What are the options when a tenant files for bankruptcy?

By Alan M. Burger, JD, and Nancy Nicole Workman, JD

In the current market environment, commercial property landlords are experiencing an increase in the number of tenants that are party to U.S. Bankruptcy Code Chapter 7 and Chapter 11 proceedings. Landlords should have a basic understanding of their rights when tenants seek bankruptcy protection.
Lease Options

Under the Bankruptcy Code, when a debtor-tenant files a petition in bankruptcy, the filing generally acts as an automatic stay on all actions of all of the debtor-tenant’s creditors, including the landlord. However, the filing generally does not prevent a landlord from obtaining stay relief and recovering possession of the leased premises if the lease terminated before the filing or the term expires during the bankruptcy proceedings.

If a debtor-tenant has an unexpired lease, the Code grants the court-appointed trustee a window of time — generally 120 days — to accept or reject the lease. During this period, the trustee must continue to perform all lease obligations. Courts view rent owed for the post-petition, pre-rejection period as an administrative expense, giving rent payment priority over other general unsecured claims and excluding it from capped expenses.

If the trustee elects to assume the lease, the trustee must first cure any existing defaults under the lease, compensate the landlord for any monetary loss resulting from the defaults, and provide adequate assurance of future performance. However, the trustee is not required to cure a default prior to assuming the lease if the default arose in connection with the tenant’s insolvency or before the trustee or another custodian took possession of the bankruptcy case. Nor is the debtor generally required to pay penalties arising from the tenant’s nonmonetary obligations under the lease.

If a trustee elects to reject the lease, the landlord is entitled to lease termination damages. These damages will be treated as a general unsecured claim unless the landlord is a secured creditor. The Code caps the landlord’s claim for lease rejection damages at the greater of two amounts: one year’s rent (calculated without acceleration) or 15 percent of rent due for no more than three years of the remaining lease term from the bankruptcy petition’s filing date or the landlord’s repossession, whichever is earlier. In addition to any termination damages, the landlord also may claim unpaid pre-petition rent without acceleration, with no cap on the amount of pre-petition damages.
Security Deposits

Despite the fact that a landlord’s claims in bankruptcy are generally treated as unsecured, the landlord is secured to the extent of its security deposit. A security deposit is generally considered property of the bankruptcy estate and thus the landlord must first seek the court’s relief from the automatic stay to set off a security deposit after the petition date. The purpose and application of the deposit should be clearly and carefully defined. For instance, it may be defined as reimbursement of improvements instead of security for future performance.

Based on a legal precedent, most courts hold that cash security provided to a landlord under a lease is applied against the landlord’s allowable or capped claim rather than the landlord’s gross claim, thereby reducing the unsecured claim that the landlord may have against the bankruptcy estate.
Letters of Credit

Letters of credit are treated as security for performance, to the extent of their value, issued on behalf of a debtor-tenant, naming the landlord as beneficiary. Unlike security deposits, letters of credit generally are not subject to the automatic stay because they are not considered to be property of the bankruptcy estate. Accordingly, the landlord may often draw on the letter of credit after the debtor-tenant defaults, even after the filing of a bankruptcy petition, without seeking court approval and without violating the automatic stay.

Although letters of credit are not considered assets of the bankruptcy estate, the judicial trend is to treat them like cash security and apply the proceeds against the landlord’s allowable claim under the Code. For example, in one case a landlord held a 10-year lease. As security under the lease, a bank issued a standby letter of credit to the landlord on behalf of the tenant. When the tenant ceased rent payments and abandoned the premises, the landlord drew on the line of credit. The tenant subsequently filed for bankruptcy and the landlord filed a proof of claim — reduced in part by the letter of credit proceeds. The court held that the intent of the parties was to treat the letter of credit as a security deposit because the letter of credit was offered in lieu of the debtor-tenant’s cash security obligation under the lease. Accordingly, the court held that the proceeds should be applied against the landlord’s allowable claim, not the landlord’s gross claim.

In another case, a different court addressed the substantive issue of whether proceeds from the letter of credit reduced the landlord’s allowable claim rather than actual damages. This case involved a subtenant that entered into a five-year sublease that required the sublessee to deliver an approximate $1 million in security under the sublease: $351,000 in cash and a $654,000 unconditional standby letter of credit issued by a bank, with the sublessor as beneficiary. As collateral for the letter of credit, the subtenant pledged cash deposited in a bank. After the subtenant filed for bankruptcy, the sublessor drew down the full amount of the letter of credit while the case was still pending and subsequently filed a proof of claim for lease termination damages.

The court found that the amount drawn on the letter of credit must be applied against the sublessor’s capped claim, thereby reducing the sublandlord’s unsecured claim in bankruptcy. The court reasoned that, although the letter of credit was not technically part of the bankruptcy estate, the subtenant had pledged more than $650,000 to the bank to secure the letter of credit, and those funds effectively would be used to pay the landlord.