10 Ways to Protect Yourself from Tenant Bankruptcies

No matter how financially sound your tenants seem at the start of a lease, there’s no guarantee they will stay that way. So it’s important to take all possible steps to protect yourself. Once a tenant files for bankruptcy, bankruptcy laws control what you can collect from the bankrupt tenant or its court-appointed trustee and what it can do with the tenant’s lease. As a result, you could end up losing a lot of money or having to deal with an undesirable third party in the tenant’s space.

Unfortunately, not all owners think about this ahead of time. Many leases may not offer any protection if a tenant goes under. Typical leases may contain only a boilerplate “bankruptcy cancellation clause” that lets you terminate the lease if the tenant files for bankruptcy—but that clause will often be unenforceable.

With the help of New York bankruptcy attorney Jeffrey N. Rich, we’ll tell you about several bankruptcy protections you should try to negotiate with all your tenants. You want these protections in place and available to use if you later become concerned with the financial well-being of a tenant. The more protections you can negotiate up front, the better the odds of reducing the financial impact of tenant bankruptcies later.

What You Need to Know

It’s important to understand the basics of bankruptcy in order to effectively negotiate protections for yourself. When a tenant files for bankruptcy, federal bankruptcy law (found in the federal Bankruptcy Code) lets the tenant’s trustee or the tenant itself either assume or reject the tenant’s unexpired lease with you, depending on which is more advantageous to the tenant. If the trustee or tenant assumes the lease, the tenant must correct its lease violations, continue to pay rent, stay in the space, and assure you that it will meet its lease obligations. The trustee or tenant will also have the right to assign the lease to a third party—but if that happens, you must get adequate assurance of continued, future performance of the lease obligations.

If the trustee or tenant rejects the lease, the tenant will stop paying rent and move out of the space. You’ll want to get compensated for the lease’s early termination. But all you’ll be allowed to do is make an unsecured claim for your damages, which can’t exceed the greater of: (1) one year’s rent; or (2) 15 percent of the rent for the remaining lease term (not to exceed three years). And, if you expected to get reimbursed for certain expenses or improvement allowances that you made, you may be out of luck if the tenant doesn’t have enough money to pay you back.

There’s also a question of whether you’re entitled to rent from the bankrupt tenant or its trustee for the period after the tenant files the bankruptcy petition and before it rejects or assumes the lease. Even if you are, some kinds of additional rent—particularly attorney’s fees—can be hard to recover.

Consider Bankruptcy Protections

Since the Bankruptcy Code can severely limit the amount of money that you can get from a bankrupt tenant or its trustee, consider seeking the following 10 bankruptcy protections whenever you negotiate a lease or related documents (for example, a letter of credit) with a tenant. Having the first four protections available can help you before a tenant files for bankruptcy. The rest can help you after the tenant files for bankruptcy.

Protection #1: Call decline in tenant’s net worth a lease default. A big drop in the tenant’s net worth could be a signal that the tenant is becoming financially shaky and may be on the verge of filing for bankruptcy. So protect yourself by having the lease call a big drop in the tenant’s net worth a material lease default. In most leases, a material—significant—lease default will let you terminate the lease, so you can get the space back and rent it to a more financially stable tenant.

You may benefit significantly if you can terminate the lease before the tenant files a bankruptcy petition. Then, the lease won’t be considered part of the bankrupt tenant’s assets. Add the following language to the lease where you list the tenant’s “Events of Default”:

  Model Lease Language

(x) If Tenant’s net worth is reduced to an amount less than $[insert #].

If the tenant balks at giving you this protection, you can suggest this compromise: If the tenant’s net worth has dropped considerably, the tenant must give you additional security, such as another guaranty or another letter of credit, by a certain deadline, says Rich. If the tenant fails to give you the additional security in time, it will have defaulted under the lease and you can evict it, he says.

Protection #2: Get tenant’s financial information on request. Since a tenant could go bankrupt quickly, stay on top of the tenant’s financial situation by making sure that you get the right in the lease to periodically check its financial information—such as financial statements, profit and loss statements, bank references, and Dun & Bradstreet report, says Rich. Getting this financial information will let you know if the tenant’s net worth has dropped low enough to trigger a lease default.

  Model Lease Language

Any time and from time to time, upon not less than [insert #, e.g., 10] days’ prior written request from Landlord, Tenant shall deliver to Landlord: (i) a current, accurate, complete, and detailed balance sheet of Tenant (dated no more than [insert #, e.g., 30] days prior to such request), including profit and loss statement, cash flow summary, and all accounting footnotes, all prepared in accordance with generally accepted accounting principles consistently applied and certified by the Chief Financial Officer of Tenant to be a fair and true presentation of Tenant’s current financial position; (ii) a current, accurate, complete, and detailed financial statement on Tenant audited by an independent certified public accountant; (iii) current bank references for Tenant; and (iv) a current Dun & Bradstreet report about Tenant. Tenant agrees that its failure to strictly comply with this Clause shall constitute a material Event of Default by Tenant under the Lease.

Expect a savvy tenant to demand a limit on the number of times you can request this information—say, no more than twice in any 12-month period.

Protection #3: Get sufficient security. Get enough security from the tenant to cover at least your up-front lease costs—such as brokerage fees and tenant improvements—as well as eviction costs. Otherwise, you’ll remain out-of-pocket for these costs if the tenant goes bankrupt. Although it would be nice to get security to cover rent payments too, a strong tenant probably won’t agree to that. And a smaller tenant probably won’t have the money. You’ll be able to make a claim for some of the outstanding rent payments in bankruptcy court.

Protection #4: Give no or short grace period to cure defaults. If the lease terminated before a bankruptcy filing, then the tenant will no longer be able to assume or assign the lease. However, most owners won’t want an automatic termination of the lease upon a tenant default as the default may be a minor one, such as one late payment. Therefore, another approach might be to make the grace period to cure a default very short in the hope that the lease would terminate before a bankruptcy ensues.

Protection #5: Avoid cash security. Regardless of how big a security deposit you require, consider having the lease require the tenant to give you a letter of credit as security rather than cash. The benefit of this kind of security is that if the tenant goes bankrupt, you won’t have to go through the bankruptcy court to draw on it. With a cash security deposit, you would have to wait to get the bankruptcy court’s permission to draw on it. Also, questions could be raised as to whether you have a perfected—that is, enforceable—security interest in the cash security.

As an additional bankruptcy protection, get a guaranty from the tenant’s principals, such as its officers, and make sure that the guaranty will keep the guarantors on the hook even if the tenant is discharged—that is, released—from its debts in bankruptcy.

Protection #6: Don’t link letter of credit to rent demand. If you get a letter of credit as security, beware of a possible obstacle: The tenant’s letter of credit may require that, if it doesn’t pay its rent, you must send it a notice of default before you can draw on the letter of credit. Then you must certify to the bank that issued the letter of credit that you sent the notice but the tenant didn’t correct the nonpayment. Here’s the obstacle: When a tenant files for bankruptcy, bankruptcy laws bar you from sending a notice of default to it. So you wouldn’t be able to collect on the letter of credit.

There are two approaches to avoid this obstacle: The hardball approach is to simply refuse to agree to give the tenant a notice of a default before you can draw on the letter of credit. If the tenant won’t accept that, consider this compromise: Have the letter of credit say that you agree to certify to the bank that you either sent a notice of default to the tenant demanding the unpaid rent or you were unable to send the notice because it was barred by law. That way, if the tenant files for bankruptcy, you can still draw down on the letter of credit.

To use this compromise, ask your attorney about including the following language in your letter of credit. (The term “Landlord’s draft” used in the Model Language refers to the owner’s request to the bank to draw on the letter of credit.)

  Model Lease Language

Landlord’s draft must be accompanied by a signed certificate stating either:

a. Tenant has defaulted in its obligation to pay rent under the Lease, and Landlord has transmitted to the tenant a notice required in respect thereof under the Letter of Credit (“Notice of Default”), but Tenant has failed to pay the sums demanded within in the time period set forth in the Lease; or

b. Tenant has defaulted in its obligation to pay rent under the Lease, and the transmittal of a Notice of Default by Landlord is barred by applicable law.

Protection #7: Make tenant pay improvement costs. Be careful when giving a tenant improvement allowance (TIA). If you expect to get the TIA paid back through the rent, but the tenant goes bankrupt, you may not recover any of it. To protect your interests, consider requiring the tenant to pay for all of its tenant improvement costs, including soft costs—that is, engineer and architect fees. If you make the tenant pay for these costs, you’ll typically charge a lower rent. But you won’t have to worry about being out-of-pocket for these costs.

Protection #8: Sign separate loan agreement for TIA. If the tenant doesn’t have enough funds to pay all of its improvement costs, you can consider lending the tenant part of or the entire amount that it’s deficient. But do it through a separate loan agreement—not the lease. If you put the loan arrangement in the lease, it may be subject to the bankruptcy law’s limitations on what you may collect in “rent”—that is, one year’s rent, or 15 percent of the rent for the remaining lease term (not to exceed three years). This could occur even if you spell out that it’s a loan.

Protection #9: Make lease rejection a default. Say in the lease that if the bankrupt tenant or its trustee rejects the lease, the rejection will cause a lease default. This language may help you terminate the lease and get the space back. Otherwise, if there’s a subtenant in the space, the subtenant might argue—and a court might agree—that the lease, even though rejected, isn’t terminated. That’s because the Bankruptcy Code says that a rejection of an unexpired lease constitutes a “breach,” rather than a termination, of the lease. Then the subtenant might argue that it has the right to continue subletting the space for as long as it pays the rent.

Consider adding the following language to the lease where it lists the “Events of Default”:

Model Lease Language

(x) Tenant rejects this Lease after filing a petition in bankruptcy or insolvency or for reorganization or arrangement under Federal bankruptcy laws or under any State insolvency act.

Protection #10: Restrict assignments. If a bankrupt tenant or its trustee has assumed the lease, it can then assign it. If this happens, you may be forced to accept an assignment of the lease—with little say in deciding who the new tenant will be. This can be especially troublesome if you’re concerned that an assignee will have a negative impact on your building or center. Although the Bankruptcy Code does impose some restrictions on whom a bankrupt tenant in a shopping center can assign to, it won’t let you completely block assignments. Also, any restrictions on assignments in your lease will be carefully scrutinized by a bankruptcy court and might be set aside. Even so, here are two ways that you might be able to control assignments to some degree:

> Use radius restriction. You may be able to control assignments by adding a radius restriction to your lease, says Rich. A radius restriction stops the tenant from operating more than one store within a certain radius of its space, he explains. The restriction, in effect, limits the bankrupt tenant’s or its trustee’s assignment right by reducing who qualifies as an assignee. The tenant can’t assign the lease to a store that already has other stores within the radius. But while the Bankruptcy Code recognizes radius restrictions in shopping center leases, be aware that radius restrictions can still be challenged by office tenants, Rich warns.

> Call retail property “Shopping Center.” If you have a retail building, call it a “shopping center” in the first part of the lease, where it describes the building. You may then be able to get extra protections under the Bankruptcy Code that aren’t available to other commercial property owners. The Bankruptcy Code gives shopping center owners more control over what kind of businesses can qualify as assignees of the tenant’s space so that the center’s tenant mix won’t be disrupted.

The Bankruptcy Code doesn’t define a shopping center. So any retail property housing two or more retail tenants—even a retail concourse area of an office building—could qualify as a shopping center. While there’s no guarantee that a court will agree that your property is a shopping center just because you say so in the lease, it’s worth a try.

Is Your Bankruptcy Cancellation Clause Useless?

Most leases have a bankruptcy cancellation clause. It typically says that it’s an “Event of Default” if the tenant files a bankruptcy petition or if involuntary proceedings under any bankruptcy laws or insolvency act are brought against the tenant and not dismissed within a certain number of days. The default could then allow you to terminate the lease. But this clause isn’t enforceable. The current federal Bankruptcy Code bars holding the tenant in default or terminating the lease because it files for bankruptcy.

But it still may be a good idea to include this clause in the lease, says Rich. Why? Because you might be able to rely on it in situations where the Bankruptcy Code doesn’t protect the tenant—for instance, if the tenant’s bankruptcy case is dismissed, he explains. It could also be useful if the code is ever changed in the future to allow lease terminations when a tenant files for bankruptcy, he adds.

Insider Source

Jeffrey N. Rich, Esq.: Rich Michaelson Magaliff Moser, LLP, 340 Madison Ave., 19^th Fl., New York, NY 10173; www.r3mlaw.com.