If you’re a landlord, you know too well that the rewards don’t come without some risk and more than a few headaches. Taking proactive steps to manage potential risks helps minimize future legal entanglements and financial losses.
Including an early termination clause in a lease can benefit both landlords and tenants, allowing for a mutually beneficial solution. But what happens after the lease is terminated and a financially distressed tenant files for bankruptcy?
The Connecticut landlord and tenant lawyers at Wofsey Rosen counsel commercial and residential landlords and tenants concerning rental agreements and how to best safeguard their interests under federal and state law.
When a Bankruptcy Court Can Void an Early Lease Termination Agreement
Early termination clauses are fairly common in leases between landlords and tenants in Connecticut. The clauses allow either party to initiate termination of the lease before it expires for various reasons stated in the lease agreement.
A tenant may have the right to terminate a lease early by notifying the landlord and then paying a calculable or fixed fee in exchange for the landlord’s release of any further obligation under the lease.
A written termination agreement will serve as evidence of the tenant’s intention to terminate the lease and the landlord’s acknowledgment of compliance with the termination conditions. Once this is done, the lease has been properly terminated in accordance with state law.
However, the federal Bankruptcy Code can supersede state law when conflicts arise. If a tenant files for bankruptcy within a specific period after terminating a lease, the fee paid to the landlord may be subject to avoidance as an improper preferential or fraudulent transfer of a valuable property interest.
What Federal Bankruptcy Law Prohibits Regarding Debtor Property Transfers
There are two sections of the US Bankruptcy Code that a bankruptcy trustee may rely on to try to avoid a transfer pursuant to an early lease termination agreement.
Section 547(b)
Section 547(b) allows the trustee to avoid (legally cancel) the transfer of a debtor’s interest in property when:
- It is to a creditor
- It is for an antecedent debt owed before the transfer was made
- It is made while the debtor is insolvent
- It is made within 90 days of the bankruptcy filing or up to a year, based on the relationship between the debtor and creditor
- It gives the creditor more than would be received in a Chapter 7 bankruptcy had the transfer not been made
An antecedent debt means an existing legal obligation that the transfer of property is intended to satisfy. There is an exception to the law where the transfer can be shown to be in furtherance of a contemporaneous exchange, in which the debtor receives some new value in consideration for the payment.
Section 548(a)
Section 548(a) allows the bankruptcy trustee to avoid any transfer made within 1 year of filing when the transfer is intended to deprive a debtor’s creditors or when the debtor receives less than reasonably equivalent value (measured in financial terms) in exchange for what was transferred.
Whether a debtor received reasonably equivalent value in an exchange will be a question of fact based on the circumstances of a particular transfer. Bankruptcy judges have broad discretion when making these determinations. They may consider factors such as fair market or commercial value, the relation of the parties, and the timing of the transfer.
How Early Lease Termination Agreements Can Be Drafted to Minimize the Avoidance Risk
Seeking avoidance of early lease termination transfers is not a practice frequently pursued by the bankruptcy trustee; however, there is some legal precedent suggesting that this could raise issues. Therefore, a lease termination agreement should be drafted to stay as clearly away from the bankruptcy prohibitions as possible.
Minimize Avoidance Risk under Section 547(b)
In the context of preferential transfers under section 547(b), the primary issue has been the meaning of ‘antecedent’ debt and at what point a debt becomes owed. A bankruptcy trustee will argue that the lease termination payment is for money that is already owed because the debt is created when the lease is executed. Therefore, the transfer is avoidable.
A landlord will argue that rental payments do not become a debt until they are due and unpaid. The lease termination agreement would specify when rental payments should be considered debt and provide the additional benefit (such as release from future financial obligations) that the tenant will receive in exchange for the lease termination payment.
You may also need to specify an agreement regarding the timing of a lease termination transfer to ensure it does not occur within the bankruptcy look-back periods.
Minimize Avoidance Risk under Section 548(a)
Challenges under section 548(a) have targeted lease termination transfers for leaving the debtor with less than reasonably equivalent value after the transfer. Courts have generally interpreted reasonably equivalent value to be the receipt of fair consideration by the debtor.
At least one federal bankruptcy court has held that a fraudulent transfer occurred pursuant to a lease termination agreement because the debtor was not fairly compensated for the loss of value that would have been gained if the leases had continued in force for the full term.
The court reasoned that the debtor had a property interest in the leases and forfeited the value of that interest when the leases were terminated. The bankruptcy trustee was entitled to recover the net value of the leases before termination.
You should include language in the lease termination provisions that requires some independent valuation before executing an agreement. An independent party’s evaluation lends credibility to the fairness of the exchange and may shift any potential liability for value equivalency to the third party.
Wofsey Rosen Has the Knowledge and Experience to Help Landlords Manage Business Risks
The Stamford, Connecticut law firm of Wofsey Rosen has been serving Fairfield County for over a century, providing a full range of legal services for commercial and residential landlords and tenants, including lease negotiations, drafting and review, and dispute resolution. Contact us today to see how we can help you.