Tenants Beware: Your Landlord's Bankruptcy Could Result in a Lost Lease

It is unfortunate, but true: a commercial tenant may someday be required to deal with a bankrupt landlord.  Any bankruptcy filing can be complicated and chaotic.  But, a tenant faced with a landlord's is more than just a creditor who is working to get paid.  The tenant must closely monitor the landlord's bankruptcy case to ensure that the tenant's leasehold interest is preserved and protected.  While bankruptcy law provides tenants with some protection, a tenant that sleeps on its rights may find itself out of luck and out of the leased space.

Bankruptcy law provides landlords with certain rights and options with respect to leases. The landlord may choose to "assume" the tenant's lease.  In that situation, the landlord is required to pay (or "cure") any past due amounts that the landlord may owe to the tenant.  The landlord is  also required to affirm to the bankruptcy court that the landlord can perform for the remaining term of the lease.  From the tenant's perspective, this is the best case scenario.  Aside from the administrative hassle of dealing with the case, such a tenant is not meaningfully affected by the bankruptcy.

The landlord may also decide to assume the lease and then assign it to a third party.  Again, assumption would require curing past amounts owed.  As for the assignment, the proposed assignee would be required to provide the tenant with "adequate assurance of future performance," meaning that the assignee must demonstrate the experience and financial wherewithal to step into the shoes of the landlord and perform under the lease.  Importantly, the landlord is not permitted to alter the terms of the lease as part of the assignment and the assignee will be required to abide by all the same terms as the original landlord.  The tenant will be given an opportunity to object to the assignment.  However, if the tenant does not find the assignee objectionable, the tenant will once again be in the enviable position of not being substantively affected by the bankruptcy case.

In the alternative, the landlord may choose to "reject" the lease.  Rejecting a lease allows the landlord to walk away from its obligations under the lease, leaving the tenant with a choice under section 365(h) of the Bankruptcy Code.  The tenant may either: (1) treat the rejection as a termination of the lease, vacate the space and file a claim in the bankruptcy case for damages; or (2) elect to retain the tenant's rights under the lease for the remaining term.  If the tenant chooses to retain its rights, the tenant will be permitted to offset rent payments against the obligations that the landlord was required to meet under the lease (for example, providing security or maintaining landscaping at a shopping center).

Therefore, by virtue of either the assumption of the lease or by the protections provided in section 365(h) if the lease is rejected, there is no circumstance where the tenant of a bankrupt landlord loses its leasehold interest, right?  Wrong.  The leasehold interest may be lost if the landlord seeks to sell its assets under section 363 of the Bankruptcy Code.   The circumstances could unfold as follows:  a landlord files bankruptcy and seeks to sell substantially all of its assets in a 363 sale.  The landlord sends all parties to the bankruptcy case (including the tenant) a sale motion that includes 300 pages of exhibits.  Buried in the sale motion is a statement that the sale of assets will be "free and clear of any interest" under section 363(f) of the Bankruptcy Code.  The bankruptcy court sets a very short deadline to object to the sale motion.  The tenant does not file an objection and the bankruptcy court thereafter enters an order approving of the free and clear sale.  The purchaser of the assets then shows up at the location and advises the tenant that it has no leasehold interest.  The tenant runs into bankruptcy court arguing that it has the right under section 365(h) to remain in the space.  The bankruptcy court rules that the tenant did not assert those rights and that the sale of the real estate was sold free and clear of all interests, including the leasehold interest.

These were generally the facts involving a tenant in a 2003 decision by the Seventh Circuit Court of Appeals, Precision Industries, Inc. v. Qualitech Steel SQB, LLC.   Since 2003, several cases have followed the Qualitech Steel reasoning in determining that a tenant did not preserve its leasehold interest.  In contrast to the facts in the Qualitech Steel case, in Dishi & Sons v. Bay Condos, LLC, a May 28, 2014 decision by the District Court for the Southern District of New York, the tenant affirmatively and vigorously asserted its rights under section 365(h) in the context of a 363 sale and the district court affirmed the tenant's rights to remain in the space after the sale.  While the tenant preserved is rights in the Dishi case (unlike the tenant in the Qualitech Steel case), the Dishi case demonstrates that this issue remains a real risk for tenants who do not speak up in a bankruptcy case.

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