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Bankruptcy and Insolvency

Commercial Real Estates Lease Issues II: My (Pick One) [_]Landlord [_]Tenant is in Bankruptcy

Tuesday, October 06, 2009

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In the previous issue of Good Company, Bruce Bagdasarian offered tips and strategies for both landlords and tenants who find opportunities in the current real estate market - voluntarily or involuntarily - to renegotiate their commercial real estate leases. In many instances, each party's goal may be to avoid a bankruptcy filing by the other; in other instances, a bankruptcy reorganization case is a strategic move.

Tenant Bankruptcies Update
By now, most commercial landlords are all too familiar with the principal Bankruptcy Code provisions governing commercial leases in a chapter 11 filed by a tenant: (1) the tenant must pay rent (at the contract amount) and perform its other lease obligations until the lease is assumed or rejected; (2) the tenant has a maximum 210-day period in which to assume or reject the lease (an initial 120 days plus one maximum 90-day extension), after which no further extensions can be granted without the landlord's express consent; and (3) most contractual anti-assignment restrictions that would otherwise prevent a tenant from assigning its lease to another entity are either largely unenforceable or, as in the case of shopping center leases, subject to certain restrictions on changes in rent source, percentage rent and tenant mix. The 210-day limit on assumption or rejection became effective in 2005. It was the latest in a chain of amendments restricting or conditioning the time in which commercial tenants had in which to assume or reject their leases. An entire industry had spawned in which the rights to assume or reject commercial leases (colloquially called "designation rights") were bought and sold like commodities, in part because bankruptcy courts exercised wide latitude in imposing absolute deadlines. The 210-day limit proved too restrictive for much of the designation rights market, especially in large retail cases involving many leases. As a result, a bill (H.R. 1942) was introduced in Congress earlier this year to repeal the 210-day limit and revert to a 1980's-era structure for lease assumption or rejection: one initial 60-day period, and no limit on the number of additional extensions that a bankruptcy court could grant "for cause shown." The bill, which also contains other substantive amendments affecting business reorganizations, would not apply to any cases already pending on the date of its enactment - if it is ever enacted.

Landlord Bankruptcies
Most of the Bankruptcy Code provisions governing the treatment of commercial leases favor landlords whose tenants are in bankruptcy. However, when the tables are turned and the landlord is in bankruptcy, the Bankruptcy Code provides significant protections to the tenant's rights under the lease, and a material disincentive against the landlord rejecting the lease. Where a tenant must immediately surrender the leased premises to the landlord upon rejection of the lease in the tenant's bankruptcy case, a tenant whose landlord rejects its lease gets a choice between two options.

Option 1: Leave.   The tenant can treat the landlord's rejection as having terminated the lease, under Section 365(h)(1)(A)(i) of the Bankruptcy Code. "Termination" is a different legal result than mere "rejection," since the overwhelming majority of the case law treats "rejection" as simply a breach of the lease, and not a termination. If the tenant has ready access to more affordable space elsewhere, treating the lease as terminated may pose some strategic advantages for the tenant.

Option 2: Stay.   The tenant can elect to retain both its rights under the lease and its possession of the leased premises for the remaining term of the lease, including any renewal or extension periods. Although the tenant would remain obligated to pay rent in the amounts and at the times required by the lease, the tenant can also offset against the rent any actual damages caused by the landlord's rejection of the lease. For example, in an office building or retail space at which the landlord is obligated to provide common area services that benefit the tenant, such as security, utilities, snow plowing, advertising, the cost of obtaining those services from other sources after lease rejection can be deducted from any rent owing the landlord.

The "stay" option is extraordinary, but it is not without pitfalls or risks. First, the commercial realities of being potentially the sole remaining occupant in an otherwise empty building or retail facility may be far from ideal. In addition, the many aspects of state real estate law that otherwise govern the lease and other rights in the property can complicate exercising the "stay" option. Secondly, the landlord's mortgagee may want to foreclose its mortgage and not recognize the tenant's rights under the rejected lease, particularly if the lease was subordinated to the mortgage. The tenant's lease may have been a sublease, in which case the prime landlord may not feel bound to recognize the tenant's "stay" rights absent a contractual obligation in any consent to the sublease that it executed with its tenant (your sublease landlord). Finally, the landlord may attempt in its own bankruptcy case to sell the real estate free and clear of all liens, claims and encumbrances under Section 363 of the Bankruptcy Code. In that event, the bankruptcy court might have to decide which of the two Code sections to enforce: the tenant's "stay" option, or the landlord's sale free and clear of the tenant's "stay" option.

The duel between conflicting provisions of the Bankruptcy Code described above arises less frequently than the court applying Bankruptcy Code provisions and remedies to the otherwise governing provisions of state real estate law. One thing is certain, however: commercial real estate leases raise complex issues in bankruptcy cases filed by either the landlord or the tenant. Understanding and anticipating how those issues will affect your lease is a critical component of being prepared to respond to a bankruptcy filing, or to know whether a filing might be in your best interests.

This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.