WeWork, a provider of flexible workspaces, filed for chapter 11 bankruptcy protection on Monday night in New Jersey. This filing has prompted landlords to evaluate their rights and exposure. Below is an overview of the typical issues that landlords face when their tenants file for chapter 11 bankruptcy.

Automatic Stay

The filing of a bankruptcy petition imposes an automatic stay, halting any attempt to evict or collect rent or to terminate an unexpired lease.

While the automatic stay also prohibits the setoff of a cash security deposit without first obtaining relief from the bankruptcy court, the stay generally does not block a draw on a letter of credit because a letter of credit issuer’s obligation to the landlord beneficiary is independent of the debtor’s obligations.¹ Yet, there is a caveat. If the lease or the letter of credit requires first sending notice to the debtor before a draw may be effectuated, the notice could be viewed as a violation of the automatic stay.

Treatment of Unexpired Leases in Bankruptcy

Subject to court approval, a chapter 11 debtor can assume (keep in place), assign, or reject an unexpired lease.

Assumption or Assignment of Valuable Leases

Valuable leases are almost always either assumed, meaning the lease stays in place for the reorganized debtor’s ongoing use, or assigned to a third party, often as part of a sale transaction. Either way, the bankruptcy estate captures the value of the lease. Because a lease must first be assumed before it can be assigned, a landlord will largely get the economic benefit of its original bargain if the lease stays in place or is sold to a buyer; namely: (i) all monetary lease defaults will be cured in cash, (ii) any pecuniary loss, most often attorneys’ fees and interest, resulting from such defaults will be paid; (iii) the debtor or assignee, as applicable, will have the burden of showing its financial ability to perform lease obligations going forward and (iv) a debtor is prohibited from cherry-picking and assuming the lease’s benefits without also accepting its burdens.² A debtor, however, does get some limited protections. It does not have to cure nonmonetary defaults that are impossible to cure. Nor must it cure a default for having filed bankruptcy or having experienced poor financial health or even insolvency at any time before the bankruptcy case is closed.³

Rejection of Burdensome Leases

Rejection is a breach of the lease, entitling the landlord to assert a claim for breach-of-contract damages, referred to as rejection damages. Unless the lease obligations are secured by a valid lien against valuable collateral or a security deposit, rejection damages are general unsecured claims, which are typically greatly impaired, receiving nothing or only a pro rata share of a small distribution at some point, perhaps years later.

The Cap on Rejection Damages

The claim for rejection damages is capped at any unpaid rent due under such lease plus the rent reserved for the greater of one lease year or 15 percent of the remaining lease term, not to exceed three years, following the earlier of the petition filing date or the date on which the landlord repossessed, or the debtor surrendered, the leased property.

There is a split among the courts regarding the calculation of the cap. Some courts have applied the Time Approach⁴ while other courts have adopted the Rent Approach.⁵ Under the Time Approach, the cap is the rent reserved for 15 percent of the rental term remaining, so long as that time period is at least one year and no more than three years. On the other hand, under the Rent Approach, the cap is 15 percent of the total dollar amount of the rent that would be payable for the entire remaining term of the lease, so long as that dollar amount is at least equal to the rent reserved for one year and does not exceed the rent reserved for the next three years. Neither the Third Circuit, the circuit that includes New Jersey, nor the New Jersey bankruptcy courts have issued an opinion on this issue. Delaware courts, which are also in the Third Circuit, apply the Time Approach.

The Application of the Cap on Rejection Damages to Landlord Protections

In the Third Circuit, a landlord’s security deposit, whether in the form of cash or a letter of credit, is subject to and will be applied to the cap on rejection damages.⁶ As such, a debtor will assert that any security in excess of the cap should be returned to the debtor’s estate. The Fifth Circuit has allowed a landlord to retain a draw on a letter of credit, given as a security deposit, in an amount in excess of the capped rejection damages because the landlord did not file a proof of claim against the debtor.⁷ The court reasoned that the express language of the Bankruptcy Code only applies the cap on rejection damages to claims against the debtor.⁸ The Third Circuit has not addressed whether a letter of credit, given as a security deposit, will be applied to the capped rejection damages when a claim is not asserted against the debtor.

When addressing whether the cap applies to the obligations of a guarantor, courts generally hold that the cap applies to limit a guarantor’s obligation only if the guarantor is a debtor in bankruptcy.⁹

Deadline for Lease Decision

A debtor is given broad discretion to assume, assign, or reject unexpired leases. There is, however, a deadline to make the decision. The initial period to decide whether to assume, assume and assign, or reject a lease is the earlier of (i) 120 days after the bankruptcy filing and (ii) entry of an order confirming a plan of reorganization.¹⁰ The court can extend the 120-day period by 90 days for cause and any further extension requires the landlord’s written consent.¹¹ WeWork has already filed a motion to reject 60 leases and filed another motion for approval of streamlined procedures to assume or reject unexpired leases.

Post-Petition Obligations Pending Assumption or Rejection of the Lease

Under section 365(d)(3) of the Bankruptcy Code, the debtor is required to timely perform all of its obligations arising post-petition, until the debtor assumes or rejects the lease. While it is clear that debtors must remain current on lease obligations arising post-petition, courts disagree as to the meaning of arising. One approach is the billing date approach, which provides that the obligations arise when they become due and payable. The second approach is the proration approach which provides that obligations arise when they accrue. These two approaches can result in very different outcomes. For example, if a debtor files its bankruptcy petition on December 14th and the December rent payment is due December 15th for the month of December, according to the billing date approach, the full rent for December would be a post-petition obligation. Yet, according to the proration approach, the rent for December 14th to December 31st would be a post-petition obligation, and the rent for December 1st to December 13th would be considered a prepetition obligation. The Third Circuit has adopted the billing date approach.¹²

Conclusion

A chapter 11 bankruptcy filing introduces a multitude of challenges for landlords. However, an understanding of the key factors discussed in this alert will allow landlords to better evaluate their exposure and safeguard their interests.

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¹ See Elegant Merch., Inc. v. Republic Nat’l Bank (In re Elegant Merch., Inc.), 41 B.R. 398 (Bankr. S.D.N.Y. 1984); In re M.J. Sales & Distrib. Co., Inc., 25 B.R. 608, 615 (Bankr. S.D.N.Y. 1982).

² 11 U.S.C. §§ 365(b)(1), 365(f)(2); see also In re Fleming Co., Inc., 499 F.3d 300, 308 (3d Cir. 2007).

³ Id. at § 365(b)(2).

⁴ See, e.g., In re Cortlandt Liquidating LLC, 648 B.R. 137 (Bankr. S.D.N.Y. 2023); In re Filene's Basement, LLC, No. 11-13511 (KJC), 2015 WL 1806347, at *4 (Bankr. D. Del. Apr. 16, 2015); In re Shane Co., 464 B.R. 32 (Bankr. D. Colo. 2012); In re Connectix Corp., 372 B.R. 488 (Bankr. N.D. Cal. 2007).

⁵ See, e.g., In re Rock & Republic Enterprises, Inc., No. 10-11728 AJG, 2011 WL 2471000, at *20 (Bankr. S.D.N.Y. June 20, 2011); In re Fin. News Network, Inc., 149 B.R. 348, 351 (Bankr. S.D.N.Y. 1993); Schwartz v. C.M.C., Inc. (In re Communicall Cent., Inc.), 106 B.R. 540 (Bankr. N.D. Ill. 1989).

 ⁶ Solow v. PPI Enterprises, Inc. (In re PPI Enterprises, Inc.), 324 F.3d 197 (3d Cir. 2003) (holding that a letter of credit given as a security deposit is applied against the capped rejection damages and not the landlord’s total damages).

⁷ In re Stonebridge Technologies Inc., 430 F.3d 260, 271 (5th Cir. 2005).

⁸ Id. at 269.

⁹ In re Episode USA, Inc., 202 B.R. 691, 695 (Bankr. S.D.N.Y. 1996), as amended (Nov. 20, 1996) citing Al Kopolow v. P.M. Holding Corp. (In re Modern Textile, Inc.), 900 F.2d 1184 (8th Cir.1990) (finding that the cap on rejection damages does not limit claims against non-debtor guarantors).

¹⁰ 11 U.S.C. § 365(d)(A).

¹¹ Id. at § 365(d)(4)(B)(i).

¹² In re Montgomery Ward Holding Corp., 268 F.3d 205, 211-212 (3d Cir. 2001).

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