Part II – Landlord Claims for Damages in Bankruptcy
In our prior post in this series, we provided an overview of the most significant issues for commercial landlords that arise once a tenant files bankruptcy. Perhaps most consequential to landlords is the decision by a debtor tenant to assume or reject its lease, and what rights a landlord has post-bankruptcy while a debtor continues to occupy its space pending that decision. Also significant to landlords is the right following a bankruptcy to apply any security deposit it might be holding against damages caused by the bankruptcy. In this second part, we discuss these issues in greater detail.
- Tenant Must Pay Rent Post-Bankruptcy Filing Until Any Rejection of Lease
Following the bankruptcy filing, a bankrupt tenant must continue to perform the obligations under its lease, including payment of rent due after the case is filed. This obligation continues pending entry of an order in the Bankruptcy Court providing that the lease is rejected. But what if a debtor files for bankruptcy on the 5th of the month but failed to pay the rent due on the 1st of the month prior to the filing? Must a debtor pay for the “stub period” before the rent comes due the 1st day of the following month? Bankruptcy courts have differed on whether a debtor must pay immediately this “stub rent.” This also becomes important where, for example, a debtor is obligated post-petition under a lease to pay real estate taxes for a period covering the pre- and post-petition periods.
But even in jurisdictions where immediate payment of the “stub rent” is not required, a landlord can seek payment of unpaid post-petition rent as an “administrative expense.” Administrative expenses have a higher payment priority in a bankruptcy. To recover the stub rent as an administrative expense, the landlord must show that the debtor tenant’s use of the leased premises provided a benefit to its estate. A landlord can seek administrative expense treatment for any expenses a landlord advances post-bankruptcy that benefitted the bankruptcy estate.
- Landlord’s Claim for Damages if a Lease is Rejected
In the event a tenant rejects its lease, the landlord has a right to file a proof of claim for the damages caused by the tenant’s rejection (i.e., breach of the lease). This would include the unpaid rent as of the filing date, as well as the rents that would have come due had the lease not been rejected. A court order would set a deadline to file proofs of claims; it is crucial that a claim be timely filed.
A landlord still has a duty to mitigate damages incurred as a result of a debtor’s rejection of a lease, to the same extent as under state law. Additionally, the Bankruptcy Code caps a landlord’s claim for damages to an amount equal to the rent required to be paid under the lease for the greater of one year or 15% of the remaining term of the lease, not to exceed three years. The “rent required to be paid” is not limited to base rent, and can include taxes, CAM, etc. The cap, however, does not apply to rent that was unpaid as of the petition date, which is separately recoverable and not subject to the cap.
This claim would be unsecured and a landlord would recover pro-rata with other unsecured creditors of the debtor’s bankruptcy estate. If a landlord is holding a security deposit (discussed below), the full amount of the security deposit is deducted from the damage claim, after applying the cap.
Landlords should be alert to any notices received from the bankruptcy court, which often set deadlines to object to proposed cure amounts where a lease is being assumed or to file claims if a lease is being rejected.
- Security Deposits
As of a bankruptcy filing, landlords often hold cash security deposits made by a tenant prior to a bankruptcy. The Bankruptcy Code treats these deposits as property of the tenant’s bankruptcy estate and, therefore, the landlord cannot apply the security deposit without modifying the automatic stay. The security deposit, though, should be listed on a proof of claim as a credit from the total amount claimed. Beware that some courts will allow a landlord to setoff a security deposit only to the extent of the capped claimed amount, meaning the balance would be returned to the debtor.
Rather than a cash security deposit, a landlord could require the tenant to post a letter of credit. This is favorable to the landlord in the event of a bankruptcy (even if the amounts recovered are setoff from any damages sought). Courts treat the letters of credit as outside a debtor’s bankruptcy estate and, therefore, a landlord is not required to file a motion to modify the automatic stay to draw on the letter of credit post-bankruptcy. For this reason, we often recommend to our landlord clients that they have their tenants post letters of credit rather than cash deposits.
Conclusion
Should you be interested in discussing any of the issues in this article, or otherwise how best to draft and enforce commercial leases with a view toward bankruptcy concerns, please contact Al Domanskis at 312-540-1075 or domanskis@boodlaw.com. Boodell & Domanskis, LLC’s creditors’ rights and real estate attorneys can provide counsel on how best to protect a landlord’s interests when drafting a lease and, if necessary, enforce your lease rights in any tenant bankruptcy proceeding.
Click to read Your Tenant Filed Bankruptcy: What Should a Landlord Do? (Part I) in its entirety.
