When a commercial real estate tenant files a chapter 11 bankruptcy, the landlord is faced with unfamiliar issues. Although each case is unique due to its own facts and the rulings of the bankruptcy court, here’s a basic overview of issues facing a landlord when its commercial real estate tenant files a chapter 11 bankruptcy case.
The Bankruptcy Code treats non-residential real property leases as “executory contracts” that the debtor-tenant may assume or reject. Executory contracts are governed by Bankruptcy Code § 365. Bankruptcy Code § 365(d)(3) requires a debtor-tenant under a non-residential real property lease to fully and timely perform its obligations from the date the bankruptcy starts (the “Petition Date”) through the assumption or rejection date.
[Editors’ Note: Does Artificial Intelligence (AI) fit into the conversation? Read Analyzing Executory Contracts: Can AI Save Us from The Contract Tsunami?]
Commercial real estate debtor-tenants must pay the rent post-petition. Bankruptcy Code § 365(d)(3) requires a debtor-tenant to pay the full contract rent when due. Until the court enters an order approving the rejection of the lease, the debtor must fulfill all other obligations under the lease. That includes maintenance, repair, taxes, and insurance. In enacting Bankruptcy Code § 365(d)(3), Congress sought to “relieve landlords of the uncertainty of collecting rent fixed in the lease in full, promptly, and without legal expense during the awkward post-petition pre-rejection period.”1
Nevertheless, some uncertainty remains. Courts differ as to the debtor-tenant’s obligation under Bankruptcy Code § 365(d)(3) to pay rent for the post-petition portion of the initial month of a bankruptcy case, often called “stub rent.” Some courts have ruled that the obligation to pay rent arises on the day that rent is due, which usually occurs before the Petition Date (the “billing date approach”). Other courts have ruled that the obligation arises on each day during the month that the tenant occupies the leased premises. In other words, throughout the stub rent period (the “proration approach”). Under the billing date approach, the stub rent arose pre-petition, and therefore the commercial real estate tenant-debtor is not required to pay the landlord under Bankruptcy Code § 365(d)(3). The landlord is entitled only to a general unsecured claim against the estate for such rent.2
Under the proration approach, stub rent is deemed to arise post-petition and pre-rejection, and must be paid by the debtor-tenant.3
Bankruptcy Code § 365 provides that a debtor, in its business judgment, may assume or reject a non-residential real property lease. By assuming a lease, the debtor-tenant’s estate accepts all obligations under the lease. Also, in assuming a lease, the debtor-tenant’s estate is required to cure all defaults under the lease, including past payment defaults.4
Assumption usually favors the commercial landlord. Once assumed, the lease binds the estate, and any breach results in a claim for the landlord. The resulting claim has administrative expense priority over unsecured pre-petition claims and gets paid in full before unsecured pre-petition claims get paid at all.5 Further, assumption signifies cure of most pre-petition defaults and assurance that the lease terms will continue to be performed.
The commercial landlord’s appraisal of an assumption may be different where the lease is below market. Having assumed the lease, the debtor-tenant may then sell or assign it to third parties despite any provision in the lease forbidding assignment.6
Moreover, the debtor-tenant may do so even if the landlord does not approve of the assignee. There are special rules for shopping center leases under section Bankruptcy Code § 365(b)(3) which may protect such landlords from assignment by an assuming debtor-tenant.
A commercial real estate tenant-debtor may choose to reject the commercial lease. Rejection signifies the debtor-tenant’s decision to breach and terminate the lease. Under Bankruptcy Code § 365(d)(4), when a lease is rejected, the debtor-tenant is obligated to “immediately surrender such non-residential real property to the lessor.” Most courts agree that rejection of a lease also terminates any sub-leases.7
The rejection of a lease constitutes a breach of the lease, treated as if it occurred immediately prior to the petition date. Most courts agree that the commercial landlord will have a general, unsecured claim for unpaid pre-petition rent, taxes, repairs, and damages to the premises along with other pre-petition obligations under the lease.8 Courts agree that the commercial landlord is entitled to an administrative expense priority claim for unpaid lease obligations from the post-petition, pre-rejection period.9
But what of future rent foregone? The commercial landlord is entitled to a general unsecured claim for future damages caused by the rejection of the lease, including future rent. However, this aspect of the commercial landlord’s claim is limited by a cap set forth in Bankruptcy Code § 502(b)(6)(A). The commercial landlord’s claim to future “rent reserved by such lease” is limited to the greater of 1 year’s rent or 15% of the remaining rent, not to exceed 3 years. Courts disagree as to whether the 502(b)(6)(A) cap applies to all future obligations owed under the lease, including repair and maintenance obligations, or just to rent.10
Unsecured claims for rejection damages and future damages, as well as administrative priority claims for post-petition and pre-rejection obligations, must all be asserted in compliance with orders entered by the bankruptcy court. Usually, this means that the landlord must file 1 or more proofs of claim, as directed by court order, on or before a bar date. Missing a bar date may cancel the claim.
[Editors’ Note: To dive deeper, you may want to read Dealing with Corporate Distress 11: How to Protect Your Claim In & Out of Bankruptcy]
The Bankruptcy Code was revised to provide that a debtor must assume or reject a non-residential real property lease within 120 days after the petition date. Otherwise, the lease is deemed rejected.11 Bankruptcy Code § 365(d)(4)(B)(i) permits the court to extend the 120-day period for 90 days on the motion of the debtor-tenant or lessor for cause. Courts routinely grant one 90-day extension. However, the Bankruptcy Code now makes clear that additional extensions cannot be granted without “prior written consent of the lessor.”12
An impatient commercial landlord may move, at any point, to compel the debtor-tenant to assume or reject the lease. While such motions may encourage the debtor-tenant to negotiate, typically the court does not grant them absent a showing of cause. To find such cause, courts require evidence that the tenant failed to perform continuing obligations under the lease (such as paying rent, taxes, or common area maintenance fees) and that such failure is material.
[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on June 28, 2019 and was most recently edited by Courtney Smith]
©2022.DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Paul is a partner in the Insolvency & Reorganization Practice Group at Jaffe Raitt Heuer & Weiss, P.C. in Detroit, Michigan. He specializes in representing debtors, secured and unsecured creditors, unsecured creditors' committees, asset purchasers and trustees in reorganizations, liquidations and other insolvency proceedings nationwide. Paul earned his Bachelor's degree from James Madison College at…
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