In the Bankruptcy of a Commercial Landlord, Who Comes Out on Top in a Sale Free and Clear, the Landlord or the Tenant?

When a landlord is in bankruptcy, a tenant that is not related to the landlord and not a debtor in the bankruptcy action will be entitled to certain protections under bankruptcy law but will also have unique concerns.

Under the bankruptcy code, a trustee may reject burdensome unexpired leases and certain contracts known as executory contracts in which the debtor is a party. When this occurs, the rejection does not terminate the agreement, but rather is treated as a prepetition breach. The other party (i.e., not the debtor) cannot seek specific performance but has the right to an unsecured damage claim (cold comfort in many instances).  

Section 365(h) is a separate provision that applies to non-debtor tenants. If a trustee rejects a real estate lease of the debtor/landlord, the tenant has two options: (a) treat the lease as terminated, vacating the premises and assert a general unsecured claim against the landlord’s bankruptcy estate; or (b) if the lease term has already started, retain its rights in or appurtenant to the property for the remainder of the lease term, including remaining in possession of the property and continuing to pay rent. If the tenant chooses the second option, and the bankrupt landlord fails to perform its obligations post-rejection (e.g., paying utilities or taxes), the tenant can offset these damages from its rent but cannot pursue any rejection damage claims against the landlord’s bankruptcy estate.

These special tenant protections also extend to the tenant’s successors, assigns and mortgagees.

So far, what rights a tenant has or doesn’t have in this situation is fairly clear. Where it gets messy is when the debtor/landlord seeks to sell the leased property free and clear of interests, including the tenant's lease. 

Section 363(f) of the bankruptcy code allows a property to be sold free and clear of interests. This can conflict with the tenant’s rights under Section 365(h).  The $10,000 question is whether a Section 363 sale trumps the tenant’s rights under Section 365(n).

The answer is: maybe or maybe not. The courts are split and so far, no clarity is in sight.

If the landlord wants to sell the property free and clear of the lease, it should be addressed directly in the bankruptcy sale process, and if the tenant wants to remain in possession, the tenant should also raise the issue as early in the process as possible. There is no point in prolonging the pain and expense with no guaranty on either side of victory in the end.


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