Lately I’m reminded of the Chinese curse wishing the listener “interesting times,” and the dynamic between desperate tenants with credit lines and inventory/equipment financiers, and frantic landlords with mortgages, has indeed been interesting of late. Seems like tenant inability to perform its commercial lease obligations is a recurring theme. So, what do the parties have to take into account?
If a tenant cannot persuade its landlord to release it from its lease obligations in difficult economic times, then it may shortly face the unenviable path of bankruptcy. Consequently, landlords and tenants need to review the documentation to recall the status of guarantees. If the tenant principals signed no guaranty, or if only one spouse in a marital community signed, there may be no reason to file for bankruptcy relief.
Recall that a guaranty signed by a single spouse is binding only on the separate property of the signing spouse, not upon the separate property of the spouse not signing, nor on that (unsigned) spouse’s undivided interest in the community property of the Arizona-based guarantor. (The same applies if the guarantor principal is a resident of California, Washington and several other western states.) Many marital communities have little separate property that is reachable by execution on a judgment.
If there’s no effective guaranty the tenant may have little incentive to file bankruptcy, but if the tenant wants to protect significant equipment or inventory from execution or seizure and sale under a landlord’s lien (or liens or interests of other parties [see below]), then a bankruptcy may be in order.
What should the landlord do if it has a reasonable certainty that bankruptcy is forthcoming? Before answering that question, how best will the landlord read the tenant who asserts it intends to do so? There are a few behaviors that signal a bankruptcy is forthcoming. Closing the premises (“going dark”) or failing to communicate with the landlord after it has changed the locks after a tenant monetary default usually a good sign that bankruptcy looms, except in the case where a tenant has moved all its wares and operates from more than one location—in that instance, closure may be only an indication of consolidation of inventory or services. Handing the landlord’s representative a business card from the office of a bankruptcy attorney may be another indication of imminent action. The seizure of a tenant’s inventory, equipment or trade fixtures by a secured lender or equipment lessor is a sign that filing is highly probable. Another is the tenant’s announcement of severe curtailment of operating hours, or reduction in staff to levels well below the usual complement of personnel at the premises.
While tenant lockouts (when available as a landlord remedy) without termination of the lease are effective to get the tenant to make up back rent, CAMs or other lease sums when money is available, they are pointless when the tenant can’t catch up the delinquency(ies) in performing the lease and a bankruptcy seems inevitable. If there’s no reasonable hope for the tenant catching up on its obligations, review carefully the landlord’s remedies section of the lease. If termination is an option without notice to the tenant, the landlord has to consider the option of ending the lease by notice to the tenant of summary termination.
The automatic stay of bankruptcy under Section 361 of the Code does not apply when a landlord’s asset is not property of the bankruptcy estate. If the landlord cancels the lease properly, prior to the date of the bankruptcy filing, this ends landlord’s risk that the tenant will consume up to 120 days—with no compensation to landlord in the meantime–to assume (or assume and assign) or reject the lease in the bankruptcy where the tenant seeks to reorganize under Chapter 11. (Of course, in a Chapter 7, the bankruptcy trustee will have control of the premises until it makes a determination whether the lease has any liquidation value, an unlikely circumstance in the significant majority of bankruptcy filings. Also, in the present financial environment, it would be rare indeed for a Chapter 11 debtor to be able to find an assignee for the lease obligations, unless it was in connection with sale of its operating business.)
So, should the landlord fire the bankruptcy-beating termination “silver bullet” when it appears likely that the tenant will soon be in federal court, to defeat the imposition of the automatic stay? Well, not always. The landlord has to calculate several things in the decision matrix. How long can the tenant hold on before filing bankruptcy? After all, from the date of termination forward, the landlord cannot recover future rent through the scheduled expiration date of the lease, so is limited in recovery to the delinquent rent and other charges amounts prior to the date of the tenant’s filing. Terminating the lease too soon costs the landlord potential rent payments for some period.
Another consideration is who has competing claims to the non-leasehold assets of the tenant. There may be equipment lessors; or conventional lenders with perfected security interests in certain assets (or the FDIC, if the lender has itself faced insolvency); or the SBA who guaranteed a business loan and took a security interest; or a franchisor or analogous asset-provider. Another factor is this: Did the tenant remove all its personal property out of the landlord’s premises—or does a lot of it remain parked inside the premises, even if the tenant has “gone dark?” In addition, there has to be a review of the lease file to see if landlord has signed a subordination of its statutory lien position against the personal property. Or—wait—does that even matter, if the lease had been terminated by the landlord? Recall that when the lease is terminated, there is no landlord-tenant relationship; and in that case, how can there be a “landlord” lien prescribed by statute? If a former landlord forgoes its landlord status, there goes the lien.
The last situation becomes a dilemma for the landlord. If it has canceled the lease before the property of the tenant is finally removed, the automatic stay impacts the landlord’s options with respect to those trade fixtures. While there may be an available landlord administrative claim in Chapter 11 for the property’s ongoing premises occupancy after the filing, for storage costs, that will not do much to position the premises for re-letting.
So did the landlord’s lease happily recite that (a) upon termination of the lease, any property of the tenant remaining within the premises is deemed to have been abandoned by the tenant and (b) that this “convention” would survive termination of the lease? If the landlord is not so well-positioned, then the landlord will want to consider the following course of conduct:
Research whether there are other parties with a status of owner, lessor or secured party with respect to the personal property;
Decide whether to terminate the lease prior to a bankruptcy filing;
With a high-quality still or motion camera, take a photographic inventory of all tenant property within the premises (this avoids liability in the face of future allegations of theft, destruction or damage to tenant’s property or personal effects of employees of tenant);
If the landlord has decided to terminate the lease and there’s more strategic space available to the landlord, move the personal property of the terminated tenant to that more salutary location, carefully, minimizing damage or loss to the property. Re-video the personal property after the move is completed, documenting the condition of the inventory of goods.
My clients gripe about this responsibility for remaining tenant personal property more frequently than any other aspect of bankruptcy (except that tenants should not be allowed to use it in the first place to re-order their business lives). First, they believe that the ipso facto principle is “just wrong,” so they should not be responsible for any dimension of the tenant’s future, because the lease provides that a bankruptcy is a material default and the tenant and its principals deserves everything they get from the moment of filing forward. Second, there’s a major disconnect between the idea that landlord had the right to terminate the lease before the bankruptcy filing date but not to throw the tenant’s property into the nearest dumpster or on the sidewalk with a “free stuff-help yourself” sign on the top of the heap. Of course, that ignores the possibility that there are other stakeholders in the property’s ownership, in addition to the fact that there may be some recovery to the landlord via an administrative claim. And, most of all, it ignores the reality that the termination of the real property right of tenant does not give the landlord license to ignore the automatic stay of the Code with respect to other debtor assets contained within the leased premises.