankruptcy estate, and the tenant will not be permitted to elect to reject, assume or assign the lease. This significantly reduces the tenant’s leverage over the landlord, because the bankruptcy filing will not resuscitate a lease that was validly terminated before the bankruptcy, and the landlord will be free to pursue an eviction of the tenant. Even if the lease is terminated, the landlord would be free to negotiate a new lease with the tenant on terms satisfactory to the landlord, in the event the landlord determined that a restructured lease with the existing tenant is more desirable than entering into a lease with a new tenant.
The word “proper” is emphasized in the paragraph above, because a bankruptcy court could conclude that the landlord’s purported termination of the lease was ineffective. This can occur if the landlord fails to terminate in strict compliance with the express terms of the lease and applicable law. For example, if the lease requires the landlord to provide seven days’ prior notice to the tenant, but it purported to terminate the lease on only three days after delivering notice, the termination may be ineffective. As another example, if the landlord demands payments that are higher than those to which it is entitled under the lease, the landlord's subsequent termination of the lease because of the tenant's failure to pay such higher amount may be improper. Any action the landlord takes against the tenant under the mistaken assumption that the tenant was in default could expose the landlord to liability.
The Bankruptcy Code overrides lease language that provides for the termination or modification of the lease due to the tenant’s commencement of a bankruptcy case, the insolvency or financial condition of the tenant at any time before the closing of its case, or the appointment of a trustee in the tenant’s bankruptcy case. Only a “proper” termination of the lease before the tenant files bankruptcy will be recognized by the bankruptcy court.
Even if the landlord does everything that it is required to do under the lease and applicable law to terminate the lease, it should be prepared for the tenant to dispute the termination in court. In certain situations, the bankruptcy court may find a way to restore a tenant’s contract rights notwithstanding the lease terms. This is especially true where lease defaults are non-monetary, where a landlord can be made whole if the tenant makes all outstanding payments, or where the terms of the lease or the issues in dispute are unclear or subject to differing interpretations.
D. Tenant Bankruptcy vs. Lease Workout
In connection with defaulting the tenant and pursuing the landlord’s remedies under the lease, where such action may force the tenant into bankruptcy, the landlord must compare its potential recovery in the bankruptcy process against what the landlord may be able to achieve through a lease modification.
First, the landlord needs to consider what is the likelihood that the tenant will actually file bankruptcy. In doing so, the issues that the landlord should think about include whether: (a) the lease represents a significant portion of the tenant’s total expenses; (b) the tenant has other leases or other contractual or debt obligations that it is having trouble satisfying; (c) any principal or affiliate of the tenant has guaranteed the tenant’s lease obligations; and (d) the landlord holds any collateral to secure its claim for lease damages and in what form such security exists (e.g., cash security deposit or letter of credit).
If the lease represents a small portion of the tenant’s expenses, if the tenant is not experiencing difficulty in complying with its obligations under other leases and debt instruments, or if a solvent principal or affiliate has guaranteed the tenant’s lease obligations, the tenant may be less inclined to actually file bankruptcy if a lease workout is not agreed to. This may give the landlord more leverage during any lease workout discussions with the tenant.
On the other hand, if the tenant is behind in its obligations under several other leases and under its other contractual and debt obligations, and is in severe financial distress, the tenant is likely to file bankruptcy regardless of whether you reach a deal with the tenant with respect to your particular lease. In this circumstance, the landlord needs to closely consider what it will realize from the lease if the tenant files bankruptcy.
Second, the landlord needs to consider whether the rent under its lease is above-market (i.e., the rent under the lease exceeds the current market rate) or below market (i.e., the rent under the lease is less than the current market rate). If the rent is above-market, the tenant may be bold in requesting rent reductions, and less likely to agree to continue paying rent at the rate provided under the lease. In this situation, the landlord should be reminded that its claim for damages resulting from the tenant’s lease rejection will be subject to a cap under the Bankruptcy Code. Therefore, the landlord may be better off agreeing to a modification of the lease to avoid the tenant’s bankruptcy. Conversely, if the rent is below market, the tenant could potentially monetize the lease, so it may be less willing to suffer a lease termination. Instead, a tenant holding a below market lease may more seriously consider filing bankruptcy to interrupt any eviction action and to assign the lease to a third party. In this situation, the landlord may want to attempt to negotiate a termination of the lease, in lieu of incurring the risk of the tenant assigning the lease to a third party in bankruptcy where the tenant (rather than the landlord) will enjoy the profit on the assignment and the landlord could be stuck with a new tenant it never bargained for. As noted in our previous article, a number of courts have held that profit-sharing provisions in leases are unenforceable in bankruptcy because they effectively act as restrictions on assignment.
Third, closely tied to the market rental rate discussed above, the landlord needs to consider whether there are potential alternative tenants for the leased premises, and how likely it would be that the premises would remain vacant if the landlord evicts the tenant or if the tenant rejects the lease in bankruptcy. If the tenant presents a serious ongoing credit risk, and the landlord expects to be able to re-let the premises to an acceptable tenant relatively swiftly, the landlord will certainly lean toward rejecting the tenant’s workout demands and terminating the lease. In this situation, the landlord may be less concerned about the tenant’s bankruptcy, as a seriously struggling tenant might not be able to satisfy its obligations if it tried to assume the lease in bankruptcy; but the landlord would want to move ahead with terminating the lease aggressively to not have the availability of the leased premises for re-leasing delayed by the bankruptcy process. Conversely, if the landlord expects there to be relatively few acceptable replacement tenants, the landlord may be more interested in reaching a deal with the tenant (thereby reducing the risk of a bankruptcy filing).
Fourth, the landlord should consider what its likely outcome would be if the tenant ultimately were to file bankruptcy. For example, if the tenant files bankruptcy while it still remains in the premises, the landlord can take advantage of the landlord protections under the Bankruptcy Code, such as the debtor’s obligation to pay the reasonable value of its leasehold interest during bankruptcy, unless and until the tenant rejects the lease in bankruptcy. In addition, the landlord might be able to pursue its rights with respect to any credit support that the tenant provided, such as a cash security deposit, a letter of credit or third-party guarantee. However, the landlord should be cognizant of any possible limitations, such as how the automatic stay may delay its ability to exercise its setoff right with respect to a cash security deposit or its ability to draw on a letter of credit if the landlord is obligated to first provide notice to the tenant. The landlord should also take into account the legal fees it may incur in fighting the tenant in bankruptcy, as well as the limitation on the damages that a landlord may assert if the tenant rejects the lease.
In light of the COVID-19 pandemic, among the risks that the landlord must consider if it tenant files bankruptcy is the possibility that the bankruptcy court may suspend the tenant’s bankruptcy case, as recently occurred in the Modell’s Sporting Goods, Inc. and the Pier 1 Imports, Inc. cases. In those cases, the landlords endured substantial delays in receiving their post-petition lease payments during the period of the case suspensions.
Fifth, if the premises are located in a shopping center or in another type of multi-tenant development, the landlord should consider whether the bankruptcy of the tenant will impact other tenants’ rights under the landlord’s leases with those other tenant (such as co-tenancy conditions).
Finally, the landlord should also think through the tenant-side considerations that are discussed in the Tenant’s Considerations section below. For example, does the landlord believe that the benefits the tenant might obtain through bankruptcy are worth the disruption to the tenant’s business, and the costs and administrative burdens that a bankruptcy filing would impose on the tenant?
E. Opportunities For the Landlord To “Improve” the Lease Through Modification
In the current economic environment, deeply impacted by the Coronavirus, most landlords are unable to find substitute tenants that make more economic sense then maintaining the current tenant in place, even with the landlord granting the existing tenant rent relief. If the landlord determines that its best business decision is to grant the tenant rent relief, rather than pursuing its default claim and leading the tenant into bankruptcy, the landlord should consider certain modifications that can add value to the lease in exchange for such relief. The following is a non-exhaustive list of concepts the landlord may consider negotiating into the lease in exchange for granting the tenant rent relief:
- Additional credit support, such as a letter of credit or a third-party guaranty.
- Increased rent in future periods, particularly if the rent under the lease is currently below market.
- Extension of the term of the lease, particularly if the tenant has complied with its lease obligations until now and the landlord would otherwise like to keep the tenant in place.
- Reduction in the term of the lease or landlord early termination right, if the landlord would prefer the tenant to vacate soon.
- Elimination of any rights of first refusal or rights of first offer, or options to extend, on the part of the tenant.
- Restructuring of any economic terms, such as lease assignment profit-sharing provisions, that may be unenforceable in the tenant’s bankruptcy case. For example, the landlord may negotiate to receive more rent in the future, in exchange for removing the profit-sharing provision.
- Modification of the existing default notice and cure provisions to the extent they can be made to be more favorable to the landlord. For example, a default can be self-executing, without the requirement of notice by the landlord.
- In light of the current COVID-19 pandemic, a requirement for the tenant to apply for governmental assistance programs and to pay any proceeds from those programs toward deferred or forgiven rent.
If the landlord has mortgaged the property, it must confirm its rights to modify the applicable lease without lender’s consent. Among other prohibited modifications, the loan documents may limit the latitude that the landlord has to grant rent relief. In addition, many loans contain covenants require minimum debt-service coverage ratios, levels of rent and/or occupancy levels. Similarly, if the landlord is an investment trust it might have fiduciary duties to its shareholders that limit its options in aiding an insolvent tenant. In either event, the consent of the applicable third party (e.g., the mortgage lender or the shareholders) may be required as a condition to the landlord entering into the applicable lease modification.
When a tenant faces financial distress and contemplates seeking rent relief or other lease modifications from its landlord, the strategy of threatening bankruptcy may make sense to consider. If the lease is at an above-market rent, then the tenant’s threat to file bankruptcy could leave the landlord at risk of obtaining limited damages if the lease is subsequently rejected in a tenant’s bankruptcy case. If the tenant’s lease is at a below-market rent, then the tenant’s bankruptcy could leave the landlord unable to capitalize on terminating the lease and capturing the higher market rent under a lease with another tenant, because the tenant may elect to assume and assign the lease in bankruptcy without the landlord’s consent (notwithstanding a lease provision requiring landlord’s consent to the contrary). Additionally, the tenant likely can assume and assign leases without giving effect to any lease clause that requires the tenant to share with the landlord a portion of any net profits that the tenant receives in connection with the assignment. Moreover, as noted in our previous article, the tenant’s bankruptcy filing will result in the imposition of the automatic stay, which can delay the landlord’s ability to set off a cash security deposit against the tenant’s unpaid lease obligations; and as explained above, the landlord faces the risk of delays in receiving post-petition lease payments, in the event the bankruptcy court allows the case to be suspended in light of the COVID-19 pandemic.
As discussed in our previous articles, the tenant can typically assume, assume and assign, or reject a lease in bankruptcy without the landlord’s consent. After the lease is rejected, the landlord will be left with (a) an administrative expense claim for any unpaid post-petition rent relating to the period between the bankruptcy filing date and the rejection date, and (b) a general unsecured claim for damages arising out of the rejection (e.g., lost post-petition rent, the costs of re-letting the premises and attorneys’ fees, all to the extent such amounts are specifically provided under the lease). That general unsecured claim for rejection damages will be limited to the greater of (a) one year’s rent, or (b) 15% of the remaining rent due under the lease, up to a maximum of three years of rent. Particularly where the lease is at an above-market rent, the landlord will be faced with the risk of receiving little or no recovery on account of its rejection damages claim (in addition to the time and cost of pursuing its remedies in the bankruptcy). Accordingly, the threat of bankruptcy can give the tenant meaningful leverage during lease renegotiation discussions.
In some circumstances, it will make sense for the tenant to file a bankruptcy case if it cannot reach a workout agreement with the landlord, particularly if the tenant has substantial other debts that it is unable to pay, if it wishes to sell its assets to a third party that wants to purchase the assets “free and clear” of liens and claims, or where the lease is at a below-market rental rate. If the tenant files bankruptcy, in addition to the right to reject the lease described above, the tenant will typically have the right to assume, or assume and assign, its lease. To the extent that the tenant wishes to sell its assets to a third party, the tenant will be able to assign its lease to that party.
The threshold question for the tenant to answer is whether it can make a credible threat to the landlord that it will actually file bankruptcy. This will depend on the tenant’s particular facts and circumstances. Even financially-solvent tenants can file bankruptcy because insolvency is not a requirement for a bankruptcy filing. As a general matter, the tenant will be allowed to remain in bankruptcy if (a) it is suffering some sort of financial distress that can be ameliorated through the bankruptcy process (even if it is solvent), (b) it is not filing bankruptcy simply to obtain a tactical litigation advantage, and (c) the bankruptcy filing serves a legitimate bankruptcy purpose. Legitimate bankruptcy purposes include the reorganization of the tenant’s balance sheet, to halt and centralize pending or threatened litigation against the tenant, to make operational changes (including exiting geographic markets and rejecting leases), or to sell the tenant’s assets as a going concern to a third-party.
If the tenant files bankruptcy primarily to reject a lease and therefore to subject its landlord to the Bankruptcy Code’s statutory cap on rejection damages, there will usually be an open question about whether the bankruptcy case could be dismissed as a “bad faith” filing. The particular facts and circumstances of the tenant’s case will drive the bankruptcy court’s analysis. If the tenant is suffering financial distress that can be ameliorated by the bankruptcy case and has filed bankruptcy to preserve value for creditors, the court will be more likely to allow the case to proceed and allow the tenant to assume, assume and assign, or reject the lease. The reverse is true if the bankruptcy court finds that the tenant was not in financial distress and only filed bankruptcy to obtain a tactical litigation advantage. Ultimately, the tenant will be able to credibly threaten a bankruptcy filing to its landlord, if the tenant is truly in financial distress and if a bankruptcy filing would serve a legitimate purpose other than simply permitting the rejection of the lease.
If the tenant’s bankruptcy filing is able to proceed and is not dismissed as a “bad faith” filing, the tenant would most likely be able to assume, assume and assign, or reject its lease, so long as the requirements to do so under the Bankruptcy Code are satisfied (e.g., the obligation to cure defaults and to provide adequate assurance of future performance, if the tenant seeks to assume or to assume and assign its lease). Bankruptcy courts normally will defer to the business judgment that the tenant makes in determining whether it is most beneficial to the tenant to assume, assign or reject its lease.
Tenants should be aware of the material drawbacks and risks to a bankruptcy filing. First, a bankruptcy filing can be extremely disruptive to the business, particularly if appropriate pre-bankruptcy planning is not performed. For example, customers and vendors may refuse to do business with bankrupt tenants (particularly if no contract requires such third-party to continue doing business with the tenant), as those customers and vendors may be concerned that the tenant’s business will liquidate, and thus not be able to comply with its obligations to those customers and vendors. Second, Chapter 11 bankruptcy is a time-consuming and expensive process, and the tenant typically will need to pay the fees and expenses of not only its own professionals, but also those of any official committees that are appointed in the case. Third, operating in bankruptcy requires the tenant to comply with numerous administrative responsibilities, such as preparing bankruptcy schedules and statements of financial affairs, and appearing at required meetings and court hearings. The tenant will need to determine whether these drawbacks and risks to filing bankruptcy are worth the benefit of assigning or rejecting a lease in a bankruptcy case.
If you have any questions about this topic, please contact Michael Riela at email@example.com or your usual Tannenbaum Helpern contact.
E-Alert is a quarterly newsletter that features the latest thinking from Tannenbaum Helpern's various departments.