Bankruptcy and Concerns of Tenants (unedited version)

Published in the Boston Business Journal, 7/6/2012 - David Ho

"There are more serious problems in life than financial ones, and I've had a lot of those. I've been broke before, and will be again." - Willie Nelson

Bankruptcy
In the U.S., business bankruptcy is a liquidation or a re-organization. The process can be briefly summarized as follows:

1. A petition filing in the local federal bankruptcy court;
2. An immediate automatic stay during which creditor actions are halted;
3. For liquidations, trustee appointment by the federal government (in re-organizations, the debtor usually acts as trustee);
4. Acceptance or rejection of existing contracts by the trustee;
5. Liquidation by debtor or trustee under court supervision or re-organization approval by the court.

In a liquidation, secured creditors, such as a mortgagee, receive funds from the sale of their collateralized assets. Otherwise and subject to more specific rules, proceeds are paid in the following order until the funds are depleted:

• bankruptcy trustee and post filing debts;
• wages and benefits, customer deposits and taxes;
• general creditors (i.e. everyone else) – suppliers, collateralized sale shortfalls, lenders etc;
• owners / share holders.

In a re-organization, the debtor can acquire new financing. Existing contracts can be modified or rejected. The court must approve the re-organization and may do so over the objection of a class of creditors (i.e. a cramdown) if it is believed they have been treated equitably.

“Everybody considering bankruptcy is broke.” - Travis Plunkett

Concerns of Tenants
There are two chief tenant concerns. One worry would be that the landlord owes but has NOT paid the tenant incentives BEFORE the bankruptcy is filed. The best avoidance is for the tenant to collect these funds at lease execution.

Otherwise escrow, a letter of credit (LOC) and / or the tenant’s right to offset rent are common protections. Without these measures, the tenant becomes a general creditor.

In an escrow, the funds are deposited with a third party who disburses the monies in accordance with an agreement that is consistent with the lease. The LOC provides for payment by the issuer to the tenant upon demand.

In both cases, there may be a delay in disbursement if there is a bankruptcy. If the escrow agent or LOC issuer becomes insolvent, some or all of these dollars may be lost.

A tenant offset right against rent is financially helpful. Nevertheless, there may be impacts to the tenant’s cash flow statement and balance sheet notwithstanding the unbudgeted expenditure.

Barring the receipt of the tenant incentive monies at lease execution, a combination of the right to offset against rent and an escrow or the LOC might be prudent.

Another worry is landlord bankruptcy DURING the lease term. If the landlord or its trustee ACCEPTS the lease, landlord defaults must be cured.

If the lease IS rejected, the tenant may void the lease OR remain in possession in which case the tenant is a general creditor for prior landlord defaults unless it has contractual rent offset rights.

In a rejection where the tenant elects to remain, expansion options may become void and the landlord unable to provide lease services such as property maintenance. If this occurs, the tenant may perform and offset these costs against rent. However, rent may be insufficient to cover costs and this may be impractical if the lessee only occupies a small portion of the building.

Hence, as landlord bankruptcy becomes prevalent, tenants must understand lease vulnerabilities better. They should focus more attention on defensive measures and if possible, landlord financial health.

“In Europe, bankruptcy laws are designed to protect creditors. We’re a nation founded by debtors, people who were trying to get away from debtors’ prison.” – Carl Steidtmann

Ho is a corporate real estate consultant specializing in transactions management, strategic planning, negotiations and training. He can be reached at david@hocommercialre.com.