Evaluating Financially Troubled Tenants: Bankruptcy Risks and Lease Termination Agreements

CLIENT ALERT

By: Christopher CandonJaclyn Fisher

October 23, 2020

In the midst of the Covid-19 pandemic and the uniquely challenging obstacles it has created for our economy, the reliability of long-term leases are increasingly uncertain.  As moratoriums on commercial evictions and foreclosures have lapsed, lease termination agreements may provide landlords and tenants with an acceptable solution to a less than desirable circumstance.  Commercial landlords may consider using lease termination agreements to help shield themselves from the pitfalls that come when an existing tenant either becomes financially distressed or ultimately files bankruptcy.  Tenants faced with growing financial difficulties may similarly find that a lease termination agreement provides a suitable resolution to their troubles by eliminating further obligations under the lease.

Issues with Tenant Bankruptcy

A financially distressed tenant introduces many uncertainties to the landlord-tenant relationship.  If a tenant files for bankruptcy under an existing lease agreement, this presents numerous issues for the landlord, including:

  • The termination of a lease becomes much more complicated and requires Bankruptcy Court approval, which may not be granted if the tenant meets its post-bankruptcy lease obligations.
  • If there are outstanding rent payments due to landlord by the tenant at the time of the bankruptcy filing, the landlord typically will have to wait until the bankruptcy proceeding has substantially progressed to determine if it can recover those losses.
  • If the bankruptcy case results in a sale of the business, debtors routinely seek to assign lease rights to the purchaser. This could result in payment of outstanding amounts owed (good), but the landlord may have little or no control in deciding the next tenant of the premises.
  • If a reorganization is not possible or certain locations are deemed to be too burdensome, the bankrupt tenant may dictate the timing and terms of the rejection of the lease and returning to the landlord a “dark” space at a potentially disadvantageous time.

Lease Termination Agreement as Solution

Lease termination agreements may be advantageous to both tenants and landlords.  Frequently, lease obligations are among the most significant expenses of large and small businesses.  Tenants seeking to wind-down their business or restructure outside of bankruptcy may approach landlords with a lease termination proposal.

For landlords, if it appears a tenant has become financially distressed (i.e., tenant has failed to timely pay rent, tenant is suffering an industry downturn, or tenant attempts to renegotiate the terms of the lease), a landlord may propose a lease termination agreement to recover the premises and resume control over the space prior to a potential bankruptcy filing.

The exact terms of a lease termination agreement will vary from case to case.  In addition to the requirement that the tenant relinquish control of the leased premises to the landlord, lease termination agreements typically include a fee payable by the tenant to the landlord as consideration for allowing the tenant to terminate the lease early.  The primary advantage of a pre-bankruptcy termination for landlords is that the landlord is then free to lease the premises to a more financially solvent commercial tenant, while still recovering the termination fee from the previous tenant to aid in any unpaid rent and other expenses that may have accumulated.  In addition to this, a pre-bankruptcy agreement allows the landlord to avoid all of the potential obstacles laid out above.

Considerations

When structuring a lease termination agreement, it is important to consider timing Specifically, the timing of the agreement and the termination fee payable under such an agreement, in relationship to a potential bankruptcy filing.  In some instances, payment of a termination fee within ninety (90) days from the time the tenant files bankruptcy may be considered a revocable preferential payment under the Bankruptcy Code, and thus subject to recapture by the bankruptcy estate.  Even if a termination fee is not included in the termination agreement, there may still be a claim for fraudulent transfer, where the Bankruptcy Court considers the termination agreement to be a “transfer” under the Bankruptcy Code and where the court finds the tenant did not receive “reasonably equivalent value” in connection with the transfer.

Being proactive and evaluating the risks in a financially distressed situation is always crucial.  As noted, a pre-bankruptcy termination agreement may be a means for mitigating certain risk, but it is not a complete protection.  To protect against subsequent bankruptcy claims (preference or fraudulent transfer), landlords may include a “clawback” provision within the lease termination agreement.  Such a provision would provide that in the event of a tenant bankruptcy and demand for the return of the termination payment, any release granted by the landlord will be void, and the landlord will be entitled to prove up its entire claim in the tenant’s bankruptcy case (i.e., unpaid rent as if the termination had never occurred).  By including this provision in the termination agreement, the landlord can at least protect itself against being left with the worst of two worlds: no claim in its former tenant’s bankruptcy, and return of the lease termination payment.

Conclusion

While lease termination agreements are not an iron clad solution in the context of a bankruptcy filing by a commercial tenant, when weighed against the alternative, lease termination agreements if done correctly can be effective for commercial landlords to help insulate themselves from the ramifications that come with a financially insolvent tenant.  Moreover, such an agreement may also benefit the tenant and keep the tenant from even filing bankruptcy.