By Melissa Nowak
When a tenant files for bankruptcy protection, the landlord can be left in a precarious position. Unlike a secured creditor, a landlord does not have a direct claim on a tenant’s property. As such, the landlord must wait in line for the liquidation of the tenant’s assets to determine if any arrears in rent will be paid, while expending costs to procure a new tenant for the premises to mitigate losses on future rent. All of this while a landlord is often making timely payments on a mortgage and continuing to pay property operating costs.
Considering this precarious position, how can a landlord maximize its protection from tenant bankruptcy under its lease?
Bankruptcy and Insolvency Act
A tenant business can file for bankruptcy protection under the Bankruptcy and Insolvency Act to seek formal relief from debts and protections provided by the Act. A larger corporate tenant with debts owing in excess of $5M may also be eligible to file for a restructuring under the Federal Companies’ Creditors Arrangement Act. This article, however, focuses on lease protections for landlords with tenants who may file under the Bankruptcy Insolvency Act.
There is a distinction between insolvency and bankruptcy. Insolvency describes a state of being wherein a person or corporation is unable to pay its debts when they are due. Bankruptcy occurs when an insolvent debtor becomes bankrupt in accordance with a formal proceeding under the Bankruptcy and Insolvency Act. In this discussion we preemptive actions that a landlord can take when a tenant begins to show signs of insolvency and lease mechanisms that can protect a landlord if a tenant files for bankruptcy.
It is important that your commercial lease includes specific language that gives the landlord to the fullest protection permitted under the Act. In addition, there are preemptive measures a landlord can take to detect and act upon insolvency before it leads to a formal bankruptcy filing. These preemptive measures can better protect a landlord. After a formal bankruptcy filing, the landlord’s remedies are more limited.
- Know your tenant’s financials. At the outset of lease negotiations, request and evaluate a tenant’s balance sheet to determine whether the tenant has sufficient cash flow to cover rent payments and whether it is earning enough money to be financially self-sustaining over the term of the lease. If a tenant offers a satisfactory balance sheet of a parent company or related entity, ensure that the parent or related entity is a Guarantor or Indemnifier of the lease. Consider requiring tenant’s financials on an annual basis throughout the term of the lease to detect any changes in a tenant’s covenant.
- Impose a Landlord’s right to consent to assignment and sublease. Once a landlord is satisfied with a tenant’s financial capabilities, do not permit the tenant to assign its obligations to another party that the landlord has not evaluated. Ensure the lease provides a landlord right of consent over any assignment or sublease of the lease. If the landlord consents, do not release the original tenant from the obligations under the lease.
- Act promptly when a tenant defaults. Under most commercial leases, non-payment of rent after a cure period constitutes default. This is often the first sign of a tenant’s financial difficulty. Monitor such occurrences closely and act quickly on the landlord’s default remedies. These remedies often include terminating the lease and distraining on a tenant’s furniture, equipment, stock or other property within the premises. Once a tenant formally files for bankruptcy, distraint by a landlord is prohibited if has not been started before the date of bankruptcy.
- Require a letter of credit. If a tenant is unfamiliar to the landlord or if the tenant’s covenant is uncertain, a landlord can request a tenant to obtain an irrevocable letter of credit from a bank for payment of money to the landlord if the tenant fails to pay rent under the Lease after applicable cure periods. This allows the landlord to substitute the issuing bank’s credit for that of a tenant and eliminate the risk of tenant non-payment.
Bankruptcy Provisions in the Lease
In case a tenant formally files for bankruptcy, what provisions should a landlord put in its lease to maximize its protections under the Act?
Under bankruptcy proceeding, a landlord does not have a secured claim against the tenant. However, a landlord does have a preferred claim for:
- Arrears of rent for a period not more than three months immediately before the bankruptcy; and
- Accelerated rent for no more than three months after bankruptcy.
The landlord is entitled to three months of arrears without explicit language in the lease. However, it will only have preferred claim for accelerated rent if the lease specifically provides for such remedy.
Regarding rent, the lease should also:
- Ensure tenant’s payment of real estate taxes and operating costs, which typically comprise additional rent, are clearly included in the definition of “rent” within the lease. If these items are included in the definition of rent, these amounts can also be collected as part of arrears for rent and accelerated rent under the Act.
- Require a prescribed amount of pre-paid rent upon signing of the lease. Ensure the language in the lease unambiguously establishes that such pre-paid rent is irrevocable and non-refundable, not as a security deposit for the performance of tenant’s obligations under the lease. A lawyer should review this clause to ensure it is sufficient given recent court decisions. The landlord is entitled to retain any pre-paid rent in a tenant bankruptcy filing.
There is an important limitation on a landlord’s protection when a tenant goes bankrupt. A landlord may have preserved their entitlement to arrears and accelerated rent under the definition of rent in a lease, including taxes and operating costs. However, the total amount payable for arrears and accelerated rent cannot exceed the value actually realized from the assets within a tenant’s premises in the bankruptcy auction. This is why it is important for a landlord to assess its tenant’s financial health at the outset and throughout the term of the lease, and promptly address any default.
A good offence is often the best defense because a landlord’s recourse is limited when a tenant formally files for bankruptcy. Landlords should include the key language discussed above to protect their rights under the lease, but detecting and addressing insolvency promptly, before the tenant files for bankruptcy, often yields the best results.
If you are looking to lease your building to a commercial tenant, contact Melissa Nowak at 416-860-8028 or email@example.com to review the lease.