On April 10, 2020, Governor Ned Lamont issued Executive Order No. 7X, detailed here, which instituted a moratorium on residential evictions and summary process actions until July 1, 2020. The Governor’s Order did not apply to commercial eviction proceedings. While a commercial landlord was permitted to serve a notice to quit and commence a summary process action during the COVID-19 pandemic, court closures throughout the State of Connecticut slowed these proceedings substantially. Since the threat of imminent eviction was minimized, a commercial tenant served with a notice to quit and sued in housing court had less incentive to seek a stay of these proceedings by filing a bankruptcy petition.
Of course, various commercial tenants with brick-and-mortar locations throughout the State have been acutely impacted by the State closures. Many businesses have been unable to meet all of their obligations including rent payments. With courts slowly reopening, commercial tenants that find themselves under the heightened threat of eviction, may begin to consider filing bankruptcy petitions. The following is a general summary of some of the implications of a commercial tenant filing a petition for bankruptcy.
The Automatic Stay. Upon a commercial tenant filing a bankruptcy petition, a pending summary process action is automatically stayed, including any efforts by the landlord to evict the tenant, with one notable exception. If the lease term had expired before the bankruptcy petition had been filed, a commercial landlord is permitted to continue any eviction action previously filed or may commence an eviction action, notwithstanding the bankruptcy filing. Otherwise, a landlord must immediately cease efforts to evict the tenant for any other reason, other than expiration of the lease’s term, and any eviction action pursued after the filing violates the automatic stay provisions of the Bankruptcy Code, and could well subject the landlord to monetary sanctions for doing so. A landlord has options, however, which may include a motion for relief from the automatic stay, by which the landlord seeks the Bankruptcy Court’s permission to continue or commence an eviction proceeding. The availability of this remedy will depend upon the status of the lease and the development of the bankruptcy proceeding.
Form of Bankruptcy Petition. How the bankruptcy proceeds will depend upon whether it is a Chapter 7 liquidation or a Chapter 11 reorganization, which are the two most common forms of bankruptcy petitions a business may file. The primary difference between Chapter 7 and Chapter 11 is that, in a Chapter 7 bankruptcy, a court-appointed trustee collects and liquidates the debtor’s assets for distribution to creditors, while in a Chapter 11 bankruptcy, the debtor company continues to operate as it pursues a Chapter 11 reorganization plan (which must be approved by the creditors and confirmed by the Bankruptcy Court) to pay pre-bankruptcy debts and obligations over a period of time. A business’s financial situation and prospects for continuing operations will certainly impact the form of bankruptcy filed.
Preliminary Considerations. In either Chapter 7 or Chapter 11 bankruptcy, two preliminary considerations for commercial tenants and landlords will be (i) what happens to the tenant’s occupancy during the pendency of the bankruptcy and (ii) what rent or arrearages will the tenant owe to the landlord.
With respect to the tenant’s occupancy, if the lease expired by its terms or by operation of law due to an uncured default before the petition, the lease is terminated and a landlord may move to lift the automatic stay to pursue eviction. In Connecticut, a notice to quit operates to terminate a lease. If the lease was not terminated before the petition, however, the lease is considered an asset of the bankruptcy estate. In either event, a landlord may always agree to negotiate a new lease.
With respect to damages, pre-petition arrearage claims are considered unsecured debts with lower priority while rent falling due for an unexpired lease after the bankruptcy petition is filed is considered an ongoing obligation of the tenant with higher priority as an administrative claim. The obligation to pay rent may be temporarily extended by the bankruptcy court for a maximum of 60 days. The debtor’s failure to pay rent may serve as a basis for the landlord to move to lift the automatic stay. If a lease is terminated pre-bankruptcy or rejected after the bankruptcy case is commenced, a landlord may also have a claim for damages because of the termination of the lease.
Unexpired Lease: Reject or Assume. If the lease had not been terminated prior to the bankruptcy filing, the trustee (Chapter 7) or the debtor (Chapter 11) may elect to reject, assume, or even assume and assign the lease to a third party (upon court approval). In a Chapter 7 liquidation, a lease is often rejected, but it may be assumed and sold as part of a business. In a Chapter 11 reorganization, whether a lease is rejected or assumed may depend upon myriad circumstances related to the tenant’s business. The decision must be made by the earlier of 120 days from the bankruptcy filing or the date of entry of an order confirming a plan (subject to a 90-day extension or further extension upon landlord consent).
Rejected Lease: Implications. If the lease is rejected or the time period elapses, the tenant is released from its obligations and must surrender the property. The landlord may collect damages for rent arrearages as well as termination of the lease capped at the greater of one year’s rent or rent for fifteen percent (15%) of the remaining lease term (capped at three years). The landlord’s claim for these damages is for an unsecured debt, which will only be paid if creditors with higher priority claims, such as administrative claims and claims for secured debts, are satisfied. Even then, if there are less funds available than what are needed to pay all of a debtor’s unsecured debts, the unsecured creditors would share the remaining funds on a pro rata basis.
One notable exception is that a landlord may have a perfected security interest in a security deposit, which is first used to satisfy the debtor’s obligations to the landlord. A security deposit is considered property of the bankruptcy estate, however, and may not be applied by the landlord unilaterally to arrearages once the bankruptcy petition is filed. The landlord would first need to obtain the Bankruptcy Court’s approval to apply the security deposit by filing a motion for relief from stay to permit the setoff. A landlord under most circumstances may reasonably apply the security deposit prior to the petition being filed but must be mindful of preference rules.
Additionally, post-filing rent until the date of surrender is considered an administrative expense, which should be paid before all other claims. If there is not enough money for all administrative claims, then the administrative claimants share proportionally.
Assumed Lease: Implications. If the lease is assumed, the tenant or bankruptcy trustee must provide “adequate assurance” that the defaults and arrearages will be cured in order to place the landlord in the position as if the tenant had not defaulted and the lease had been fully performed, as well as “adequate assurance” for the future performance of the lease. This potentially includes the obligations to replenish any drawdown on the security deposit. The tenant may request modifications or waivers from the landlord to negotiate mutually agreeable terms.
The tenant may also assume the lease and assign it, even despite the existence of anti-assignment language in the lease, subject to some limited grounds for the landlord’s objection, if the assignee’s financial position provides the requisite “adequate assurance” described above. One notable basis for objection is in situations in which the lease is of property in a shopping center. As is the case with a tenant’s election to assume a lease, the tenant must cure all defaults before the assignment.
Conclusion. The COVID-19 pandemic has negatively impacted businesses, both large and small. Some businesses may reasonably expect to recover, while others may shutter. In terms of a commercial tenant’s bankruptcy, there are a wide range of possible resolutions that may heavily depend upon the tenant’s options, motivations and ultimately, choices moving forward. For example, a landlord may have a greater chance to negotiate with a previously profitable small business that wishes to keep operating at its sole location, as opposed to a large business making strict economic decisions about which leases to assume or reject at its various stores or locations. To the extent the resolution is not an either/or proposition of rejection or assumption, a landlord and tenant may be in a position to negotiate a reasonable approach moving forward for the continuing operation of the business and occupancy of the property. Landlords in particular, will need to balance the concessions a tenant may request against the prospects of a vacancy in an unstable market.
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