This article was published first in Michigan Real Property Review (Fall 2014/Winter 2015, Vol. 41, No. 3 & 4). Published by the Real Property Law Section State Bar of Michigan. It is reprinted here with permission.
As many commercial landlords can attest based on experience, a tenant that files bankruptcy receives the benefit of rights and protections under the Bankruptcy Code1 that it would not have outside of bankruptcy. Among other things, the automatic stay imposed under Section 3622 prevents a landlord from continuing any collection, eviction or other enforcement proceedings, and the tenant may have a right to assume and to assign the lease under Section 3653 notwithstanding prohibitions or restrictions on assignment in the lease.4
However, this does not become an issue if the tenant no longer has an interest in the lease at the commencement of the bankruptcy case. So, if a landlord anticipates that a tenant may file bankruptcy, the landlord may want to consider taking steps to terminate the tenant’s interest before it can file.
Background: What Happens in a Tenant’s Bankruptcy
Subject to court approval, a bankruptcy trustee (or a chapter 11 debtor in possession5) may assume or reject any unexpired leases of a tenant debtor under Section 365 of the Bankruptcy Code. Generally, a trustee is required to perform under the lease for the period between the commencement of the bankruptcy and when the lease is assumed or rejected. The court may grant a temporary extension of up to 60 days. However, after that, the trustee is required to comply with the lease.6
As a condition of assuming a lease, if there is an outstanding default, the trustee generally must: (1) cure the default (or provide adequate assurance of a prompt cure); (2) compensate the landlord for any “actual pecuniary loss” resulting from the default (or provide adequate assurance of compensation); and (3) provide adequate assurance of future performance.7
There is an exception from this cure obligation for defaults arising from a failure to perform non-monetary obligations that are impossible to cure at the time of assumption. However, if the non-monetary obligation relates to a failure to operate as required by a nonresidential real property lease, the default must be cured by performance beginning at the time of assumption and the landlord must be compensated for pecuniary losses resulting from the default.8 As discussed below, there is an additional exception for defaults under ipso facto and other similar provisions.9
In the context of a shopping center lease there are special requirements for establishing adequate assurance of future performance.10 These are designed to provide comfort to the landlord that the financial and operational results will be similar to what it originally bargained for, including requirements that: (1) the financial condition and operating performance of a proposed assignee and its guarantors be similar to that of the debtor and its guarantors at the time the lease was executed; (2) percentage rent will not decline substantially; and (3) the use will continue to comply with radius, location, use or exclusivity provisions, and will not disrupt the tenant mix in the shopping center.
If the trustee assumes a lease, as long as there is adequate assurance of future performance by the assignee, the lease may be assigned notwithstanding any provision in the lease or applicable law that prohibits, restricts, or conditions assignment.11 Note that the trustee and bankruptcy estate are automatically released from liability for any breaches that occur after assignment.12 Also note that an order authorizing assignment is subject to a temporary 14-day stay after entry unless the court orders otherwise.13
An unexpired nonresidential real property lease of a tenant is deemed rejected if a trustee does not take action within 120 days after bankruptcy commences (or the earlier entry of an order confirming a plan of reorganization). The 120-day deadline may be extended up to 90 days for cause, but further extension requires written consent of the landlord.14
If the trustee rejects a lease, the rejection is treated as a breach. If the lease has not been assumed, the breach is deemed to have occurred immediately before the bankruptcy commences.15 Although there is a tendency to view rejection as the equivalent of termination of a lease, that is not necessarily the case. Before taking any action to repossess the leased premises a landlord is well advised to obtain formal confirmation one way or another that the debtor has surrendered and has no further interest in the premises.
Leases That Are Not Subject to a Tenant’s Bankruptcy
Assignment and assumption of a lease under Section 365 of the Bankruptcy Code applies only to “unexpired” leases,16 and Section 365(c)(3)17 specifically precludes a trustee from assuming an unexpired lease if “such lease is of nonresidential real property and has been terminated under applicable nonbankruptcy law prior to the order for relief.”18 In addition, if a tenant’s interests in a lease are terminated prior to bankruptcy, the lease does not become part of its bankruptcy estate, and thus the automatic stay would not be applicable.
Consequently, if a landlord is aware that a tenant may be filing bankruptcy, its strategy for dealing with the tenant and any outstanding defaults should take into account the advisability of terminating the lease to avoid the complications of bankruptcy. However, recognize that this may have the effect of reducing the potential recovery from the tenant for defaults. For example, in Michigan an action for rent is a distinct cause of action, since rent is tied to use of the premises. If a lease is terminated, future rent never becomes due.19 A landlord can still pursue a claim for damages, but termination of the lease will preclude an alternate claim based on rent due for post-termination periods.
Assuming a landlord decides that it would be in its best interests to terminate a lease, the next question is what is required to effectively terminate the tenant’s interests in the lease for purposes of the Bankruptcy Code.
Ipso Facto and Other Similar Provisions
Leases often provide that a bankruptcy filing or other similar circumstances are automatically events of default that may result in termination of the lease. It would be natural for a landlord to want to look to this provision to extricate itself from a tenant bankruptcy. However, that is not an option since the requirement that defaults be cured as a condition of assumption of a lease does not apply to breaches relating to:
(A) the insolvency or financial condition of the debtor at any time before the closing of the case; (B) the commencement of the case under this title; (C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement; or (D) the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform non-monetary obligations under the executory contract or unexpired lease.20
It is interesting to note that this type of lease provision would have worked under the bankruptcy act that was in effect before the Bankruptcy Code was enacted in 1978. Section 70b provided that a prohibition on assignment would not prevent the trustee from assuming an assigning release, “but an express covenant that an assignment by operation of law or the bankruptcy of a specified party thereto or of either party shall terminate the lease or give the other party an election to terminate the same is enforceable.”21 However, Section 365 of the Bankruptcy Code reversed this result.
In addition, under the section of the Bankruptcy Code that defines property of the bankruptcy estate, interests of a debtor are included in the estate:
notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law … that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.22
In other words, a tenant’s interest in a lease will become part of the bankruptcy estate even if the lease provides that it terminates upon bankruptcy of the tenant.
So, until the law changes, a landlord will not be able to rely on a provision that automatically terminates a lease upon the filing of a bankruptcy since that provision will not be recognized in bankruptcy.
Unexpired v. Terminated
Be aware that there is case law that notwithstanding action to terminate a lease prior to bankruptcy, the lease may be considered “unexpired,” and thus may continue to be subject to assumption by the trustee. As discussed in a Second Circuit Court of Appeals decision,23 state law determines the status of a lease and a terminated lease can nevertheless be “unexpired” for purposes of Section 365 if state law permits reinstatement.
The court noted a prior decision in which it held that, under applicable state law, until a landlord obtained a writ of possession the debtor had a right to vacate the judgment of possession by curing the rent default and paying interest and costs. Consequently, it held that a debtor that retained a possessory interest after issuance of the judgment of possession had an unexpired lease–at least until the writ of possession was issued. (It later held that upon issuance of the writ the debtor’s right to redeem was extinguished.)
Applying the law of a different state in the Super Nova case, the court noted that the tenant had a right to avoid eviction and reinstate the lease up until actual execution of the warrant of eviction (as opposed to being cut off upon issuance). Although the warrant of execution had been issued, it had not yet been executed at the time the bankruptcy petition was filed. Since the automatic stay prevented execution of the warrant, the tenant’s right to reinstate the lease was preserved; thus the lease was “unexpired” at the time the bankruptcy was filed and could be assumed.
In Michigan this issue could become relevant depending on a landlord’s election to use a notice to quit for nonpayment of rent,24 which is in effect a demand for either payment or possession, or a notice to quit on termination.25 Under MCL 600.5741, if the landlord brings a summary proceeding to obtain possession based on nonpayment of money, the judgment of possession will include a determination of the amount due. Under MCL 600.5744, if the judgment for possession is based on nonpayment of money, then the writ of restitution will not be issued if the tenant pays the amount stated in the judgment plus costs.
In other words, when eviction is based on nonpayment of rent, a tenant has a right to pay the back rent and reinstate the lease up until the time the writ of restitution is issued. So, if it files bankruptcy before that point, the lease will become part of the bankruptcy estate, giving the tenant its special rights and protections, even if a judgment of possession has been entered.
The result should be different if the summary proceeding is to recover possession where the lease has been terminated. The tenant will not have a right to redeem, and it should not have an interest in the lease that becomes part of its bankruptcy estate. In addition, Section 365(c)(3) expressly precludes a trustee from assuming a non-residential lease if it has been terminated prior to bankruptcy. (Note that if the tenant remains in possession of the premises, this does not mean that the landlord can simply ignore a bankruptcy filing and proceed without regard to the pending case. Rather, the landlord should file a motion in the bankruptcy case for relief from the automatic stay “for cause.”)
Strict Compliance with Lease Terms
If a landlord decides to proceed with termination, it is important that it strictly comply with the provisions of a lease. For example, a bankruptcy court concluded that the landlord had not effectively terminated the lease prior to bankruptcy under the following circumstances.26 The lease included the following default provision:
In the event of any default of Tenant in paying any installment of Basic Rental, additional rent or other sums payable hereunder, Landlord may elect to immediately terminate this Lease by serving a written notice upon Tenant not less than five (5) days after the day of serving such notice; provided that this Lease shall not terminate or expire if Tenant remedies such nonpayment within such five (5) day period. Landlord shall not be required to give Tenant notice of any default in the payment of rent more than two (2) times in any twelve month period.…
The notice provision included the following:
All notices to Tenant under this lease shall be conclusively presumed to have been delivered one day after mailing by United States mail, first class, certified or registered, and postage prepaid, addressed to Tenant, C&C TV and Appliance, Inc. at 101 East Baltimore Pike, East Lansdowne, PA 19050 or to such other address as Tenant may in writing from time to time designate, with a copy to [its lawyer] ....
The landlord proceeded to send a series of notices. They were sent to the leased premises rather than to the address identified in the notice provision, and only one of the letters was sent to the tenant’s counsel. At a subsequent meeting between the tenant and the landlord, the tenant disclosed that it was considering a bankruptcy filing. That same day the landlord sent a letter stating that the lease was terminated effective 5:00 p.m. that day. It contended that the debtor had failed to pay rent, and that since it had already received two notices of default during a 12-month period, no further notice of default was required. This was the only notice that was sent to the proper address with a copy to the tenant’s counsel.
The court emphasized that forfeitures are “disfavored” and considered “odious.” Consequently, the court felt justified in requiring strict compliance with the lease. In this case the lease required the landlord to provide a five-day cure period unless there had been at least two notices of default during the prior 12-month period. Since the landlord sent a copy of only one of the default notices to tenant’s counsel, it did not provide two proper notices of default as required under the lease.
In addition, the court noted that notices were “conclusively presumed” to be delivered one day after mailing. Thus, the notice of termination was not effective the same day, but rather the following day. Since the debtor had filed bankruptcy by 9:00 a.m. the following day, the court decided that the termination notice was “delivered” after the automatic stay went into effect.
The court also questioned whether a landlord could unilaterally terminate a lease without obtaining a court judgment for possession. Under applicable state law a tenant had a right to redeem a lease terminated for nonpayment of rent up until execution of the writ of possession. However, the court did not need to reach this issue since the landlord failed to comply with the requirements for termination under the lease.
Case Study
Even if a landlord commits to terminating a lease prior to bankruptcy, this strategy may or may not be effective. An interesting example of this point involved a commercial landlord’s request for relief from the automatic stay that turned on whether the landlord effectively terminated the lease prepetition.27
The debtor operated a nightclub at a location that it leased from the landlord. The landlord sent the debtor a default notice for failure to make lease payments and on the basis that the debtor defaulted on a promissory note that constituted a default under the lease through a cross-default provision.
Based on the cross-default, the landlord contended that the lease was “no longer in effect” and the debtor was “occupying the premises as a Tenant at Will.” (There is an inference that the landlord relied on the cross-default because under state law the tenant would have had a right to cure the lease payment default and reinstate the lease.)
The landlord also insisted that the debtor continue paying rent under a supposed month-to-month tenancy. When the debtor failed to pay rent, the landlord gave a pay-or-quit notice, and when the debtor again failed to pay, the landlord sued to recover possession of the premises.
A state court entered an order obligating the debtor to pay both past due rent and ongoing rent into the court registry. After the debtor was late on a payment by less than a day (due by 5:00 p.m. one day, but not deposited with the court until 8:00 a.m. the next morning), the court entered a default judgment for possession and issued a writ of possession. After considering the debtor’s request for reconsideration, the court ordered the debtor to vacate the premises. One day before the deadline for vacating, the debtor filed bankruptcy.
The landlord requested relief from the automatic stay, arguing that the bankruptcy case was a bad-faith filing since the debtor needed the premises to operate its nightclub, but could not assume the lease because it was terminated prepetition. While acknowledging that it could not assume a terminated lease, the debtor disputed that the lease was terminated. The landlord argued that the lease was terminated either (1) when it notified the debtor of the cross-default, or (2) when the state court entered a judgment for possession and issued a writ of possession.
Addressing the second argument, the bankruptcy court determined that under state law the lease was not terminated by entry of a final judgment for possession or issuance of a writ of possession. The court reasoned that there were typically three remedies for default under applicable state law: (1) terminate the lease and take possession; (2) take possession for the account of the tenant and hold the tenant accountable for the difference between rent that was due and what the landlord actually received; and (3) sue the tenant for rent as it becomes due. The court saw this as clear confirmation that simply retaking possession does not terminate a lease (since it was also consistent with acting for the tenant’s account).
There was an additional argument that a debtor cannot assume a lease if the debtor has lost possession regardless of whether the lease is terminated. However, a tenant did not lose possession under state law until the writ was executed, and until then a tenant could prevent removal by tendering any rent in arrears with interest. So the lease was not terminated and the debtor could still assume the lease even if a judgment for possession had been entered and/or a writ of possession had been issued.
As for the supposed termination based on the promissory note cross-default, the court did not agree that the landlord established that there had been a default. The debtor apparently made all of the monthly payments due under the note. The supposed default was based on a failure to pay late charges of $169.26–since payments were due on the 5th of each month and one month the debtor paid on the 7th of the month. However, late charges were not automatic under the note, and the noteholder did not assess late charges until after the bankruptcy was filed. Consequently, the landlord did not have a basis for terminating the lease prior to bankruptcy.
Furthermore, even if the debtor had defaulted under the note, the landlord did not prove that it effectively terminated the lease. The landlord’s conduct following the notice purporting to terminate the lease did not acknowledge the termination. Based on its ambiguous conduct, the court concluded that the landlord did not establish that it effectively terminated the lease.
Since the landlord failed to establish that the debtor defaulted on the note, its default notice did not effectively terminate the lease and the debtor still had a leasehold interest with a right to assume the lease (assuming it was able to satisfy the applicable Bankruptcy Code criteria for assumption). Accordingly the landlord’s request for stay relief was denied.
Conclusion
If a landlord decides to terminate a lease prior to a possible bankruptcy to avoid the delays inherent in a bankruptcy and to prevent a tenant debtor from having the ability to assume and assign the lease, it should take clear, affirmative steps to do so in strict compliance with all applicable requirements. This desire is often in tension with a desire to continue to collect rents to the extent possible. Steps that facilitate collection of rents (such as use of a notice to quit for non-payment and waiting to terminate the lease) will undermine attempts to avoid the impact of a tenant bankruptcy. Landlords should recognize that sometimes they have to make a choice.
Endnotes
1 11 USC 101 et seq.
2 11 USC 362.
3 11 USC 365.
4 Further, the Bankruptcy Code specifically prohibits termination or modification of a lease based on an assumption or assignment permitted under Section365. 11 USC 365(f )(3).
5 Under 11 USC 1107 a debtor in possession is generally given the rights and powers of a trustee, including the right to assume and assign executory contracts and leases.
6 11 USC 365(d)(3).
7 11 USC 365(b)(1).
8 11 USC 365(b)(1)(A).
9 11 USC 365(b)(2).
10 11 USC 365(b)(3).
11 11 USC 365(f).
12 11 USC 365(k).
13 FR Bankr P 6006(d).
14 11 USC 365(d)(4).
15 11 USC 365(g).
16 11 USC 365(a).
17 11 USC 365(c).
18 Note that commencement of a bankruptcy case by filing a voluntary petition constitutes an “order for relief.” 11 USC 301.
19 Chard, Shoffner & Valvo, Michigan Lease Drafting and Landlord-Tenant Law, § 7.24 (online version current to Jan 16, 2015).
20 11 USC 365(b)(2).
21 11 USC 110b.
22 11 USC 541(c)(1).
23 Super Nova 330 LLC v Gazes, 693 F3d 138 (CA 2, 2012).
24 SCAO Form DC 100a.
25 SCAO Form DC 100c.
26 In re C&C TV & Appliance, Inc, 97 BR 782 (Bankr ED Pa 1989).
27 In re 2408 W. Kennedy, LLC, 512 BR 708 (Bankr MD Fla 2014).
