Because federal bankruptcy law preempts California landlord/tenant law, it’s important that commercial landlords and tenants alike understand the process when a tenant has filed for (or is considering filing for) bankruptcy. The timing of a tenant’s bankruptcy is critical because once a tenant files for bankruptcy an automatic stay immediately stops any state court action against the tenant including pending unlawful detainer actions (evictions). Once the bankruptcy stay is in force, the tenant can maintain possession of the premises for up to seven months so long as it pays rent post bankruptcy filing. Landlords’ recourse depends entirely on the timing of the landlord’s pre-bankruptcy actions. If a judgment is obtained prior to the bankruptcy filing, the landlord will be able to recover possession. If an unlawful detainer action is filed but a judgment is not yet obtained, the landlord can file a motion with the bankruptcy court seeking to lift the stay so that the landlord can proceed with the unlawful detainer action. This can be accomplished in relative short order. If the bankruptcy action is filed before the landlord filed an unlawful detainer action, then the landlord is bound by the bankruptcy procedures which give tenants 120 days time to consider their options (90 days longer with a court approved extension).
Due to the bankruptcy risk, it’s advisable for landlords to move quickly where they suspect a tenant is heading for bankruptcy and is behind in rent. Of course, there is a cost (especially for large retail centers) to serving three day notices and filing unlawful detainers on the drop of a hat. Long time tenants with proven track records are known entities. There is a benefit to working with these known entities to see if the problem is a short term one or, if not, whether a compromise can be reached. Either way, open lines of communication allow landlords to get a better sense of the tenant’s current position while simultaneously letting the tenant know that the landlord is willing to talk. However, if there is any hint that bankruptcy is on the horizon, the sound business decision is to file an unlawful detainer action as soon as possible (after a three day notice to pay rent or quit is served) and to pursue the action to judgment as quickly as possible.
The decision for tenants on the verge of bankruptcy on the other hand is much simpler. They want to file for bankruptcy as soon as possible. However, it’s important that they are not filing bankruptcy for the sole purpose of avoiding eviction. First, at best the eviction proceedings are merely delayed (and rent for the post bankruptcy filing will still be due). Second, there are consequences to filing frivolous bankruptcies. For a tenant that truly qualifies, bankruptcy is certainly worth considering and back due rental obligations should be a factor in that decision. Because of the negative consequences attached to bankruptcy, it’s important to consult with a bankruptcy attorney to fully understand whether it is right for your business.
Once a landlord knows that a bankruptcy has been filed, it must immediately stop any efforts to collect pre-petition debt. The landlord should not serve three-day notices or continue any existing unlawful detainer action. This includes sending demand letters or even making telephone calls regarding collection. Landlords who knowingly violate the automatic stay can be liable for damages including punitive damages. However, where an unlawful detainer action was filed prior to bankruptcy, Landlords can file a Motion for Relief from Automatic Stay with the bankruptcy court asking that the stay be lifted. This can take anywhere from a few days to as long as six weeks.
If the tenant files for bankruptcy before an unlawful detainer complaint is filed, then the landlord’s options are limited by bankruptcy procedures that provide tenants time to make decisions about how to deal with the lease. The tenant has 120 days to decide whether to reject, assume or assign the lease, and upon court approval can obtain a 90 day extension for this decision (a total of seven months). This allows the tenant to remain in possession of the premises but with the important caveat that the tenant continues to pay rent during this period.
If the tenant opts to reject the lease (usually because the market is favorable to lower rents), the tenant must surrender possession. The unpaid rent which was due prior to the bankruptcy filing becomes an unsecured debt. To assume the lease (continue the lease), the tenant must demonstrate to the bankruptcy court that it can meet its future lease obligations and must meet all previous obligations under the lease including paying previously unpaid rent. A tenant may also opt to assign the lease to a third party in which case all prior obligations must be satisfied including past due rent. While most commercial leases contain provisions that limit or place conditions on assignments, bankruptcy courts usually approve assignments so long as the debtor demonstrates that the new tenant can perform its lease obligations. Landlords have greater protection in the retail center context – the landlord can require that the new tenant be at least as financially sound as the debtor, that the new tenant demonstrate that percentage rent (if any) will not decline, that the tenant mix at the center not be disrupted and that radius and exclusivity clauses are not violated.
Contact an experienced San Diego commercial lease lawyer for more information on tenant bankruptcies.