update
Morgan Lewis will periodically provide Real Estate Strategies to executives
real estate
strategies
www.morganlewis.com
contacts
and in-house attorneys responsible for handling real estate issues arising from
current market conditions.
J.J. Broderick
Philadelphia
215.963.5104
Tenant’s Rights After Landlord’s Bankruptcy: jbroderick@morganlewis.com
An Important Question During Tough Economic Times
Bob Cooney
Philadelphia
As our sagging economy has impaired Special Purpose Bankruptcy 215.963.5806
commercial real estate, evidenced most Remote Entities rcooney@morganlewis.com
clearly in the dramatic declines in the
As a preliminary matter, tenants can
stock prices of publicly traded REITs
derive some comfort from the fact that Neil Herman
and real estate operating companies. New York
commercial real estate is less likely to
The possibility of commercial landlords 212.309.6669
be exposed to bankruptcy nowadays
filing for bankruptcy has increased because properties are now often nherman@morganlewis.com
substantially. A bankruptcy filing by a owned by special purpose bankruptcy
commercial landlord creates thorny remote entities, commonly referred to Andrew Gottfried
issues, and a commercial tenant should New York
as “SPEs.” SPEs are entities that are
be aware of its rights in that event. 212.309.6148
formed for the purpose of avoiding
Unfortunately, the scope of the tenant’s agottfried@morganlewis.com
insolvency. They are the product of
rights is limited, and not surprisingly, mortgage securitization and are intended
a tenant is often dealing with the to protect the holders of the securities
proverbial “lesser of two evils.” sign up
from having the underlying mortgages
Nonetheless, a commercial tenant is compromised by a landlord bankruptcy.
well advised to consider the issues in
advance if it gets wind of a possible However, if a landlord is an SPE, the Bankruptcy’s Effect upon
bankruptcy filing by its landlord, in an landlord could be exposed to the risk Existing Leases
effort to minimize its out-of-pocket of bankruptcy if the income source for If a landlord is not an SPE (or if the SPE
expenses as well as to ameliorate the the SPE (i.e., the rental income from the structure does not achieve its intended
effects of the possible disruption to property) is affected by increasing vacan-
result) and a bankruptcy filing occurs, all
its business. cies and defaults. Such exposure is more
of the landlord’s property becomes part
foreseeable in a single-tenant property
of an estate to be administered for the
At the outset, we note that this article than a multi-tenant property. If the situa-
is directed primarily to tenants of office benefit of the landlord’s creditors. This
tion does arise, it is likely that the lender
and industrial properties. A retail includes a landlord’s rights under unex-
(e.g., the servicer for the securitized
landlord’s bankruptcy, as well as the pired leases. Following the bankruptcy
mortgage) will take over the property
relationship between retail landlords and without a landlord bankruptcy, and the filing, the landlord remains as “debtor in
retail tenants generally, involves unique rights of the tenants will be determined possession,” or a trustee is appointed to
issues and corresponding legal rights. by the subordination provisions of their act on behalf of the bankruptcy estate,
While much of this article is relevant to leases. At least that is the intended depending in part on whether the
retail tenants, those unique issues and result. Since mortgage securitization has bankruptcy is a reorganization or a
corresponding legal rights involve proved to have more problems than many liquidation. (We will generally refer to the
additional complexity that we will not realized, it will be interesting to see if the landlord for the remainder of this article,
address in this article. SPE structure can achieve this result. but a bankruptcy trustee has the same
Morgan Lewis Real Estate Strategies / page 2
rights and may be acting for the bank- located (e.g., the tenant might operate leasehold—typically from the proceeds
ruptcy estate in many instances.) Once a business not sufficiently “upscale” for of the sale.” However, “adequate
the filing occurs and the bankruptcy the landlord’s future plans, might have protection” may not fully compensate a
estate is created, the landlord has the densely populated space that strains tenant for all of its out-of-pocket costs.
option of assuming (and perhaps the building’s systems, or might be
assigning to a third-party purchaser) or experiencing financial difficulty itself). Tenant Options If a Lease
rejecting any unexpired leases. Is Rejected
If a lease is rejected, the tenant has Under the Bankruptcy Code, a rejection
If a lease is assumed, the lease the right to remain in possession of the
of the lease constitutes a breach, and
continues in full force and effect, and leased premises or, if the rejection gives
the lease can be treated as terminated
the tenant retains all of its rights under rise to a right of termination under the
by the tenant if the terms of the lease
the lease. The landlord is entitled to terms of the lease or applicable state
or applicable state law gives rise to a
assume the leases and assign them in law, to treat the lease as terminated. In
termination right as a result of such
connection with the sale of underlying addition, the rejection is deemed to be a
breach.3 Finding an express termination
right in the lease or under state law is
uncommon, however. Consequently, a
“Adequate protection” may not fully compensate tenant is in a state of theoretical
a tenant for all of its out-of-pocket costs. ambiguity following rejection. Fortunately
(for the tenant), the rejection almost
invariably equals termination because
the landlord has affirmatively indicated
property. Prior to assuming the lease, breach of the lease as of the date of the
that it wants the tenant out of the
however, the landlord must cure any bankruptcy filing, so the tenant becomes
defaults outstanding under the lease, an unsecured creditor of the bankruptcy property and is unlikely to fight a
and must provide “adequate assurance” estate to the extent of any damages that tenant’s claim of a deemed termination.
of its ability to perform its obligations arise from the breach. Nonetheless, a tenant would be well
under the lease following assumption.1 advised to secure a written termination
A bankrupt landlord is often willing to A final possibility arising from a landlord agreement to confirm that it is not
assume a lease to keep the rent stream bankruptcy filing is the ability of the exposed to any alleged liabilities following
flowing. However, if a tenant is paying landlord to sell the property free and the rejection of its lease.
below-market rent, the landlord is more clear of any interest in the property
likely to reject the lease in an effort to (including tenants’ interests under If the tenant does not want to treat the
re-lease the space and secure a higher leases).2 In such an event, the property rejection of the lease as a termination,
rent (though probably not in the current may be sold subject to or free and clear the Bankruptcy Code allows the tenant
market where all paying tenants are ap- of tenants’ leasehold interests. It is vital to remain in possession of the leased
preciated, even if their rent is potentially that a tenant promptly review any premises, in which case the tenant
below market). Furthermore, even if the proposed sale documentation impacting must continue to pay rent in accordance
rent is market or above market, there are its lease to ascertain the intention of with the terms of the lease.4 If the
other considerations that might influence the landlord and its proposed purchaser. tenant elects to stay in possession of
a bankrupt landlord to reject a lease. Each affected tenant will be entitled the leased premises after the landlord
to “adequate protection” of its interest rejects the lease, the landlord may
For example, the lease might cover only under Section 363(e) of the Bankruptcy not evict the tenant unless the tenant
a small portion of the building, or a lease Code, and there may be room for defaults in the performance of its
might break up potentially large blocks negotiation with the landlord and/or the obligations under the terms of the lease.
of contiguous space that would be more purchaser. In Precision Industries, Inc. v.
profitable to lease in their entirety. In Qualitech Steel SBQ, LLC, In re Qual- In the event of a rejection, the right to
either case, a landlord may believe the itech Steel Corporation, 327 F.3d 537 remain in possession is the only
property is more valuable if it is available (7th Cir. 2003), the court held that protection provided to a tenant under
for a larger user. Alternatively, the tenant “‘[a]dequate protection’ does not neces- the Bankruptcy Code, and the rights of a
may not fit the landlord’s desired profile sarily guarantee a lessee’s continued tenant who remains in possession under
for the building due to a change in the possession of the property, but it does a rejected lease are unclear. The Bank-
tenant’s circumstances or a change in demand, in the alternative, that the ruptcy Code allows the tenant to retain all
the area in which the building is lessee be compensated for the value of its of its rights that are “in or appurtenant to
Morgan Lewis Real Estate Strategies / page 3
the real property,” including rights such then offset rent on account of the was held in escrow or commingled with
as “any right of use, possession, quiet damages caused. the landlord’s operating funds. Most
enjoyment, subletting, assignment or leases and states allow commercial
hypothecation.”5 With respect to other Similarly, if a landlord fails to fulfill landlords to commingle security
rights under the lease (such as the land- certain obligations that the bankruptcy deposits, in which case they are likely to
lord’s obligation to repair and maintain court finds are continuing obligations of be included in the bankruptcy estate. A
the property, to provide building services, the landlord after filing for bankruptcy tenant trying to recover a commingled
and to rebuild in the event of casualty), security deposit would likely be treated
(as opposed to claims accruing prior to
whether or not they are “in or appurtenant as an unsecured creditor. However, if
filing) and the lease or applicable state
to the real property” is a factual question a cash security deposit is held in
law provided the tenant a termination
for the bankruptcy court to determine escrow or otherwise segregated so that
right due to the landlord’s failure to it is identifiable, then it is less likely to
based upon the underlying lease and perform the obligations, the tenant may
applicable state law. be considered part of the bankruptcy
be able to terminate post-rejection if the estate. If the landlord does not have a
tenant determines that continued possessory interest in the cash, there is
In a multi-tenant building, remaining in
occupancy is not viable. However, a court a greater chance that the tenant could
possession under a rejected lease would
could find that an express termination recover the security deposit.
be risky because the tenants rely on the
right did not survive rejection or that
landlord to be responsible for rights that
such termination right is precluded by Unlike a cash deposit, a security deposit
may not be considered “in or appurtenant in the form of a letter of credit should
to the real property.” In contrast, in a the right of the tenant to offset rent.
When determining its course of action, not be subject to a fact-specific analysis
single-tenant building where the lease is because the landlord only has a right to
often a triple net lease, the tenant could each tenant must carefully consider the
draw under the letter of credit if the
become responsible for some or all of risks associated with the landlord’s failure
tenant fails to perform under the lease.
these obligations and remaining in to comply with its obligations under the
The landlord has a possessory interest
possession would be less problematic. rejected lease and the significance of in the letter of credit, but has no right to
To the extent a landlord is not required to any claims accrued prior to the landlord the proceeds absent a tenant default.
perform its obligations under a rejected filing for bankruptcy. A tenant must Further, the tenant does not have to
lease, the Bankruptcy Code provides consider factors such as whether the recover the letter of credit in the same
that the tenant’s sole remedy against the tenant or the landlord has repair and way it has to recover a cash security
nonperforming landlord is to offset maintenance obligations under the lease, deposit. Consequently, if the lease
damages against the rent payable under
the lease after the date of the rejection
of the lease.6 As the offset is limited to Unlike a cash deposit, a security deposit in the
the total future rent payable, this would
likely be an incomplete remedy for a form of a letter of credit should not be subject
tenant in a multi-tenant building.
However, this remedy could be sufficient
to a fact-specific analysis.
in the single-tenant, triple net lease
context. A tenant may need rights in
addition to offset rent to effectively use the extent of such obligations, the expires or is validly terminated without a
the offset right, and those rights might condition of the property as a whole, tenant default, the letter of credit should
be limited to those provided by the the term of the lease, the availability of lapse in accordance with its terms or be
underlying lease and applicable state alternative space, potential relocation surrendered by the bankrupt landlord in
law. The Bankruptcy Code does not issues, and allocation of responsibility accordance with the lease.
clearly identify a right of self-help in for building and utility services.
such instances, but such right may be Prospective Protections
implied by a bankruptcy court to allow the Security Deposits Landlord bankruptcy is rarely considered a
tenant to make use of the offset right. Another important issue for a tenant is significant issue when a lease is initially
For example, if a roof developed a leak, whether its security deposit will become negotiated. As the foregoing suggests,
a court may allow the tenant to repair part of the bankruptcy estate. If the there are limited steps that a tenant
the leak and offset the cost of repair security deposit is a cash deposit, a bank- can take to protect its rights during
against the rent rather than having to ruptcy court will undertake a fact-specific the original negotiation of the lease.
wait for the leak to cause damage and analysis and examine whether the cash However, provisions purporting to give
Morgan Lewis Real Estate Strategies / page 4
tenants specific rights conditioned upon actions of its sublandlord. If its analysis conducted by a bankruptcy
or triggered by the landlord’s bankruptcy sublandlord terminates the lease, then court. A tenant (or subtenant) should
or insolvency (often called “ipso facto the sublease would likely be terminated closely monitor, and be prepared to act
clauses”) are unenforceable in bankruptcy. as well. If, on the other hand, its quickly following, any landlord (or
Protective provisions that do not link a sublandlord does not terminate following sublandlord) bankruptcy filing in an
tenant’s rights to an event of bankruptcy the rejection of the lease, the subtenant effort to minimize its out-of-pocket
or insolvency may also be unenforceable may be obligated to remain in space that expenses and ameliorate the effects of
despite a bankruptcy because bankruptcy no longer has all of the benefits under the the possible disruption to its business.
courts will look closely to determine lease that the subtenant bargained for.
whether cleverly worded contract
language is merely a veiled ipso facto In addition, a subtenant faces the risk endnotes
clause. Although they may be unenforce- that its sublandlord could declare
able, it is worth adding protective bankruptcy. In that event, the sublandlord 1 11 U.S.C.A. § 365(b)(1)(C) (West 2008).
provisions that define not only the has the right to reject both the lease and 2 Id. § 363(f).
landlord’s obligations to repair, provide the sublease, which will severely limit
3 Id. § 365(h)(1)(A)(i).
services, and rebuild, but also the the rights of the subtenant. If the lease
tenant’s right of self-help and termination is rejected, it is almost certain that the 4 Id. § 365(h)(1)(A)(ii).
in the event of the landlord’s failure to sublease will be rejected as well, and the 5 Id. § 365(h)(1)(A)(ii).
satisfy such obligations as rights “in subtenant will have no rights under the
or appurtenant to the real property.” Bankruptcy Code vis-à-vis the landlord. 6 Id. § 365(h)(1)(B).
A tenant might also want to include The subtenant will retain its unsecured
negotiated language in the lease, claim against the sublandlord for
reserving its rights to terminate the lease damages arising from the deemed
where the bankrupt landlord rejects its breach of the lease, but that is likely to
lease. Finally, a tenant could try to protect be a hollow comfort. If the subtenant has
its security deposit by negotiating for the obtained a nondisturbance agreement
option to furnish the security deposit either from the landlord at the inception of the
in cash or by a letter of credit. Due to the sublease (which is generally difficult to
administrative issues associated with cre- achieve), then the subtenant may have
ating and maintaining a separate account the right to remain in possession of its
for the individual tenant, a landlord is not space under the terms of the lease or the
likely to agree to such a provision. sublease. Such rights would depend upon
the terms of the nondisturbance
Subleases agreement.
Commercial subtenants face a more
difficult position in the event of a Conclusion
landlord or sublandlord bankruptcy. If A landlord’s (or sublandlord’s) bank-
the landlord files for bankruptcy and the ruptcy and the rejection of a lease (or
lease is rejected, the subtenant will have sublease) provide the tenant with limited
no rights under the Bankruptcy Code options. Unfortunately, the outcome for a
vis-à-vis the landlord or its sublandlord tenant (or subtenant) is uncertain and
(the prime tenant). In that event, the its rights, to the extent available, will
subtenant is dependent upon the often be determined by a fact-specific
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