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Lease Workouts in Troubled Times - Handling Tenant Defaults

By Matthew J. Marino

The Alternatives to Restructuring:  Handling Tenant Defaults

If restructuring is either unsuccessful or impractical, landlords and tenants need to be familiar with the judicial process for eviction and breach of contract.

  • Consider options – think twice before reflexively serving a Notice to Pay Rent or Quit.  In better economic times, the landlord's first response to a tenant default frequently was the service of a statutory Notice to Pay Rent or Quit as a prerequisite to eviction.  However, in these times, where tenant demand for space is far less, eviction may not be the best option as it assumes that the premises can be re-leased to a more creditworthy tenant.  Eviction also may result in a dark space that detracts from the desirability or appearance of a retail center.
  • A breach of lease action may meet the landlord's needs.  Even for tenants in default, eviction is not the landlord's only option.  If the lease so provides, the landlord may sue the tenant for breach of lease to collect the rent due without evicting the tenant.  This option may be lost if the landlord serves the tenant with a Notice to Pay Rent or Quit, and the tenant vacates the premises.  While such a lawsuit may create an adverse relationship in the short term, it may lead to a judgment or settlement to collect some portion of the amount due while maintaining the appearance of the project.  If the landlord elects this course, a default must be established under the lease, but it should not be by service of a statutory Notice to Pay Rent or Quit.  Some leases may vary, but a short letter or Notice of Rent Delinquency, setting forth the amount due and the applicable cure period, likely will be sufficient to establish the default so that an appropriate action can be pursued.
  • If the landlord desires eviction, consider requesting voluntary relinquishment first.  If the tenant is without hope of recovery, in lieu of eviction proceedings, the landlord may consider requesting a consensual relinquishment of the premises while retaining its right to pursue tenant for damages for breach of the lease.  Often tenants will accept the inevitability of their business failure, and a voluntary turnover of possession helps both landlord and tenant in that the landlord need not pursue an unlawful detainer and the tenant provides landlord the maximum opportunity to mitigate damages while minimizing enforcement costs.  To effect this agreement, a written stipulation agreeing to tender possession is best, but any writing whereby the tenant states an intent to abandon the premises likely is sufficient.  Unless reference is made to the statute that makes the tenant liable for post-termination rent, it is important that the landlord never "terminate" tenant's lease obligations except by a formal termination agreement.  Likewise, the landlord should avoid use of the word "surrender," which has an historical meaning that might be construed to release the tenant from post-surrender liability.
  • No self-help.  Regardless of the length or severity of the tenant's default, California law prohibits the landlord from engaging in any self-help actions to evict the tenant, such as re-keying the premises or denying the tenant any access or other privileges under its lease (such as parking, gym access, or similar amenities).  Even after the landlord obtains judgment for possession in an unlawful detainer action, eviction must be effected by the County Sheriff pursuant to a writ of possession.
  • Tenant bankruptcy concerns:  Apply deposits and terminate leases prior to filing.  Tenants frequently attempt to induce landlords into forbearing from legal action by threatening bankruptcy.  Be aware that a landlord is legally free to pursue any enforcement actions against the tenant until it receives notice of an actual bankruptcy filing by the tenant itself (not related, parent, or subsidiary entities); however, any enforcement action after this filing and notice of the filing is voided by the filing.  After such notice is received, all enforcement actions against the tenant must cease, including default notices, unlawful detainers, collection actions and application of security deposit.  However, if the cure period under a Notice to Pay Rent or Quit or other termination notice has expired prior to the bankruptcy filing, the lease will not be part of the estate subject to bankruptcy protection and the landlord retains the right to exercise its rights and remedies.  After filing, the bankruptcy trustee succeeds to the tenant's rights under an existing lease and has at least 120 days to accept or reject the lease.  If the trustee rejects the lease, the landlord has a priority claim in bankruptcy for the rent due from the filing date through the rejection date.  Any remaining unpaid or lost rent may be submitted as an unsecured claim in bankruptcy, subject to the applicable bankruptcy damages cap for claims of this type under 11 U.S.C. § 502(b)(6).  The statutory language is complicated but, as a general matter, usually results in the landlord being limited to approximately 12 months worth of rent.

    If the landlord is holding a security deposit from the tenant and fears that the tenant will file for bankruptcy, the landlord should consider whether to resort to the security deposit to cure outstanding defaults before any bankruptcy filing. The landlord needs to make sure that all contractual requirements for application of all or a portion of the deposit are satisfied. Once the bankruptcy is filed, the automatic stay will prevent the landlord from application of a security deposit absent relief from the bankruptcy court. While the landlord will ultimately be permitted to apply the deposit in satisfaction of its claims against the tenant (to the extent that the deposit is not greater than the cap on landlord's lease rejection damages provided by the Bankruptcy Code), the delay in the ability to resort to the deposit could be months and even years.

    While letters of credit given as security for lease obligations are not considered to be part of the bankruptcy estate, similar issues may arise. Contractual requirements for a pre-bankruptcy draw must be met, particularly if the particular lease provides that a draw on the letter of credit must be based on an "event of default" and a default under the lease requires some form of notice to the tenant. If such notice has not been given (and has expired) prior to the bankruptcy filing, relief from the automatic stay is required to give the necessary notice and thus no draw may occur. There is no assurance that the bankruptcy court will grant the relief. A draw without resort to contractual requirements may expose the landlord to damages for breach of lease as well as disgorgement of amounts improperly drawn. Additional issues may arise if the amount of the letter of credit is greater than the bankruptcy damages cap.
  • Abandoned premises.  An unlawful detainer action is not required to regain possession of abandoned premises.  Possession of abandoned premises can be obtained through an expedited procedure (approximately 18 days) that does not require a court order; however, rent must be due and unpaid for 14 consecutive days and the landlord must have "reasonable belief" that the tenant has abandoned and must have complied with certain statutory notice requirements.