Bankruptcy Overview and the Unexpired Lease

December 20, 2009  |  Joan M. Quade

Many clients over the years have had questions regarding bankruptcy law and the consequences of a tenant in possession of commercial space, filing Bankruptcy. The bankruptcy law is complex and comprehensive. The following is meant as a simplified overview and, of course, you should consult with an attorney on specific cases.
Bankruptcy is covered by Federal Law. The purpose of the Bankruptcy Act is to convert the estate of the debtor into cash and distribute it fairly among creditors. Once a debtor files Bankruptcy, there is an automatic “Stay”. In regards to collection activity, this means it is a violation of the Stay for any creditor to do anything to attempt to collect a debt. It stops all collection activity including collection letters being sent by the creditors.

real estate law

Chapter 7 covers liquidation. See 11 U.S.C.S. 701 et seq. This is where a debtor is unwilling or unable to repay their obligations, and involves the debtor surrendering to a trustee all assets that are not specifically exempted by the bankruptcy laws for liquidation into cash. See Re Ross, 95 B.R. 509 (Ohio 1988). The estate is dismantled, converted to cash, and distributed equitably among the creditors. A trustee in a Chapter 7 case may be either appointed by a United States Trustee or elected by the creditors. See 11 U.S.C.S. 701-703. The trustee must be a disinterested person residing within the judicial district where the case is pending, and be competent to perform the duties required. See 11 U.S.C.S. 321(a)(1).
Chapter 11 covers reorganization. See 11 U.S.C.S. 1101 et seq. Chapter 11 generally permits debtors to retain their assets, restructure most debts, and to repay obligations over an extended period of time. See Re Ross, 95 B.R. 509 (Ohio 1988). The debtor’s reorganization plans are expected to preserve the interests of creditors and to offer at least partial repayment of all the debtor’s obligations. See id. In other words, the Court finds a way to avoid having the debtor lose everything, while promising the creditor’s they will get their money, albeit a little later and maybe not the entire amount that they had anticipated. In Chapter 11 cases, the debtor usually will remain in possession of the assets. See Re Anniston Food-Rite, Inc., 20 B.R. 511 (Ala. 1982); Re Stein & Day, Inc., 87 B.R. 290 (NY 1988).
11 U.S.C. 365 covers unexpired leases. See, generally, 11 U.S.C.S. 365. Subject to certain limitations, bankruptcy trustees are authorized to assume or reject a lease that has not expired. See 11 U.S.C.S. 365(a). The decision to assume or reject a lease must be approved by the Court. See In re Thinking Machs. Corp., 67 F.3d. 1021, 1025 (1st Cir. 1995). In addition, the lease cannot be assumed in part, but rather must be assumed as a whole with all of the benefits and liabilities that run with it. See Stewart Title Guaranty Co. v. Old Republic Nat’l Title Ins. Co., 83 F.3d. 735, 741 (5th Cir. 1996). If the lease is rejected, however, the tenant may still be liable for breach of contract as a claim against the assets of the estate. See 11 U.S.C.S. 365(g).
If a default in the lease exists at the time the tenant decides to file for Bankruptcy, the trustee must correct it before assuming the lease. See 11 U.S.C.S. 365(b); see also Richmond Leasing Co. v. Capital Bank, N.A., 762 F.2d. 1303, 1309-10 (5th Cir. 1985). If there has been a default in the unexpired lease of the debtor, the trustee may not assume the lease unless the trustee does three things at the time for assumption. See 11 U.S.C.S. 365(b). The trustee must cure or fix the default, compensate for any actual economic loss suffered by any party resulting from the default, and provide adequate assurance that the trustee will not default again in the future. See id. This is referred to as assuring future performance under the lease. If the trustee cannot cure or compensate at the time for assumption, then she must guarantee that she will promptly do so in the near future. See id.
However, the trustee must make a decision and assume or reject the lease within 60 days from the filing of Bankruptcy. If the tenant is proceeding under Chapter 7, and the trustee does not assume or reject an unexpired lease within 60 days from the order for relief, then that lease is deemed rejected by the court. See id. Therefore, if the trustee plans on assuming the lease and keeping it active, then he must decide to do so within 60 days. (A court may fix a longer time period than 60 days if given a good reason). If rejected, the tenant must immediately surrender the property subject to the lease. See id. If the lease is to be assumed, and there is no current default on the lease, the trustee must continue with the normal obligations under the lease until the liquidation plan is approved by the court. See 11 U.S.C.S. 365(d)(3). If the debtor is proceeding under Chapter 11, then the trustee may assume or reject an unexpired lease within the 60 days just as in a Chapter 7 case.
Until the lease is actually assumed or rejected, the trustee must perform all the obligations of the debtor arising from the lease and arising after the date of filing. This of course, includes the payment of rent. However, the Court may, for cause, extend the time for performance of an obligation and the case law is split on whether the rent is an expense of the estate and automatically is paid out of the estate account or if it gets treated like any other debt. This section also does not specifically address a remedy for the lessor if the trustee fails to comply with its obligations to pay rent. Generally, what needs to be done is to bring a motion to lift the Bankruptcy stay and request an unlawful detainer. This is really just asking the Bankruptcy Court for permission to bring an unlawful detainer. All of this, of course, takes time because of all the notice requirements. Also, generally, the trend is to not treat a failure to pay rent or perform other obligations as an automatic rejection of the lease or as a reason to deny an extension to assume. So, even if the tenant does not pay rent during the 60 days they may still be able to accept the lease.
The reality is that once Bankruptcy is filed, one must wait to see if there is an acceptance or rejection (they have 60 days) and, if rent is not being paid, to make a decision to file a motion in the Bankruptcy Court to obtain permission to evict the tenant with an Unlawful Detainer. During the 60 days, the tenant should pay the rent, but, if they don’t, your option is to bring the motion to lift the bankruptcy stay and bring the Unlawful Detainer.
Collecting past due rent incurred before the filing of the Bankruptcy is not possible if the tenant files a no assets liquidation bankruptcy and is part of the reorganization plan in a Chapter 11 Bankruptcy. Therefore, collection may be delayed and the amount will be adjusted.
If you have issues and questions arise in relationship to your commercial real estate, feel free to contact BGS Attorney Joan Quade.