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Avoiding preferential transfers in bankruptcy

By Stuart J. Glick

Whenever a landlord enters into a settlement agreement with a tenant who has failed to pay rent, there is always the specter of litigation later on if the tenant files bankruptcy and seeks to avoid and recover each payment as a preferential transfer. Of course, if the tenant eventually decides to assume (i.e., keep) the lease, then there is no issue because the tenant would have to make those payments anyway. But if the tenant decides to reject the lease, resulting in a claim by the landlord against the tenant, insult may be added to injury when the tenant seeks to recover all payments made pursuant to any prepetition settlement agreements. With some careful drafting, however, these types of lawsuits may be avoided.

While the Bankruptcy Code gives certain defenses to creditors, it is better to try to structure your settlement agreement such that the payments do not even qualify as preferential transfers. This can be done in a number of ways:

1. Structure the Payments Such That Their Source Is Other Than the Payment. In many instances, a tenant makes settlement payments from sources other than its own funds. Loans are made by affiliated companies or by the tenant's principals to the tenant, which are then used to pay the landlord. A simple solution to the preference issue is to require that the funds with which the payments of the antecedent rent are made come from such "other sources." Thus, the tenant's affiliate and/or the tenant's principal make the payment directly to the landlord. Because the payments are not from the tenant's assets, they are not subject to avoidance as preferential transfers.

2. Structure the Settlement Such that the Payments Are Not Antecedent Debt. A landlord is likely to know whether a tenant will survive shortly after a settlement has been made with that tenant. Thus, in situations where there are a number of years left on a tenant's lease, a landlord could structure the settlement payments such that they are not payments of antecedent debt, but rather are prepayments of future debt. For example, assume that the tenant is three months in arrears. Under the settlement agreement, the tenant prepays the last three months of its lease over the course of the first three months of the settlement. Be certain to structure the payments so that there is a reasonable estimation of any CAM (common area maintenance charges), real estate taxes, utility charges and other similar charges. During the last three months of the tenant's lease, the settlement would provide that the tenant is required to repay the three months of payments that were due at the time the settlement agreement was executed. If the tenant were to file bankruptcy at that later time, then clearly those payments would be of antecedent debt. But if a tenant has survived the entire term of its lease, it is less likely that it will then file bankruptcy. This solution works particularly well in those circumstances where there are many years left on a tenant's lease. If such a tenant files shortly after its entry into a settlement agreement, and rejects its lease, the Bankruptcy Code provision that governs the filing of "rejections claims" would limit the extent of a landlord's claim anyway to much less than the remaining term on the lease. Further, the additional balloon payment for the unpaid rent would be additional to the amount capped by the Bankruptcy Code.

3. Increase the Security Deposit to Ensure That the Landlord Does Not Receive More than It would Have Received Under a Hypothetical Liquidation. (If the Payment has Not Been Made.)

One requirement for a preferential transfer is that it enables the landlord to receive more than the landlord would have received if the transfer had not been made, and if the landlord received its distribution in accordance with the applicable provisions of the Bankruptcy Code. Secured lenders often avoid preferential transfers by showing that the funds they received were subject to their security interest (i.e., they would have received this sum anyway). A landlord can make a similar argument to the extent of the tenant's security deposit. Where the amount to be paid pursuant to the settlement agreement exceeds the security deposit, however, there may be potentially avoidable preferential transfers. A landlord can avoid such claims by requiring that the tenant increase its security deposit in an amount equal to the sums to be paid under the settlement agreement. Ninety days after the date of each settlement payment, a commensurate amount of the security deposit can be refunded to the tenant.

4. The "Springing Guaranty"

Assume that the debtor's principals or affiliated companies do not have the funds with which to make the payments, such that the payments must come from the tenant. The payments can nevertheless be guaranteed by the tenant's principals and/or affiliated company, with the guaranty only being effectuated or "springing to life" if the tenant files, or is involuntarily placed into, bankruptcy. Such a guaranty can also be collateralized with property that is not the tenant's property. The security documents could readily provide that they be discharged 90 days after the date of the last settlement payment. Indeed, as part of the transaction, the discharge documents can be held in escrow.

5. Disprove Insolvency

If this is the case, consider obtaining from the tenant contemporaneously with the settlement, financial settlements (audited, if possible) that reflect the tenant's solvency.

Conclusion

These suggestions, which can be used either individually or in combination, should be considered when drafting settlement agreements with tenants. The point is to give the landlord rights that the landlord would not otherwise have upon the filing of a bankruptcy by its tenant. Which of these alternatives (or combinations thereof) is best in any particular situation is fact-specific. But these issues should be considered at the time the settlement agreement is entered into, when the landlord has the maximum leverage.