by Thomas W. Rogers, special contributor

As the economy pushes more businesses into financial trouble, many tenants are seeking bankruptcy protection.  This article will provide a brief overview of the bankruptcy process and its effect on the landlord-tenant relationship.

The process

Bankruptcy permits the tenant to shake off unprofitable financial relationships without the usual unpleasant consequences.  A tenant commences a bankruptcy case by filing a petition seeking bankruptcy relief.  The date on which a petition is filed is referred to as the petition date.  Events and transactions before the petition date are generally referred to as pre-petition matters while claims, events and other actions occurring or arising after the petition date are called post-petition matters.  Within a few days of the filing, the bankruptcy clerk serves a notice on parties the tenant identifies as creditors.

Filing the petition establishes a bankruptcy “estate” over which the court gains jurisdiction.  All of the tenant’s property, including leasehold interests, make up the estate.  Once a tenant has filed bankruptcy, an automatic stay goes into effect that prohibits the landlord from proceeding with collection or eviction efforts, regardless of whether the landlord has been notified of the filing.

Violations of the automatic stay, including any demand for pre-petition rent or late fees, can sometimes subject the violator to harsh penalties.  Thus, it is imperative the landlord honor the automatic stay and refrain from taking any action against the tenant outside the bankruptcy proceeding.

Subject to certain exceptions, and provided the tenant complies with a number of related requirements, the tenant may either assume or reject an unexpired lease.  The decision to assume or reject the lease is a matter within the sound business judgment of the tenant.  After the tenant has filed for bankruptcy, it has up to 120 days to decide the fate of its lease.  Thereafter, the tenant can ask the court for an extension of up to 90 days.  This means a tenant has up to 210 days to decide whether to assume or reject the lease.

Assumption

Assumption is the legal continuation of the landlord-tenant relationship.  If the tenant is in default on the date, it elects to assume the lease and continue the relationship, the tenant must do the following before the assumption will be approved: cure the default, compensate the landlord and convince the landlord, in the future, the tenant will perform as expected under the lease.  However, the Bankruptcy Code shields tenants from the application and effect of certain nonmonetary provisions and “disincentive clauses.”  These clauses include provisions in the lease that make the tenant’s insolvency or bankruptcy an event of default.  Such provisions are unenforceable against a tenant in bankruptcy.

In the case of a shopping center lease, the tenant also must convince the landlord that, among other things:  any percentage of rent will not decline substantially; the assumption of the lease is subject to all of the tenant’s obligations under the lease, including any radius, location, use or exclusivity provision and the assumption will not disrupt any tenant mix or balance in the shopping center.

Rejection

Rejection is a process by which the tenant actually breaches the lease.  If a tenant rejects a lease, the rent owed pre-bankruptcy becomes part of the landlord’s pre-petition claim.  The Bankruptcy Code provides streamlined procedures for the tenant’s initiation of the lease rejection.  It also outlines the way to calculate claims for damages arising from the breach and indicates how the resulting claim will be treated.

Upon the rejection of a lease, damages are calculated by taking the greater of either the rent reserved by the lease for one year or 15% of the remaining rent under the lease, but not to exceed the rent reserved by the lease for three years and then adding any unpaid pre-petition rent to that amount.  Courts also have applied the damage calculation to lease termination damages when the debtor is a guarantor of the lease and not the tenant.  Security deposits are included within the bankruptcy estate.  As a general rule, if the landlord applies the security deposit post-petition, the security deposit will be subtracted from the landlord’s rejection damages claim.

Assignment

The Bankruptcy Code renders unenforceable the provisions in the lease that prohibit assignment.  If the tenant wants to assign the lease, it must first assume the lease and provide adequate assurance of future performance by the assignee of the lease, regardless of whether there has been a default under the lease.

Conclusion

This article is intended to provide an overview of the bankruptcy process and its effect on the landlord-tenant relationship.  However, it is not designed to substitute for the legal advice of an experienced bankruptcy professional.  If you are a landlord or tenant and you are confronted with a bankruptcy case, you are encouraged to contact an attorney, preferably a bankruptcy attorney, for advice on protecting your rights.

Thomas W. Rogers, is a real estate attorney with the law firm GreenbergTraurig LLP.