Bankruptcy law's impact on landlords, tenants and HOAs

April 21, 2006

Part 3: New bankruptcy law: What's in it for real estate?

G.M. Filisko
Inman News

Editor's note: The new bankruptcy law that took effect on Oct. 17, 2005, included many provisions that affect both residential and commercial real estate. But attorneys are still debating whether the real estate market overall will benefit from the changes. In this three-part series, we consulted with bankruptcy and real estate law attorneys on the specifics of how the new law impacts homeowners, renters, landlords and homeowner and condo associations. (See Part 1 and Part 2.)

There are a handful of miscellaneous provisions in the new bankruptcy law that affect average homeowners and renters, and a few that apply to commercial properties.

The first is simple: Condominium and homeowners' associations benefit from the provision that requires that fees owed to these organizations are no longer dischargeable in bankruptcy.

Take, for instance, a couple who were behind in their mortgage and condo assessments. They could still file for bankruptcy and, depending on their income and assets, walk away from high credit card balances (in legal lingo, those debts would be "discharged") when the bankruptcy is final. But even after the bankruptcy becomes final, they'd still owe overdue condo assessments (legal lingo: that debt is "non-dischargeable"). Of course, the condo association still has to have a means to collect the debt if there isn't enough money in the bankruptcy estate, but that's another story. The condo owners can't simply stiff the condo association by filing for bankruptcy protection.

Another provision helps you if you're a landlord with tenants who are behind in rent payments. Before bankruptcy reform, courts across the country constantly faced the question of what law governed -- state landlord-tenant law or federal bankruptcy law -- when a tenant facing eviction filed for bankruptcy. The answer to that question determined whether the eviction went forward or whether the eviction was stayed until a bankruptcy court resoled the issue in the tenant's bankruptcy.

The new law now says state law will govern. Kevin E. Mangum, a bankruptcy attorney in Casselberry, Fla., gives an example of how the eviction process now works. If a landlord has gone through the eviction process and obtained a judgment of possession and the tenant files for bankruptcy, under the old law, the eviction action was stayed. Now, however, the eviction isn't stopped automatically, he says.

But tenants have a right to "cure" (legal lingo: fix a breach in a contract; in this case, by paying overdue rent) and keep the rental unit by paying back rent, said Mangum. "If there's an eviction in process, and the tenant files for bankruptcy, instead of waiting on the landlord to act, the tenant has duty to be proactive and tell the court why it has a right to stay in the premises."

Being proactive means tenants have to take several steps. First, they have to obtain a 30-day stay by listing their landlord on their bankruptcy petition and filing a certificate attesting to two things: One, their state's law allows them to cure their default after their landlord has obtained a judgment for possession, and two, that they've deposited with the clerk of the court money to cover rent that will come due if the court grants a 30-day stay.

The landlord can object to the tenants' certification, and if that happens, the court must hold a hearing to determine whether the tenants' certification is true. If the court finds that it's not, the landlord wins, and there's no stay. The eviction can go forward.

If tenants are able to get a 30-day stay, to keep the rental property any longer, they have to file a second certificate stating that they've paid all overdue rent required under the lease. If they can do that, the stay remains in effect.

Don't forget, however, that if you're a landlord attempting to evict tenants who are endangering the property or using drugs on it, you can still proceed. The tables are turned, however, and the burden is on you to file a certification -- and serve it on the tenants -- stating that you started the eviction before the bankruptcy petition was filed or that the tenants are endangering the property or allowing drugs to be used on it. Just as you can object to a tenants' certification to stay in the property, tenants can object to your certification to get them out for misusing the property. If that happens, the court will hold a hearing to determine who's telling the truth.

The code also has several provisions that affect commercial properties. First, it makes it easier for creditors to ask the court to lift the automatic stay in single-asset real estate bankruptcies regardless of value if the debtor hasn't filed a confirmable reorganization plan or begun making interest payments within 90 days of filing for bankruptcy. The old bankruptcy rules defined single-asset real estate cases as those with projects of $4 million or less, said Robert Nelson, a bankruptcy attorney at Van Cott Bagley in Salt Lake City, who specializes in large bankruptcies that often involve commercial property. "The $4 million limit has been eliminated, and the new automatic stay provisions now apply to all real estate projects small and large," he said.

"Take the example of a developer who's begun his project but run out of funds and is in jeopardy of foreclosure, so he files for Chapter 11 bankruptcy hoping to buy time to find a new investor," Nelson said. "I've seen real estate debtors hide behind the automatic stay, and courts have permitted it."

Under the new rules, within 90 days, the developer must file a reasonably confirmable plan of reorganization or start making interest-only payments under the loan agreement, says Nelson. "This forces the developer very quickly to put up or shut up," he said, "and it forces activity so that commercial agents will benefit through a sale or some other transfer."

"I think the direction this amendment has taken has been foreshadowed in the past few years," Nelson said. "Developers file at the last minute just to see if they can buy more time, but single-asset cases aren't favored, and they haven't been favored for some time. Judges have seen enough of these cases that they no longer buy pie-in-the-sky projections from developers. The changes reflect what many judges I was dealing with were imposing anyway."

The bigger difference affecting commercial property, Nelson said, applies to "debtors with mega-locations that have to make decisions quickly about whether to assume or reject their leases." For instance, Nelson was an attorney involved in the Sizzler International bankruptcy case in 1996, and the company took years to tell landlords which leases it would accept and reject for its steakhouses.

"Some leases, it was clear they should reject, so they just didn't make payments. Others, they re-instituted monthly rent payments, but they didn't cure delinquencies," he said. "The court kept extending the deadline for accepting or rejecting the leases for almost two years," he said, which left landlords holding the bag on delinquent rent for all of that time.

If Sizzler filed for bankruptcy under the new rules, it would have 60 days to "get its money and act together and initiate rent payments, but it wouldn't have to fix delinquencies in that time," Nelson said. Within seven months, though, it would have to make the final decision on all leases, and for those leases it assumed, it would have to cure all delinquencies immediately.

Even better for landlords, damages from a breach under the new, assumed leases would become priority claims under the bankruptcy. That means, if the company defaulted on the rent under the assumed lease, the landlord's claim would be at the top of the line for repayment, right up there with legal fees and other expenses that are given priority status in a bankruptcy.

"The seven-month deadline is real tough," Nelson said. "I've heard enough whining from debtors' attorneys that my guess is that this provision is going to present problems."

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