How to structure a lease to protect against the risk of a bankrupty of the tenant

Real Estate Issues, Fall 2001 by McNally, Susan Fowler, Klein, Carter H, Abrams, Michael s

The recent downturn in the economy has resulted in greater volatility in the financial status of many tenants, thus compelling landlords entering into office leases with these tenants to accept far greater risks than they are accustomed to. Due to the unconventional nature of the tenant improvements that many of these tenants require (i.e., dot.com and high-tech tenants), their premises may not be readily re-leasable if they default. This article will explore how landlords can reduce the risks involved in leasing space to such tenants.

Landlords generally prefer to enter into leases with creditworthy tenants (i.e., tenants with high and demonstrable net worth, substantial tangible assets, and a long track record of successful operation). Start-up companies generally do not have significant net worth, but they usually do have a significant burn rate (i.e., the rate at which they burn though other people's money, whether angel financing, venture capital, or money raised through a public offering). When the financial status of a tenant is extremely volatile, the risk of a lease default increases. Dot.com tenants usually have no tangible assets and their operating histories cover a span of months (if not weeks) rather than years. The tenant improvements preferred by most high-tech tenants are unconventional and many (especially Internet and telecom-related companies) require significantly greater electrical and air conditioning capacity than traditional office tenants. Landlords attempting to re-lease high-tech premises after an early termination due to a tenant default may find themselves spending substantial sums of money to alter the premises for a more traditional tenant's use.

To induce landlords to accept the risks associated with renting to tenants whose long-term financial stability is questionable, many such tenants offer various credit enhancements, the most widely accepted of which are cash security deposits, personal guaranties, and letters of credit. Historically, the most typical forms of security accepted by landlords have been cash security deposits and prepaid rent. Both have certain limitations under bankruptcy and state laws. To understand these limitations, and to appreciate the advantages of letters of credit, it is necessary to understand how a landlord's claims against a tenant in bankruptcy are treated by the bankruptcy court.

sec 362(a) of the Bankruptcy Code provides for an automatic stay or injunction against creditors taking various types of actions affecting the debtor or its property. The stay issues automatically from the moment the petition for bankruptcy is filed by or against the debtor. The automatic stay prohibits creditors from taking possession or otherwise obtaining any property of the debtor, enforcing a lien against the debtor's property, or continuing any litigation against the debtor, after the debtor has filed for or become the subject of bankruptcy proceedings and until the bankruptcy court grants relief from the automatic stay. A landlord's claims against a tenant in bankruptcy are treated differently based on whether the tenant assumes or rejects the lease. If the tenant assumes the lease, the lease is reinstated and the landlord is paid all arrearages. If the tenant rejects the lease, the landlord's claims are subject to a statutory cap.

During the period commencing on the bankruptcy filing date and continuing until the debtor's assumption or rejection of the lease (the "Post Petition Period"), the debtor is required to perform all of its obligations, including paying the rent, in a timely manner.

Under sec 365 of the Bankruptcy Code, the trustee or tenant/debtor in possession ("debtor") must either assume or reject the lease within 60 days of the bankruptcy filing date; however, the court may grant one or more extensions of the 60-day period and routinely does so. A landlord may oppose an extension of the time period, or move to compel the debtor to assume or reject the lease; however, unless the debtor is in default with respect to its Post Petition Period lease obligations, the landlord is unlikely to prevail.

The landlord is entitled to an administrative claim (i.e., a claim that gets paid before the claims of other unsecured creditors) for any default by the debtor during the Post Petition Period. The landlord may also obtain a bankruptcy court order compelling the debtor to immediately pay all defaulted amounts incurred during the Post Petition Period. This is the case even if the debtor has insufficient funds to pay all other administrative claims in full, such as those of the debtor's attorneys and other professionals.

In order to either assume the lease, or to assume and assign the lease to a third party, the debtor must cure all existing defaults and provide adequate assurance of future performance under the lease. The two principal issues between debtors and landlords over the assumption and assignment of leases are (1) what defaults exist and the amount of money or other actions necessary to cure the default and (2) whether the debtor's or its assignee's financial condition is sufficient to demonstrate adequate assurance of future performance. Generally, with respect to adequate assurance, the court will permit an assignment of the lease if the assignee's financial position is substantially comparable to that of the debtor's at the time the debtor entered into the lease.