The commercial real estate market is in distress. While residential foreclosures have received the bulk of media coverage, owners of commercial real estate are defaulting on their mortgages at an unprecedented pace. If your business leases commercial space, the likelihood that your landlord will file for bankruptcy is higher now than it has been in recent history. Because a landlord bankruptcy may occur without warning, tenants need to be aware of their rights and responsibilities in the event a filing does occur.

When a landlord files for bankruptcy, the Bankruptcy Code allows the landlord to either "assume" or "reject" an unexpired lease of real property. The decision to assume or reject any particular lease will be based on a number of factors, including whether the lease is above- or below-market, the duration of the lease and whether the landlord has significant cash obligations to the tenant. In general, a landlord will seek to assume favorable leases that complement its future business plans and reject unfavorable leases that are not necessary to an effective reorganization.

If the lease is assumed—an act which requires court approval—any outstanding unpaid obligations of the landlord (e.g., payment of tenant improvements) must generally be paid at the time of assumption. The parties then go forward as if there had been no bankruptcy. Alternatively, the landlord may seek to assume the lease and then assign it to another entity (e.g., a strategic or financial buyer).

If the lease is rejected, a tenant generally has two options:

  • The tenant can treat the lease as terminated and vacate the space. The tenant would then have a monetary claim against the landlord for damages arising out of the termination (including a claim for unpaid construction allowance payments). This claim would be treated in bankruptcy as an unsecured claim.
  • Alternatively, the tenant may retain its rights under the lease, including its rights of use, possession, quiet enjoyment, assignment, subletting and hypothecation, and continue to occupy the space and pay rent for the remainder of the term, including any renewals or extensions. If the lease term has begun and the tenant elects to retain its rights under the lease, the tenant must continue to pay rent, but may set off amounts owed by the landlord under the lease against its rent obligation, including any unpaid construction allowance (even if the lease does not provide for offset). Under this second option, the tenant will not have a monetary claim against the landlord beyond the right to set off rent.

Another important issue for a commercial tenant is the return of its security deposit. A tenant’s right to recover a security deposit in the event of a landlord bankruptcy will vary based on the terms of the lease and whether the lease is assumed or rejected. If the lease is assumed, the security deposit will be unaffected by the bankruptcy process. If the lease is rejected and the tenant remains in possession, the tenant will likely be able to set off its final lease payments to the extent of the security deposit, provided that the tenant would otherwise be entitled to a return of the security deposit under the lease.