Lease Terms and Tenant Defaults or Bankruptcy
The COVID-19 pandemic may be starting to abate, but certain sectors of the economy — including commercial real estate — will feel its effects for years to come. Commercial real estate owners in sectors hit hardest by the pandemic, such as hospitality, office leasing and malls, will have a slower recovery than industrial space or retail space dedicated to consumer staples. Some tenants will remain, but others will go out of business, leaving empty space and unpaid rent.
What options do landlords have if a tenant defaults on his or her leases, wants to renegotiate details, or declares bankruptcy? The answer depends on the terms of the lease.
- Cash security. Generally, if there is a cash security deposit, the landlord can apply it to the tenant's default. However, if the tenant files for bankruptcy, the deposit is considered part of the bankruptcy estate. Once that happens, the landlord is considered a secured creditor. Secured creditors are not paid until the bankruptcy is settled, unless the bankruptcy court approves a motion for the landlord to have access to the funds.
- Letter of credit. The situation is different if the tenant's security is in the form of a letter of credit. In this instance, the landlord's agreement is with a third-party bank or other guarantor rather than with the tenant. If the tenant defaults or files for bankruptcy, the landlord can draw on the letter of credit for debt service payments or payments to contractors if he or she is compliant with all other requirements outlined in the letter of credit (e.g., formally declaring the tenant in default).
- Guarantor. Depending on the tenant's creditworthiness, a landlord may require a third-party guarantor. This is because small-business owners are often asked to personally guarantee that rent will be paid. Small-business owners can protect themselves by forming LLCs or S-Corps. Signing the lease as an officer of the corporation helps protect them from personal liability for the actions of the business entity, such as defaulting on a lease. However, a guarantor may not protect the lessee in the event of bankruptcy, since the landlord is not precluded from collecting from a third-party guarantor who is not bankrupt. This means the guarantee will stand unless the tenant-guarantor declares personal bankruptcy.
Another important factor for commercial landlords to consider is related to the temporary changes made by the Consolidated Appropriations Act, 2021 (CAA), which was signed into law on December 27, 2020, to Chapter 11 of the Bankruptcy Code. The affected sections include Bankruptcy Code Section 365(d)(4) (giving debtors more time to decide whether to continue in their existing leases); Bankruptcy Code Section 365(d)(3) (extending the time for Subchapter V small-business Chapter 11 debtors to pay rent); and Bankruptcy Code Section 547 (allowing a debtor or a trustee to recover payments made by the debtor during the 90-day period prior to commencement of the bankruptcy case). These changes will sunset on December 27, 2022, but will apply to any bankruptcy case commenced before that date.
Wherever possible, commercial landlords should take the time now to review their tenants' leases and assess their options.
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