Much like executory contracts, commercial real estate leases are governed by special rules in bankruptcy. If a lease’s term has not yet expired, it is known as an “unexpired lease” (yet more clever bankruptcy terminology). This post explores how landlords and tenants are treated in bankruptcy, first in the more common situation of a tenant’s bankruptcy and then briefly in the context of a landlord’s bankruptcy.

Assumption and rejection. If the debtor is the tenant under an unexpired commercial lease, it must either assume or reject the lease within 120 days of the filing of bankruptcy. The court can extend this time period without the landlord’s consent for 90 additional days, making a total of 210 days, but any further extensions require the landlord’s prior written consent. If the lease is not assumed (or assumed and assigned) within this period, the lease automatically will be deemed rejected and the debtor will have to move out. 

• Assumption of a lease requires the debtor to reaffirm the lease, cure all pre- and post-filing defaults, and show that it will be able to perform its obligations in the future. Additional restrictions must be met before a lease located in a shopping center can be assumed or assigned. 
• Rejection of a lease means that the lease is breached, the debtor tenant has to vacate the property, and the landlord can file a claim against the debtor’s estate for the amount of any past or future rent. 

Capping a landlord’s claim. If a lease is rejected, the landlord’s damage claim for termination of the lease will be treated as a pre-filing unsecured claim.  In addition, the claim for future rent under the lease will be capped at an amount equal to the greater of one year’s rent or fifteen percent of the remaining lease term, up to a maximum of three years’ worth of rent, calculated from the earlier of the date the bankruptcy petition was filed or the date when the landlord recovered possession of, or the tenant surrendered, the premises. This ability to cap a landlord’s claim in bankruptcy is often a major benefit to a debtor tenant, especially when the lease rejected is a long-term lease with rent obligations higher than current market rates. Landlords with security deposits, either in the form of cash or letters of credit, generally will be able to retain or draw on that security at least up to the amount of their capped bankruptcy claim.

Assignments of leases in bankruptcy. Although some leases contain restrictions or outright prohibitions on the tenant’s ability to assign the lease, many of these provisions will be unenforceable in bankruptcy. This can allow a debtor to “assume and assign” a lease to a third party over the landlord’s objection. Since third parties will often pay substantial sums to take over a lease with rent obligations below current market rates, these below-market leases can be valuable assets for debtors.   

The recent bankruptcy law changes. The 210 day maximum lease decision period represents one of the major changes enacted with the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"), discussed in an earlier post. Before these amendments took effect in October 2005, although debtors initially had only 60 days to assume or reject leases, they were permitted to seek extensions of this period without any statutory limitation. Cumulative extensions of a year or more, over a landlord’s objection, were not uncommon under the pre-BAPCPA version of the Bankruptcy Code. That is no longer possible under BAPCPA.

Impact on retailers. This change is particularly significant for retailers with dozens or even hundreds of leased stores. In the past, retailers usually evaluated sales at stores for at least one holiday shopping season, and sometimes two, before deciding whether to retain the store. Now a retailer has only seven months to make that decision. This shortened period also impacts a retailer’s ability to sell off its unwanted leases, especially through a sale of "designation rights" (the right to designate the assignee of a lease), as the buyer of those rights now will have a limited time to find buyers for those leases.

Landlord as debtor. Sometimes the debtor is not a tenant but a landlord. In that situation, although the debtor can reject a lease and no longer perform any of its duties as landlord, it cannot use bankruptcy to evict a tenant that prefers to stay in possession of the premises. In Section 365(h)(1) of the Bankruptcy Code, a special provision reminiscent of the rights of a licensee of intellectual property under Section 365(n), a tenant may elect to remain in the premises for the remaining term of the lease, plus any renewal or extension of the term that may be provided in the lease if enforceable under applicable state law. If it so elects, the tenant must continue to pay the rent required under the lease but can offset against that rent any damages caused by the landlord’s nonperformance. 

Sublandlord as debtor. When the debtor is a sublandlord (also known as a sublessor), these protections generally do not apply and the subtenant is at risk of losing possession of the premises.  Because a sublandlord is a tenant under a master lease (with the "real" landlord), if the debtor rejects the master lease it, and its subtenants, usually will not have any continuing rights to possession of the premises. Subtenants looking to protect themselves in such a situation often obtain, as part of their sublease, a non-disturbance agreement, direct lease right, or similar protection from the master landlord.

Get good advice. Whether the debtor is a tenant or a landlord (or both), bankruptcy can have a significant impact on commercial real estate leases and subleases. For this reason, it is important to get prompt legal advice on your particular lease, both at the time the lease is negotiated and in the event of bankruptcy, to protect your rights.