When the Tenant Becomes the Debtor
Almost every commercial or residential landlord that has done business for any length of time has received a least one notice that a tenant has filed a voluntary bankruptcy petition. What usually follows is a series of difficult choices for the landlord, animated by the inability, at least immediately, of freeing the premises from the tenant’s possession. Of course, the other main concerns are the ability to collect rent as it comes due and, if there are arrears in rent payments, to figure out the chances of collecting.
This article is intended to help the landlord understand the basic issues when a tenant files for bankruptcy and how to be prepared for the possibility of the tenant’s future bankruptcy filing. The economic stakes of a tenant’s bankruptcy are often high enough to merit obtaining experienced counsel to help determine the best course of action.
The Landlord Should Promptly Learn Facts About the Bankruptcy Case.
A landlord typically learns of a tenant’s bankruptcy by way of an official notice that arrives by mail and identifies the tenant as the “debtor.” Such a notice could come a week or more after the bankruptcy petition was filed. Other times, an email arrives from the tenant or its bankruptcy attorney, advising of basic facts regarding a filing that occurred only earlier that day or the day before.
In any case, as soon as possible the landlord who has not received an official notice should obtain written confirmation of the bankruptcy filing, with the full case name, number, and date of filing. While the official notice has all that information and more, if it has not arrived the landlord will likely need to obtain as much information as possible from the tenant’s bankruptcy attorney. Case information is also available on-line to anybody with access to the internet and who has obtained log-in credentials under the federal courts’ PACER system.
Bankruptcy Comes in Chapters.
A tenant might typically file bankruptcy under one of three available “chapters,” each of which represents a different set of challenges to the landlord. Under chapter 13 or chapter 11, the debtor-tenant usually continues to operate a business and to retain possession and control of assets and financial affairs. By contrast, chapter 7 is a liquidation proceeding, under which a trustee is appointed with authority to take possession of the debtor’s property and sell it to pay monetary claims against the debtor.
A. Chapter 7 Issues.
In Northern California, most commonly a residential tenant (who of course will usually be an individual) will file a chapter 7 petition (in some areas of the country, the chapter 13 case, discussed below, is more common). In chapter 7, a debtor will not seek to reorganize financial affairs, and instead any business of the debtor typically must be closed.
The individual chapter 7 debtor seeks a discharge of debts that would ordinarily include the amount of any rent owed to the landlord as of the date the voluntary bankruptcy petition was filed. Most individual debtors ultimately retain all assets, because they are entitled to exempt them as necessary to making a living or because they have little or no value over and above the amounts of liens or encumbrances and any applicable exemption amount.
Like other chapters in bankruptcy, chapter 7 ordinarily imposes an “automatic stay” on the collection of debt and efforts to take back possession. As such, the landlord is prohibited from collecting rent due as of the bankruptcy filing and from evicting the tenant from the premises.
The tenant, however, is not relieved of the obligation to pay rent that comes due for possession of the premises after the date of the bankruptcy filing. Landlords should understand that if the tenant paid a deposit for payment of rent and the deposit is still in the landlord’s control, the ability to set off past-due rent from the deposit is limited, at least until such time as the trustee determines that no part of the deposit can be recovered for the benefit of creditors and the bankruptcy case is closed. The landlord should refrain from effecting any set-off until the landlord can determine that the law allows it, usually after its existence has been disclosed to the trustee and the bankruptcy case is closed without action by the trustee to recover it. Experienced bankruptcy counsel can assist in that determination.
Except to the extent a deposit may be in play, the chapter 7 trustee is rarely otherwise interested in the debtor-tenant’s lease. But if the tenant fails to pay rent going forward and fails to surrender the premises, the landlord is nonetheless typically prevented from dispossessing the tenant, unless and until the landlord obtains permission from the Bankruptcy Court to do so, or until the bankruptcy case is closed. Any dispossession of the tenant cannot be based solely on the tenant’s bankruptcy filing (even if the lease contract says otherwise): if a tenant has paid rent current and has otherwise complied with terms of the lease, the landlord will have no grounds to retake possession.
But where a tenant wrongly holds over or otherwise retains possession without payment of post-bankruptcy rent, the landlord will likely need qualified legal assistance to determine whether relief from the automatic stay will be likely granted at any particular time, and to file the necessary papers with the Bankruptcy Court to obtain such relief to go forward with an eviction proceeding. Landlords should refrain from “self help” during this time, because a knowing violation of the automatic stay can have dire consequences, including payment an award of punitive damages to the individual debtor harmed by such a violation.
Finally, in rare cases the landlord receives a second official notice, stating that the chapter 7 trustee anticipates a recovery of money that will enable the trustee to pay some amount on creditors’ claims. The notice will include a deadline for the filing of proofs of claim. Missing the deadline almost always means that the tardy creditor will be paid nothing on its claim against the debtor.
B. Chapter 11 and Chapter 13 Cases Involve Yet More Legal Issues.
The situation is more complex when the landlord faces a tenant’s chapter 11 or chapter 13 bankruptcy. The following discussion is in the context of a chapter 11 case, which most commonly is pursued by commercial tenants that continue in operation. Chapter 13 is open only to individuals, but like chapter 11 it offers the debtor an opportunity to retain assets and reorganize the debtor’s financial affairs, including to retain rights under a residential or commercial lease so long as certain standards are met.
As in chapter 7, the landlord’s rights to evict the debtor-tenant are restricted in chapters 11 and 13. Typically the tenant owes past-due rent or other charges under the lease at the time the bankruptcy petition is filed, and payment is “put on hold” by the automatic stay. The debtor-tenant has an opportunity to propose a method to repay such amounts and to propose a future course of action in regard to the lease. But meanwhile, the tenant is obligated to maintain timely post-bankruptcy rent payments under the terms of the lease. The landlord often will need experienced legal counsel to help determine the extent to which the landlord can enforce rights under the lease going forward, until such time as the debtor proposes, under its Plan of Reorganization, how obligations under the lease are to be handled.
A chapter 11 debtor can propose to restructure ongoing contracts through the Plan of Reorganization. A commercial tenant’s chapter 11 can therefore can have an impact on the rights of its landlord going beyond payment or nonpayment of past-due rent. Typically the debtor-tenant will seek to “assume” the lease, to “reject” the lease, or to assume and assign the lease to a third party, which party would then be bound by terms of the lease. Assumption generally means that the landlord-tenant relationship will continue to exist on the same terms stated in the existing lease. There are a number of requirements to assumption of a lease, including a proposed method to cure any monetary arrearages, and a showing of the ability to meet future rent and lease obligations. Where an assumption is contemplated, the debtor must also show that the new party will be financially capable of performance, among other things. It is possible that the debtor, who cannot force acceptance of modified terms in the lease, will seek the landlord’s agreement to modify terms notwithstanding. In such case, the landlord is generally in a position to seek material concessions from the tenant in return for such agreement.
If the tenant rejects the lease, the landlord-tenant relationship will be terminated. As such, the tenant must vacate the premises and any damages that result to the landlord become payable only as a nonpriority unsecured claim, typically among many other claims of vendors and customers of the debtor.
The provisions of the Bankruptcy Code that govern the treatment of leases are complicated and involve a number of deadlines. Almost invariably, the commercial landlord faced with a tenant’s chapter 11 or chapter 13 case will need the help of experienced counsel to navigate the process and if necessary to oppose the Debtor’s efforts to assume a lease where it cannot demonstrate that it meets all legal requirements.
Early in the case, the landlord should gather copies of all lease documents and memoranda and should document the status of payments from the tenant under the lease. The landlord should be ready to file a timely proof of claim in the tenant’s bankruptcy case, to provide documentation of all amounts due under the lease as of the bankruptcy filing and thereafter. The filing of the proof of claim is generally necessary to assure that the landlord’s rights are adequately protected, as the tenant may not have adequately documented its obligations under the lease when it filed its bankruptcy petition and schedules. While the filing of the proof of claim results in the landlord’s submission to the jurisdiction of the Bankruptcy Court (and thus typically the loss of rights, for example to a jury trial), the landlord’s rights to payment are generally best served by the filing of a proof of claim.
In any bankruptcy case, the landlord’s claim to damages for the tenant’s breach of the lease is subject to limitation under a formula that generally restricts payment of consequential damages (i.e. lost future rent). This limitation can come into play should the tenant seek to reject the lease early in its term.
The Landlord Should Always be Ready for a Tenant’s Potential Bankruptcy Filing.
To help protect against undue losses in a future bankruptcy case, the landlord should diligently avoid the accrual of past due rent. Once the tenant enters bankruptcy, it becomes far more difficult to recover the money owed. As such, as soon a tenant falls behind on the rent, the landlord is best served by taking appropriate action under the lease and state law. In addition, if a tenant falls well behind on periodic lease payments and makes a large “catch up” payment but soon thereafter files bankruptcy, the large payment may be subject to disgorgement as a so-called “preference payment,” adding considerable salt to the wound otherwise inflicted by bankruptcy. Collecting rent in the ordinary course is thus the best policy.
The landlord should also be diligent regarding documentation not just of rent due, but of all the terms and conditions of the lease contract. As such, the landlord should avoid undocumented “side deals” with the tenant. If a bankruptcy is filed and a fight develops over just what terms are to be assumed or rejected by a debtor, proper documentation of the landlord’s rights will be critical.
Finally, it is best that the landlord be generally familiar with the bankruptcy process. More issues than are summarized above may arise in a tenant’s bankruptcy. As such, it is not intended to provide legal advice, which is properly based on detailed knowledge of all relevant facts. But when the landlord knows the general principles, if and when a tenant enters bankruptcy the landlord will be aware of the obstacles and will know when to contact an attorney experienced in bankruptcy law who can help avoid the worst pitfalls and help plan for the future.