Add Five Bankruptcy Protections to Lease

All signs point to the economy getting worse before it gets better. So, more than likely, you are going to have your fair share of tenant bankruptcies. Be prepared by negotiating certain bankruptcy protections with all your tenants.

When a tenant files for bankruptcy, federal bankruptcy law lets the tenant's trustee or the tenant itself either assume or reject the tenant's unexpired lease, depending on which is more advantageous to the tenant, says New York City attorney Jeffrey A. Moerdler. 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 will 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).

CHECKLIST OF BANKRUPTCY PROTECTIONS

The following protections can help you before and after a tenant files for bankruptcy. As always, speak with your attorney and review all language before adding anything to your lease.

[ ] 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, says Moerdler. In most leases, a material—that is, 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, he explains.

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 #].

[ ] 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 Moerdler. 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.

[ ] 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, says Moerdler. 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.

Practical Pointer: As an additional bankruptcy protection, Moerdler suggests getting a guaranty from the tenant's principals, such as its officers, and making sure that the guaranty will keep the guarantors on the hook even if the tenant is discharged (released) from its debts in bankruptcy.

[ ] Don't Link Letter of Credit to Rent Demand

If you get a letter of credit as security, 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. Then, if the tenant files for bankruptcy, you can still draw down on the letter of credit.

Ask your attorney about including the Model Language below in your letter of credit:

Model Language

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

1. 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

2. 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.

[ ] 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.

Here are two ways that you might be able to control assignments to some degree:

1. Use radius restriction. You may be able to control assignments by adding a radius restriction to your lease, says Moerdler. A radius restriction stops the tenant from operating more than one store within a certain radius of its space. 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 federal bankruptcy code recognizes radius restrictions in shopping center leases, be aware that radius restrictions can still be challenged by office tenants.

2. Call retail property “Shopping Center.” If you own 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 federal bankruptcy code that aren't available to other commercial property owners. The federal 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 federal 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.

Practical Pointer: Although the federal 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.

Insider Source

Jeffrey A. Moerdler, Esq.: Member, Mintz, Levin Cohn, Ferris, Glovsky and Popeo, P.C., 666 Third Ave., New York, NY 10017; (212) 692-6700; JAMoerdler@mintz.com.

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