These difficult times may leave many residential and commercial tenants concerned about what will happen to them if their landlord ends up in bankruptcy. The US Bankruptcy Code gives the landlord in this situation a number of rights it would not otherwise have, but the tenant is not without protection. Although the law regarding assumption of leases is often the same regardless of whether the debtor is the landlord or the tenant (focused on whether keeping the lease is a benefit or a detriment to the debtor), Section 365(h) of the US Bankruptcy Code gives nondebtor tenants valuable options and rights when their lease is rejected by a debtor-landlord. However, bankruptcy courts have disagreed as to whether Section 365(h) prevents a debtor-landlord from undercutting those rights by selling the underlying real estate purportedly “free and clear” from the tenant’s lease under Section 363(b) of the US Bankruptcy Code.
Debtor-Landlord’s Assumption or Rejection of Lease
A landlord in bankruptcy has the right to either assume or reject each lease. If the lease is assumed, the landlord’s and tenant’s rights and obligations under the lease continue largely unchanged, although the tenant may end up with a different landlord if the property is sold in the bankruptcy.
When a lease is rejected by a landlord, the tenant has two options under Section 365(h) of the US Bankruptcy Code (Section 365(h) Rights):
- The tenant can elect to treat the lease as terminated and vacate the property. The tenant can then assert a general unsecured claim against the landlord’s bankruptcy estate for the landlord’s breach of the lease and all provable damages associated with the breach (e.g., loss in revenue, moving expenses, increases in rental expenses at the new location, etc.). This claim would then receive a pro rata share of any distributions to general unsecured creditors. Most cases, though, provide general unsecured creditors with a small, or no, distribution. Although lease rejection by the landlord may be welcome news to certain tenants—it could provide the tenant with the opportunity to get out from under a disadvantageous lease or a lease it no longer needs—landlords don’t often reject leases with above market rents.
- If the lease term has already started, the tenant can elect to retain its rights in the real property for the remainder of the lease term, including the right to remain in possession of the property, while remaining obligated to pay rent. If it makes this election, the tenant cannot assert a claim for rejection damages and the landlord will not be obligated to perform any of its lease obligation (like paying utilities and taxes or maintaining the property). The tenant, however, can offset post-rejection damages resulting from the landlord’s failure to perform its obligations under the lease. For example, if the landlord is required to pay utilities and maintain the property and fails to do so, the tenant can pay the utilities, arrange for maintenance, and then reduce its rental payment obligation by the amounts the tenant paid to perform the landlord’s lease obligations.
What Happens If the Debtor-Landlord Sells the Underlying Property?
Section 363 of the US Bankruptcy Code authorizes a debtor to sell its property “free and clear” of liens, claims, encumbrances, and interests under certain circumstances. The issue of whether a debtor-landlord may sell real property “free and clear” of its tenant’s rights (thereby terminating the tenant’s right to use and occupy the leased premises) is an issue that continues to divide courts.
If a debtor-landlord files with the bankruptcy court a Section 363 motion to sell its real estate, a tenant must act quickly and diligently, through knowledgeable bankruptcy counsel, to preserve its Section 365(h) rights by (a) objecting to the proposed sale, (b) monitoring all bankruptcy proceedings and all sale-related filings, (c) negotiating for appropriate language in all sale-related orders to protect its Section 365(h) rights, and (d) being prepared to file and litigate additional objections, if needed.
In one notable chapter 11 reorganization of a New Jersey casino, the debtors filed a motion to sell their real estate “free and clear of all liens, claims, encumbrances, and other interests of any kind” under Section 363. One tenant, a nightclub operator that leased part of the real estate to be sold by the casino debtors, negotiated for a provision in the sale order preserving “any rights elected to be retained by [tenant] pursuant to” Section 365(h) after the debtors rejected the lease. This negotiated provision of the sale order expressly preserved the tenant’s right to continue using its leased premises under Section 365(h) post-rejection.
In response to the debtors’ motion to reject the lease, the tenant filed a notice with the bankruptcy court electing the second option—to “retain its rights as a tenant under § 365(h)” and remain at the premises for the remainder of the lease term. Litigation between the purchaser and tenant ultimately resulted in several courts affirming that the tenant properly preserved its Section 365(h) rights to remain a tenant at the premises after the sale of the leased premises and rejection of the lease. This result was largely due to the tenant’s continuous efforts throughout the bankruptcy case to protect and preserve its Section 365(h) rights in the face of numerous court filings designed to reduce or eliminate those rights.
The takeaway is that if your landlord—commercial or residential—files a bankruptcy petition and you want to remain in possession of the premises you lease from the landlord, you should actively participate in the landlord’s bankruptcy case, through counsel, and preserve all of your rights as a tenant under Section 365(h) of the US Bankruptcy Code and otherwise.
Barclay Damon’s Restructuring, Bankruptcy & Creditors’ Rights Practice Area issues alerts on an ongoing basis to keep clients and friends up to date on important developments in the insolvency space. If you have any questions regarding the content of this alert, please contact Janice Grubin or Jeff Dove, co-chairs of the Restructuring, Bankruptcy & Creditors’ Rights Practice Area, at jgrubin@barclaydamon.com and jdove@barclaydamon.com, respectively; Robert Wonneberger, partner, at rwonneberger@barclaydamon.com; or Ilan Markus, partner, at imarkus@barclaydamon.com.