Structure Rent Repayment Plans to Take Advantage of New Bankruptcy ‘Preference’ Rules

They say that no good deed goes unpunished. And if you’ve cut tenants a break on their rent during the COVID-19 crisis, you may have learned the truth of this maxim the hard way. This is especially so if the tenant later declared for bankruptcy. Thanks to the so-called rule of preference, you might have had to cough up the deferred rent payments to the tenant’s other creditors.

But that probably won’t happen again, at least in the COVID context, if you know how to take advantage of the new federal laws that provide landlords and tenants temporary relief from the preference rules. Here’s what you need to know.

Bankruptcy, 101: The Rule of Preference

Section 547 of the U.S. Bankruptcy Code enables debtors and bankruptcy trustees to “claw back” certain out-of-the-ordinary payments that a debtor makes under an agreement entered into in the 90 days before it files for bankruptcy. In addition to having to disgorge that money, recipients of preference payments must move to the back of the line in the scramble to get whatever pennies on the dollar that they can from the debtor’s bankruptcy estate.

Normally, this is a good rule that protects creditors because it prevents debtors from gaming the bankruptcy system by transferring assets to preferred creditors before filing for bankruptcy. But during the pandemic, it has had unforeseen and undesirable consequences on commercial leasing. As businesses reel from COVID-19 financial losses, landlords and tenants have been collaborating to hammer out solutions. In most cases, this involves the delay or deferral of rent payment obligations. Regrettably, though, deferral and catch-up payments made under forbearance arrangements are subject to the preference rules if the tenant later files for bankruptcy. And that exercises a chilling effect on landlords.  

Example: Back when the pandemic begins, a landlord agrees to let a retail tenant that has to close temporarily under state emergency COVID-19 shutdown orders defer its April, May, and June 2020 rent and associated charges for six months. Under the deal, the tenant agrees to repay the regular rent plus a ½-month catch-up amount each month, starting Jan. 1, 2021. Better late than never, the landlord figures.

But the landlord’s attorney isn’t so sure. What are you nuts?! If the tenant goes bankrupt and doesn’t assume the lease, the attorney explains, as many as three of those rent repayments will be voidable preferences that the landlord will have to repay, depending on when the tenant actually files for bankruptcy. After the landlord gets an earful from counsel about the risk of the “preference” rule, it calls off the deal—or shortens the deferral period to such an extent that it grants the tenant no real payment relief.

Practical Pointer: Note that tenant payments under early lease termination agreements may also be deemed to be preferential and thus subject to claw back under Section 547.

The New Preference Relief Law

On Dec. 21, 2020, Congress passed a massive $900 billion pandemic relief package that the president signed six days later. Buried within the bowels of the 5,600-page Consolidated Appropriations Act (CAA) are a number of temporary changes to the Bankruptcy Code designed to help individuals and businesses get through the COVID-19 financial crunch.

The most impactful of these, at least as far as commercial leasing is concerned, are the revisions to the Section 547 preference rules. The CAA creates a temporary exception to the preference rules by exempting deferred payments made under rent deferral agreements made after March 13, 2020.

The 5 Rules You Need to Know

Knowing about the exemption is just the first step. Landlords (and tenants) also need to understand how the rules work and what they do and don’t cover. Here are the five things you need to know either to: (a) ensure that the rent forbearance agreements you make qualify for the exemption; or (b) determine whether the arrangements you’ve previously made need to be restructured.

1. Property arrangements covered. The landlord and tenant must have entered into a nonresidential lease or executory contract before the tenant went bankrupt. In other words, the CAA exemption from Section 547 preference liability doesn’t cover residential leases.  

2. Forbearance arrangements covered. The CAA specifically bans bankruptcy trustees and debtors from voiding a transfer of a “covered payment of rental arrearages.” This crucial term is defined as a payment of arrearages made in connection with an “agreement or arrangement” to defer or postpone rent and other periodic changes made or entered into on or after March 13, 2020. Because the exemption applies retroactively, your current forbearance arrangements may qualify.

3. Cap on repayment amount. To meet the “covered payment of rental arrearages” definition, the amount of deferred rent that the tenant must repay may not “exceed the amount of rent and other periodic charges agreed to under the lease” before March 13, 2020. In other words, you can’t charge the tenant a premium for deferring the rent.

4. No additional fees, penalties, or interest. A variation on the same theme as Rule 3 above is that “covered payment of rental arrearages” doesn’t include fees, penalties, or interest in an amount greater that what the tenant was scheduled to pay or what the tenant would have owed under the lease had it made every payment under the lease on time and in full before March 13, 2020. Thus, repayment amounts above the pre-March 13 rental amount will remain subject to preference claw back under Section 547.

5. Expiration date. The CAA exemption is temporary and “sunsets” two years after its enactment—that is, on Dec. 27, 2022. But that still gives landlords nearly two full years of protection.

Leasing Strategy

The punch line is that the new CAA preference relief rules give you more flexibility to enter into rent repayment arrangements with tenants facing COVID-19 financial challenges. Here are a couple of leasing pointers:

Put it in writing: It’s unclear whether a repayment deal must be in writing to qualify as an “agreement or arrangement,” or whether an unwritten course of conduct would be sufficient. Accordingly, attorneys recommend putting any repayment arrangements in writing just to be sure. This includes both the new agreements you make going forward as well as those informal arrangements dating back to on or after March 13, 2020, that are currently in effect, which you should go back and establish as a formal written agreement.

Think twice about early termination payments: Notice that the CAA definition of “covered payment of rental arrearages” that the Section 547 exemption covers does not include payments that tenants make to terminate their lease early. Accordingly, it may be worth considering structuring these arrangements as rent repayments to guard against risk of preference liability in case the tenant files for bankruptcy within 90 days of making early lease termination payments.

Be sensitive to due date: Recognize that the due date of a “deferred” payment that isn’t made has significant implications under bankruptcy law:

• A “deferred” rent payment that comes due after a tenant files for bankruptcy wouldn’t be subject to preference claw back and might be entitled to treatment as an administrative expense, which is typically paid in full; but
• A “deferred” rent payment that comes due before bankruptcy filing is likely to be deemed a general unsecured claim. Result: Landlords would probably get just pennies on the dollar.