In a chapter 11 bankruptcy, a business may:
- reject leases on unprofitable locations with a cap on damages
- assume leases on profitable locations with a one-year payment plan for past-due rent
- assume and assign leases to a third party
Rejecting Leases and Capping Damages
On May 4, 2020, J.Crew filed for chapter 11 bankruptcy, becoming the first major retailer to fall victim to the economic impact of COVID-19. They will use bankruptcy to break leases on their unprofitable stores. This makes good business sense. Outside bankruptcy, a business that breaks a lease is responsible for the remainder of the rent due, i.e., if there is five years left on a lease, the company owes the landlord five years’ rent. Landlords have a duty to mitigate damages by actively seeking a new tenant, but finding a tenant during the COVID-19 crisis, especially one at the same rent, has been and will continue to be difficult. If the new tenant pays a lower market rent, the defaulting business must pay the difference.
Bankruptcy caps those damages to the greater of one year or 15 percent of the remaining rent due up to three years.[1] These prepetition damages become an unsecured nonpriority claim in bankruptcy to be dealt with through the plan of reorganization.[2]
Assuming Leases with a Payment Plan for Past-Due Rent
Businesses may assume leases on locations they wish to keep open.[3] A business that is behind on rent may assume those leases by “promptly” paying past-due rent and providing adequate assurance of their future ability to pay.[4] “Promptly” is generally considered to be a one-year payment plan.[5]
After filing for bankruptcy, businesses must be prepared to be current on post-petition rent for locations they want to keep, or they could find themselves subject to a relief from stay motion and then evicted.[6]
Assuming and Assigning Leases
A location that is unprofitable for one business might be desired by another. Bankruptcy allows a business to transfer its lease in a process called assume and assign.[7] Landlords have little power to object to these transfers.[8] These transactions can bring in money from a transfer fee and avoid rejection damages.[9]
Process, Deadlines, Ipso Facto, and Other Considerations
Process. Leases are assumed or rejected by motion or through the plan or reorganization.[10] The court uses the “best interests” test, which presumes that the debtor acted “prudently, on an informed basis, in good faith, and in the honest belief that the action taken was in the best interests of the bankruptcy estate.”[11]
Deadlines. Chapter 11 business debtors have 120 days from the date of filing bankruptcy to assume or reject their unexpired leases, extendable for good cause by 90 days to a total of 210 days.[12] Unassumed leases are automatically rejected after the deadline.[13] State law determines whether a lease is unexpired as of the petition date. It is essential to file the bankruptcy before any of the leases they wish to assume are terminated under state law.[14]
Ipso Facto. Bankruptcy renders inoperative clauses that modify the lease because of insolvency (Ipso Facto clauses).[15] This includes the recapture of move-in incentives or acceleration clauses.
This article has discussed tools and strategies to help a business manage its leases and hopefully emerge successfully from the COVID-19 economic crisis.
[1] 11 U.S.C. § 502(b)(6).
[2] 11 U.S.C. §§ 365(g)(1), 502(g)(1).
[3] 11 U.S.C. § 365(b)(1).
[4] Id.
[5] General Motors Acceptance Corp. v. Lawrence, 11 B.R. 44, 45 (BC ND GA 1981).
[6] 11 U.S.C. § 365(d)(3).
[7] 11 U.S.C. § 365(f).
[8] 11 U.S.C. § 365(f)(1).
[9] 11 U.S.C. § 365(k).
[10] 11 U.S.C. § 365(a).
[11] In re Pomona Valley Med. Group, Inc., 476 F.3d 665, 670 (9th Cir. 2007).
[12] 11 U.S.C. § 365(d)(4).
[13] Id.
[14] 11 U.S.C. § 365(c)(3).
[15] 11 U.S.C. §§ 365(b)(2)(A),(B) & (e)(1), 541(c)(1)(B)
