Even landlords who conduct in-depth analyses of tenant credit and financial health will experience some tenants who become financially unstable during the term of the lease. In an environment where replacing tenants can be challenging, many landlords should consider the potential benefits of negotiating a restructuring of the tenant’s lease obligations or offering an agreed exit strategy.
Obtain Current Financial Statements
Including in leases a provision that requires tenants to provide current financial statements will help landlords have the information necessary to assess the likelihood that a tenant’s inability to pay is due to temporary circumstances. Even if the lease does not expressly provide for the tenant to furnish financial information, landlords may require current financial information as a prerequisite to entertaining any restructuring or workout of the lease. This financial information, along with consideration of the relationship history, will help the landlord determine if the tenant will be able to meet his/her obligations under a restructured lease.
Consider Defaulting the Tenant
If a tenant is not meeting lease obligations, it is usually advantageous for a landlord to default the tenant (reserving all rights and remedies) as restructuring discussions are ongoing. If appropriate, default letters can be drafted such that they are “friendly” but still effective. Putting the tenant in default enables the clock to begin running on any periods of notice and grace required before the landlord can exercise remedies such as terminating the lease and/or possession, pursuing any guarantors, and/or accessing any collateral held as security for tenant’s obligations. In addition, being in position to terminate a lease before the tenant files for bankruptcy ensures that the tenant’s leasehold interest does not become part of the bankruptcy estate, subjecting the landlord to a judicial process that usually results in the landlord receiving little or no damages for unpaid rent.
Consider Increasing Security for the Lease
Lease restructuring discussions often involve a reconsideration and increase of the security for the tenant’s lease obligations. While cash security deposits are easy to access and apply towards a tenant’s obligations, the landlord will not be able to immediately access the funds in the event the tenant files for bankruptcy (instead, the landlord will have a secured claim in the bankruptcy proceedings for the security deposit). For this reason, many landlords require letters of credit to be provided in lieu of or in addition to a cash security deposit. Because a letter of credit is an agreement with a financial institution, letters of credit are generally treated as independent from the bankruptcy estate and available to be drawn upon even in the event of a tenant bankruptcy provided that no default/demand needs to be made upon the tenant prior to the draw. Similarly, landlords are able to seek enforcement of guarantees (provided the guarantor is not in bankruptcy and provided that the landlord is not required to first seek enforcement against the tenant).
Evaluate Restructuring and Workout Options
Many factors influence a landlord’s decision to modify the terms of a lease for a financially unstable tenant. Outlined below are a few common approaches to lease restructuring. In each case, the landlord will benefit from making it clear to the tenant that the landlord can exercise remedies in the event the tenant fails to comply with the agreement.
1. Early Termination
Landlord and tenant might agree to a lease termination date, sometimes with payment of a termination fee (either upfront or over the course of the remaining occupancy). In some circumstances, a landlord may allow a tenant to reduce their rent obligation by recapturing a portion of the space, with or without payment by tenant of a fee. Landlords often encourage tenants to seek an assignment or sublease prior to considering a request for early termination. It is prudent for termination agreements to contain a provision that unwinds them in the event the tenant files for bankruptcy and the bankruptcy court claws back the termination fee as a preferential transfer.
2. Rent Abatement or Deferral
If a landlord has confidence in the long-term viability of the tenant, the landlord might consider abating or reducing certain months of rent, sometimes requiring those amounts to be paid at a later date. If possible, many landlords try to maintain the total amount of rent payable over the term by either deferring rent or increasing the lease term. In the case of abated or reduced rent, landlords usually require that, in the event of future default, all abated or reduced rent becomes immediately due and payable with accrued interest and late fees. If there is arrearage, some landlords ask tenants to sign a promissory note in the amount of the past due rent, specifying a payment schedule and any interest.
3. Other Terms
A request for a lease restructure is an opportunity for the landlord to review the entire lease. If the tenant has been granted special rights, such as rights of first offer, exclusive use rights, early termination rights, or operating expense caps, the lease restructuring is an opportunity to eliminate those provisions.
Conclusion
Many landlords are willing to consider lease restructuring in the current market environment where vacancy rates remain high. Each tenant relationship is unique, and the strategies outlined in this article are only a selection of approaches to navigating the challenging situation of a financially unstable tenant.
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