If Your Tenant Files Bankruptcy

April 2, 2002

11 Min Read
If Your Tenant Files Bankruptcy

Author's note: I have put off addressing this topic in my column because significant bankruptcy-reform legislation has been proposed in at least the last four congressional legislative sessions. If this legislation passes in its current form, some of the actions recommended below may be subject to change. If new bankruptcy legislation is enacted, I will provide an update in this column as quickly as possible.

To mimic comedian Al Franken (better known as his character, Stuart Smalley, of "Saturday Night Live" fame), "How would my tenant's bankruptcy affect me, Al Franken?" Bankruptcies are a reality in our industry, and every bankruptcy filed by any tenant of yours, no matter what the circumstance, affects you and requires you to at least take precautionary steps.

The most recent statistics available indicate the number of bankruptcies filed has hit an all-time high. You need to be aware of what to do when you find out a tenant has filed bankruptcy, and you need to understand there are several different types of bankruptcies your tenants might file. The most common types are Chapters 7, 13 and 11.

Chapter 7

Currently, a Chapter 7 is an attempt to discharge all unsecured debt and some or all secured debt. Secured debt is debt for which collateral has been pledged in exchange, such as a mortgage on a home, title on a vehicle or even a purchase-money security interest in items you might buy on a credit card. Secured debts are generally dischargeable under Chapter 7 so long as the debtors are willing to surrender the secured asset to the creditor. A side note: Some states require you notify these types of creditors before you perform a lien sale.

The largest debt component of a Chapter 7 is usually unsecured debts, e.g., a MasterCard or Visa, doctor bills, unpaid back rent for an apartment, or even a delinquency owed to a self-storage facility for nonpayment of rent or other damages. At the end of the Chapter 7--assuming there are no assets for the trustee to liquidate and distribute to creditors--you will not receive any of the money due you. Your debt is discharged and you can take no action in the future to collect it.

Chapter 13

Conversely, a Chapter 13 is often referred to as a "wage earner plan." The debtor files a petition for bankruptcy that prevents creditors from collecting the debt, but he plans to repay some percent--sometimes up to 100 percent--to his creditors over a period of years known as the "bankruptcy plan." If you get a notice about a Chapter 13 and follow the procedures for filing a proof of claim, you can expect to see some of the money the debtor owes you over a period of time (three to five years).

A debtor may not file a Chapter 7 more than once every six years; however, Chapter 13 can be filed more often. While the courts may intervene on serial filings, there is no real statutory limitation on the number of times a debtor can file a 13.

Chapter 11

A Chapter 11 is a business reorganization somewhat similar to what you have been reading about Enron or Kmart. These are cases where the debtor is trying to reorganize and remain in possession of its assets, typically a business-type debtor. Since businesses use self-storage facilities, you may find yourself involved in this complicated form of bankruptcy.

In a Chapter 11 or 13, the debtor is expecting to pay you and all his other creditors some percentage of the past-due debt over a period of time and may intend to stay in your facility. The debtor is required to remain current in his post-bankruptcy petition or you can force him to leave by a "motion for relief from stay." Unfortunately, less than 10 percent of debtors who enter into Chapter 11 come out of it with a discharge. Most of these bankruptcies are either converted to another chapter, or the debtor's assets are liquidated and the bankruptcy ends up dismissed.

Proceed With Caution

Beyond the basic steps described in this column, dealing with a tenant's bankruptcy requires the assistance of your attorney. It is counter-intuitive--meaning you don't often get the result you expect--and bankruptcy law is full of pitfalls. If you make one wrong move, you could end up involving yourself in undesirable ways.

Here's an example of a pitfall: A nonaffiliated creditor is not allowed to accept more than a $600 payment toward a debt within 90 days prior to the filing of the bankruptcy. Affiliated or related creditors have an even longer time limit.

Any money paid above and beyond that $600 is considered preferential, and the bankruptcy trustee will seek those funds returned to the debtor's estate for distribution to all creditors. If you choose to ignore the trustee's demand for repayment, you will be sued by the trustee as part of the bankruptcy.

The Basics

The first thing you need to know about bankruptcy is the automatic-stay provision. Any time a bankruptcy is filed, as soon as the stamper hits the paper at the Clerk of Court's office, an automatic stay is invoked. This is an order of the court that prevents any creditor from doing anything to try to collect the debt or exercise any other contract rights while the bankruptcy is pending--unless special approval is sought from the court.

If you get a notice of bankruptcy or even hear one of your tenants has filed bankruptcy, you must stop everything you are doing to collect the debt--at least until you confirm the tenant has not filed. If you are sending out bills, late notices or lien-sale notices, you must stop. In Chapters 11 and 13, you may send bills for any debt incurred after the date of petition, although it may not be collectable if the debtor sends you notice he is rejecting his lease with you. However, under all chapters, you may not do anything to try to collect even one cent of money accrued prior to the date of the filing. If you are in the middle of your notice working toward lien sale, advertising intent to sell, or ready to perform your lien sale--even if you get notice the morning of--you must stop the sale.

When you find out about a bankruptcy, figure out where the tenant is in the bankruptcy process before doing anything else. Determine the chapter of bankruptcy filed and whether the debtor is a current or past tenant. Then call your attorney. You should receive a notice disclosing the type of bankruptcy and providing some deadlines and a date for the meeting of creditors. At the end of the process, you will be writing off some amount of debt and may need to seek the court's permission to remove the debtor's property from your facility under what is called "relief from the automatic stay."

The next thing you ought to do is gather all your information on the debt: how much you are owed, how long the debt has been accruing, and what type of payments you have received in the 90 days prior to the filing of the bankruptcy. This way, you may at least know if you will be subject to a preferential-claim action.

You also need to determine if there are any potential exceptions to discharge that your attorney can raise. Exceptions are set forth in the Bankruptcy Code that explains certain types of debt that cannot be discharged in bankruptcy. Unfortunately, you have to raise the objection. One common objection that prevents discharge of your debt is the allegation of fraud.

Fraud is generally difficult to prove because it is an intent-based claim, and it is often difficult to prove what was going on in someone's mind at the time they entered a particular transaction. However, there are a couple simple examples of fraud of which you should be aware in determining whether a claim of nondischargeability is worth pursuing:

1. If you received any check payments that were returned for nonsufficient funds and those payments have not been made good, the bankruptcy courts tend to presume bounced checks represent a fraudulently obtained debt.

2. If someone misrepresented his identity to you for the purpose of avoiding detection in your credit or background check, the debt may be found to have been obtained fraudulently.

In certain limited situations, you may be able to file an objection to a discharge. (There are more than 30 of these types of exceptions in the Bankruptcy Code; however, many child-support, student-loan and tax-type exemptions would be inapplicable to a self-storage application.) If your objection is upheld by the court, the debt to your facility would be held nondischargeable and would survive the bankruptcy. However, if your objection is denied, not only will your debt be discharged as part of the bankruptcy, you will be potentially responsible for the attorneys fees and other costs incurred by the debtor in defending the action. Often, rather than officially objecting, you can work out an agreement with the debtor's counsel for a partial payment or payoff arrangement.

Once you have received notice of a bankruptcy, you should not allow the debtor to store on the premises without paying rent. In a Chapter 11 or 13, if the debtor wishes to remain, he is required to keep current in his post-petition obligations. If he does not, you should seek approval from the court to remove him. In a Chapter 7, if the debtor does not voluntarily vacate, you must seek approval from the court to remove him by lien sale or eviction.

Removing a Bankrupt Tenant

In the situations mentioned above, you can go to the court and seek a "relief from the automatic stay" to repossess your space. Call your attorney and tell him you need to file a "motion for relief from automatic stay" because you are either not receiving current rent under the Chapter 11 or 13, or the tenant remains on the premises under a Chapter 7. Your attorney will file paperwork with the court asking it to allow you to take necessary actions to repossess your space and indicating you are suffering undue hardship as a result of the tenant. After a length of time, the court will lift the automatic stay.

This does not mean you will be allowed to collect the debt owed you, only that you have obtained leave to evict or exercise lien-sale remedies. Keep in mind that if money is gained from the sale, a sizeable amount may belong to the debtor's estate.

Proof of Claim

The final issue of which to be aware is proof of claim. The notice you receive will tell you whether the court is accepting proof of claims. At some point in Chapters 11 and 13, the court will always seek proof of claim. Often in Chapter 7, when estimates indicate there will be no funds available, the court does not bother asking for one.

A proof of claim is a court-issued form on which you list the amount of the pre-petition debt you are owed. These forms have very specific requirements for demonstrating to the court that money is in fact due, including breaking out any interest or late fees, etc. The forms require you to classify the type of debt and attach supporting documents. There are also filing deadlines that must be met. The proof of claim is the only way to protect your right to any sort of distribution that will be made by the bankruptcy court or trustee. While it may seem like a futile exercise and you will often wait a long time before you see any money, the proof of claim is the only way to recoup any debt owed you.

The most important thing is to be vigilant. If you allow your tenants to get four and five months behind in rent before taking action, shame on you! In 47 of the 50 states, you have lien-sale rights shortly after the end of the first month of delinquency. If you are prosecuting your lien sales promptly and efficiently, your debtors should not be more than two months delinquent before they file bankruptcy--which is obviously a less bitter pill to swallow than four or five months of rent. Further, if you have properly screened tenants by performing credit checks, or have a system in place to collect delinquent rent, you will substantially reduce the amount of money, time and energy spent dealing with bankrupt tenants.

Jeffrey Greenberger practices with the law firm of Katz Greenberger & Norton LLP in Cincinnati, which primarily represents owners and operators of commercial real estate, including self-storage. Mr. Greenberger is licensed to practice in the states of Ohio and Kentucky, and is the legal counsel for the Ohio Self Storage Owners Society and the Kentucky Self Storage Association. He is a regular contributor to Inside Self-Storage magazine and the tradeshows it sponsors. For more information, Mr. Greenberger can be contacted at Katz Greenberger & Norton LLP, 105 E. Fourth St., Suite 400, Cincinnati, OH 45202, or by calling 513.721.5151.

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