When A Tenant or Landlord Files Bankruptcy William J. Amann, Esq.

A.  OVERVIEW OF BANKRUPTCY PROCESS 
The filing of a bankruptcy petition, whether by an individual or a business, is usually a major event to that person or business.   Upon the filing of a bankruptcy petition, all non-exempt legal and equitable interests of the debtor, including property rights, become part of the so-called “bankruptcy estate” under  11 U.S.C. § 541.  Property of the estate also includes other property interests that the debtor acquires post petition (see § 541 (a)(5) and (7)) as well as proceeds, profits and other similar property.  However, as § 541 (a)(6) indicates, an individual debtor’s future earnings are not ordinarily property of the estate.  Also, § 541 also provides that certain beneficial interests in trusts, like ERISA qualified pension plans and spendthrift trusts, are not part of the estate.
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Unless a particular federal interest requires a different result, property interests are created and defined by state law.  SeeButner v. United States, 440 U.S. 48, 55 (1979).   
 
 

1. THE AUTOMATIC STAY, 11 U.S.C.§ 362(a)

 
      Upon the filing of a petition under any chapter of the Code, a stay arises automatically pursuant to 11 U.S.C. § 362(a). The stay is an injunction against the commencement or continuation of actions against the debtor and its property. Foreclosure, collections and certain set-off rights are enjoined and actions in violation of the automatic stay are generally void and of no effect.  SeeIn re Soares, 107 F.3d 969 (1stCir. 1997). Seealso, In re A& J Auto Sales, Inc., 223 B.R. 839 (D.N.H. 1998)(post petition towing of cars seized by the IRS pre-petition violated stay).  The basic idea of the stay is to give the debtor a temporary break from their creditors so that they can both formulate and propose a reorganization plan or time for the orderly administration and liquidation of assets. 

      There are over twenty-five exceptions to the stay.  See11 U.S.C § 362(b).  Among these exceptions are actions taken to perfect or maintain the continuance of perfections of liens.  See11 U.S.C. § 546(b), actions by lessors against debtors of non-residential real property when the lease term expires pre-petition or during the case to obtain possession, the commencement of any action by the Secretary of Housing and Urban Development to foreclose a mortgage or deed of trust in any case in which the mortgage or deed of trust held by the Secretary is insured or was formerly insured under the National Housing Act and covers property, or combinations thereof, of five or more living units. 11 U.S.C.  § 362(b)(22) excepts from the stay, the continuation of any eviction, unlawful detainer action, or similar proceeding by a lessor against a debtor involvingresidentialproperty in which the debtor resides as a tenant under a lease or rental agreement and with respect to which the lessor has obtained, before the filing of the bankruptcy petition, a judgment for possession against the debtor[1].  However, a debtor-tenant may take steps to prevent the exception (thus preserving the automatic stay) by (1) filing and serving with the bankruptcy petition, a certification under the pains and penalties of perjury as to why, under non-bankruptcy law, the debtor is entitled to cure the monetary default AND the debtor files with the Bankruptcy Clerk, any rent that would become due within thirty (30) days after the petition date and (2) file within thirty (30) days of the petition, a certification to the Court that the debtor has in fact cured the monetary default.  If the debtor meets these obligations, the lessor may file an objection and the Court will hold a hearing within ten (10) days.

            11 U.S.C. § 362(b)(23) provides an exception for residential eviction actions based upon the endangerment of the property or when illegal, controlled substances are used on the property.  
 

1. TREATMENT OF LEASES AND EXECUTORY CONTRACTS UNDER THE 

BANKRUPTCY CODE, 11 U.S.C. § 365
 
§ 365 provides specific time frames within which executory contracts and unexpired leases must either be assumed or rejected.  It requires a debtor (or trustee) to perform under the contract or lease until it has been assumed or rejected and to cure past defaults prior to assumption.  

§ 365 (d)(3) carves out an exception to the Automatic Stay discussed above. It states, in relevant part as follows: The trustee shall timely perform all the obligations of the debtor…arising from and after the order for relief under any unexpired lease ofnon-residentialreal property, until such lease is assumed or rejected… So, § 365 (d)(3) protects landlords by allowing them to enforce the lease post-petition without having to resort to the automatic stay process.  However, the debtor is not without protection either.  Under the 2005 Amendments to the Code (BAPCPA), a debtor-tenant is allowed to reject a lease and to limit the damages his landlord can claim and receive.  

§ 365 (d)(3) requires that a debtor timely performs all of its obligations under a lease that occur from the time it files bankruptcy to the time it assumes or rejects.  If real estate taxes are assessed during that period, then under the so-called “proration rule”, a debtor would only have to pay for amounts thataccruedpost-petition.  SeeIn re Learningsmith, Inc., 253 B.R. 131 (Bankr. D. Mass. 2000).   

Another school of thought, referred to as the “performance rule”, holds that § 365 (d)(3) requires a debtor to pay for all of its obligations that accrued up to the time it either assumes or rejects (including pre and post amounts). New Hampshire seems to follow the minority view’s performance rule, at least in one specific instance. SeeIn re Lakeshore Construction Co. of Wolfeboro, Inc., 390 B.R. 751 (Bkrtcy. D.N.H. 2008).  
      BAPCPA has left unaltered, the time a debtor has in which to assume or reject a residentialreal property lease or a lease of personal property-the trustee/debtor still has sixty (60) days from the petition date to assume or reject. Revised § 365 (d)(4) gives a maximum of two hundred and ten (210) days from the petition date, for the debtor to assume or reject a commercial (a/k/a nonresidential) lease.  In order to extend that time, a debtor will need the consent of the landlord.

            The legal standard a debtor must demonstrate in order to assume or reject a lease is the business judgment test.  SeeGroup of Institutional Investors v. Chicago, Milwaukee, St. Paul, and Pacific R. Co.,318 U.S. 523 (1943);  In re Trans World Airlines, Inc.,261 B.R. 103, 120-121 (Bankr.D.Del.2001); Wheeling-Pittsburgh Steel Corp. v. West Penn Power Co. (In re Wheeling-Pittsburgh Steel Corp.),72 B.R.845-846 (Bankr.W.D.Pa.1987).
          A court is required to examine whether a reasonable business person would make a similar decision under similar circumstances. SeeIn re Exide Technologies, 340 B.R. 222 (Bkrtcy. D. Del. 2006).  This is not a difficult standard to satisfy and requires only a showing that rejection will benefit the estate. SeeIn re Patterson,119 B.R. 59, 60 (E.D.Pa.1990); In re Blackstone Potato Chip Co., Inc., 109 B.R. 557 (D. R.I. 1990).    
 

1. ASSUMPTION AND/OR REJECTION OF REAL PROPERTY LEASES (COMMERCIAL VS. RESIDENTIAL)

 
An assumed lease becomes a binding, post-petition obligation on the bankruptcy estate.  Accordingly, debtors/trustees and creditors’ committees are usually hesitant to assume a lease too soon, without knowing the likely benefits and burdens to the bankruptcy estate.  As discussed above, a debtor has a maximum of two hundred and ten (210) days to assume or reject under § 365(d)(4).  If the debtor wants to seek an extension of time of the initial one hundred and twenty (120) day deadline imposed by the statute, it must do so within the one hundred and twenty (120) days.  SeeIn re Tubular Technologies, LLC,362 B.R. 243 (Bankr. D. S.C. 2006). 

If a lease is in default at the time of the petition, the debtor must cure all monetary defaults or provide adequate assurance that the monetary defaults will be promptly cured.  11 U.S.C. § 365(b)(1).  However, non-monetary defaults (e.g. “going dark clauses or other non-monetary disputes or defaults) do not necessarily need to be cured prior to assumption. The First Circuit so held in In re BankVest Capital Corp., 360 F.3d 291 (1stCir. 2004). Congress redrafted § 365(b)(2)(D) and (b)(1)(A) to codify the essential holding of BankVestso that the debtor/trustee need not cure defaults that relate to a breach of a nonmonetary obligation on nonresidential leases if it is impossible to do so.  Nonmonetary breaches of executory contracts and personal property leases still have to be cured before assumption.  

If a debtor assumes the lease but then defaults, the landlord’s claim is treated as an administrative claim against the estate.  See11 U.S.C. 503(b)(7).  The administrative claim is limited (so as not to afford the landlord a super-priority to the detriment of other unsecureds).  The statute caps a landlords’ claim at sums that would be due over a two (2) year period (instead of the entire remaining lease term).  
      Permitting debtors to shed disadvantageous contracts while keeping beneficial ones is one of the core purposes of the Code-to give worthy debtors a fresh start.  In re Carp, 340 F.3d 15 (1stCir. 2003).  
 

1. CALCULATION OF DAMAGES

 FOLLOWING REJECTION OF REAL PROPERTY LEASES
 
      A landlord’s claim is potentially comprised of two parts, (1) a claim for pre-petition rent and a claim for damages for rejecting/breaching the lease.  § 502(b)(6) provides a mechanism for a party to object to a landlord’s rejection claim.  More specifically, § 502(b)(6)(A), limits a landlord’s rejection for future rent to the lesser of  one years’ worth of rent or 15% of the rent over a three (3) year period.  
 

1.       OTHER ISSUES AFFECTING REAL PROPERTY LEASES (WHEN YOUR 

LANDLORD FILES BANKRUPTCY)
 
            § 356 (h) addresses the situation where the lessor is the debtor.  A tenant faced with this situation has two choices:  (1) treat the lease as terminated and make a claim for damages or (2) continue in possession and pay rent in accordance with the lease.  § 356 (h)(1)(B) allows the tenant to offset damages arising from its landlord’s rejection against future rent due under the lease.  If the tenant chooses to treat the lease as terminated, it is released from its obligations, in addition to being able to make a claim for damages.  SeeIn re Nickles Midway Pier, LLC, 372 B.R. 218 (D. N.J. 2007).  
 

1. LANDLORD PRE- AND POST-PETITION STRATEGIES UNDER BAPCPA 

 
            Whether you are a residential or commercial landlord, communication with your tenant and diligence about the marketplace is probably the best strategy to guard against a loss due to the rejection of a lease. It might be advisable in some circumstances to negotiate only triple net leases (where the tenant pays directly for all maintenance costs, utilities, taxes and insurance).  Also, the Golden Rule seems to apply, treat your debtor as you would want to be treated.  In other words, if the going lease rates in your market are much lower than what you are charging, don’t be surprised if the lease is rejected.  Put yourself in the debtor’s shoes and try to negotiate in a way that meets either the monetary or nonmonetary needs of your tenant.  Maybe a longer or shorter term or renegotiation of other terms would be attractive to the debtor and better for you than rejection. Also, with respect to security deposits, they become part of the bankruptcy estate upon filing.  The best approach is not to apply security deposits to post-petition, pre assumption amounts that may come due; instead, hold the deposit so it can be applied to any potential rejection damages.

            If you have decided that assuming the lease, even on different terms, is not feasible for you or the debtor then be diligent about how your rights may be affected by the bankruptcy case.  There are a myriad of events in a case which can affect a debtor’s ability to reorganize and how assets and claims will be handled.  Whether you are a tenant or a landlord, I strongly recommend that you seek legal advice at the earliest signs of financial distress.


[1]Judgment, in this section, means a final, non appealable judgment.  In,In re Alberts,  the exception did not apply when the eviction judgment had been timely appealed for de novotrial on the merits. SeeHousing Authority of Beaver County v. Alberts, 381 B.R. 171 (Bankr. W.D. Pa. 2008).