A bankruptcy deals with both the assets and the obligations of a debtor. Bankruptcy addresses these assets and obligations by creating a fictional estate. All assets of the debtor become property of the estate. The administration of this estate is dealt with by a Trustee (in most Chapter 7s this is the case) or by the debtor in possession (you see these in Chapter 11s and Chapter 13s). The administration is dealt with addressing the secured and unsecured obligations of the debtor. During the course of this administration the trustee or debtor in possession will incur obligations of its own, these obligations are called administrative expenses. Administrative expenses are given priority over a debtor's unsecured obligations.
A lease or executory contract can create a situation where the lease is property of estate and a claim against the debtor of the estate.
This is most common where the debtor is a lessee. Assume John leases his business storefront from Land Overlord, Inc. John then files for bankruptcy. John's rights to use the store front become an asset of the estate. John's lease comes with both burdens and benefits. John has performance obligations that include paying rent. If John does not pay these rents then Land Overlord, Inc. will have claim. Let's assume John does not have the ability to pay his rent and files a chapter 7 bankruptcy.
Once John has entered bankruptcy the Trustee has essentially three ways to address this lease:
John leased his premises from Land Overlord Inc. for a ten-year term with monthly rentals of $1000. After John filed for relief lets look at what the effects of each potential action the trustee could take.
If the lease is rejected, this can happen explicitly or if the trustee has not directly assumed the leases within 60 days or 120 days of the petition for relief being filed for residential property and nonresidential property respectively. So, if the lease is rejected then John has no further right to use the storefront. If the lease is rejected, John also has no further personal liability on that lease. This rejection of the lease effectively creates a breach of the lease. That breach will give Land Overlord Inc. a claim against the bankruptcy estate as an unsecured creditor. This means Land Overlord Inc. will only be able to recover from the estate as an unsecured creditor. An unsecured claimant's payout depends upon the assets in the estate. But, remember Secured, and priority claims are ahead of unsecured claims so Land Overlord Inc. often will not be able to recover for the breach of the lease.
If the lease is assumed, then the lease becomes an asset of the estate. John can continue to operate in the storefront. Assumption is more common in Chapter 11 and Chapter 13 cases where the purpose is to continue with operations as John restructures his debts. If this was the case here, then John would be a debtor in possession and the estate would have an obligation to continue paying the rents. This obligation is what is called a first priority administrative expense of the estate.
What if John files bankruptcy and he Trustee sells his storefront lease to Mary? This type of assignment would then relieve the trustees and the estate from any liability for any breach of such contract or lease occurring after such assignment. After the assignment Land Overlord Inc. could only look to Mary for the obligations under the lease.
These three considerations are important in understanding how your lease and your bankruptcy interact. Often times small business owners have lease obligations that they can no longer fulfill when they apply for bankruptcy. To address this risk landlord's will have young business owners or unproven business ventures sign a personal guaranty for the lease. These future rents payable upon a breach of the contract can be in the tens of thousands or more. Bankruptcy can help by converting that lease obligation into an unsecured debt if the lease is rejected by the trustee. If you have a lease and Covid has shuttered your business, then consult with the Smith Law Firm LLC to see if filing bankruptcy could be an effective way to avoid the massive costs associated with breaking that lease.