John Monaghan
Definite trend

If misery truly does love company, then firms contemplating bankruptcy can take comfort that office landlords are feeling their pain.

As the region’s economic troubles congeal, the prospect of tenants seeking bankruptcy relief is of increasing concern for commercial building owners. In many cases, the strategy can quash a lease outright, diluting the proceeds a landlord would otherwise reap on a long-term deal. That situation is playing itself out on a large scale at the Arsenal on the Charles office complex in Watertown, for example, with struggling Arthur D. Little Co. preparing to shed its 350,000-square-foot lease after filing for bankruptcy relief in February.

Thus far, Boston attorney John Monaghan said he has not seen a dramatic spike in bankruptcy filings. But for those firms which do take that approach, Monaghan said a growing number are electing to reject their leases, as is their right under Chapter 11.

“It is definitely happening,” the Holland & Knight bankruptcy specialist said last week. Monaghan attributes the trend partly to the sharp hike in office rental rates during the past few years, followed by the subsequent plunge in activity and rents. Companies that struck lease agreements at the peak of the market are often at a competitive disadvantage, he said, particularly given that real estate costs often are among a firm’s biggest expenses. Not only did firms overpay for space in the boom, many took excessive amounts, especially players in the high-tech sector.

Under Chapter 11 guidelines, a tenant has 60 days after filing to decide whether to reject a lease or remain on board, although the debtor can seek extensions after the period, perhaps to renegotiate terms. If talks fail, the rejected lease will only provide the landlord with the greater sum of one year’s rent or 15 percent of the total lease value. As an unsecured creditor, the owner ultimately may receive just a fraction of that amount.

Even calculating claims for other damages, including rent payments due at the time of the bankruptcy filing, Monaghan said building owners are now more likely to compromise. “In this economy, landlords are having to choose between vacant space or partially filled space at a lesser rent, and in many cases, they are opting to choose the partially filled [route],” said Monaghan, who is currently working with a tenant on such a negotiation.

C. Gabriel Cole, an expert in real estate and the telecommunications industry, agreed that landlords are being more accommodating than they have been in many years. His company, Needham-based ixpanse, has helped several firms buy out of their leases without going into bankruptcy. In the past six months, ixpanse has negotiated a buyout payment equal to nine months’ worth of rent, while another was whittled down to 24 months.

“They are so scared the tenant is going to go into bankruptcy, the landlords are much more willing to work with them today,” said Cole. Prior to the downturn, he said, building owners were loathe to settle for anything less than payments equal to three years’ worth of rent.

Market Swings

Some of the nation’s leading telecommunications companies have already filed for bankruptcy, such as Winstar and Teligent, and Cole said there are a host of others on the fence, including XO Communications, Williams and Level Three. It is often hard to survive without bankruptcy unless the real estate is addressed, said Cole, because the drain on a balance sheet makes investors less likely to provide new capital.

Other than a willingness to compromise on lease terms, there is little a landlord can do to control the process once bankruptcy is filed. Cole said bankruptcy judges are generally reluctant to give a landlord preferential treatment over other unsecured creditors, and companies that file for bankruptcy can assign a lease to a third party with extensive leeway unavailable under normal circumstances.

Prevention is the best cure for finding oneself in a bankruptcy dilemma, said Monaghan, noting that “I tend not to get contacted by [landlords] until it is too late.” Provisions such as security deposits or letters of credit can be powerful insurance, he said, but they must be structured precisely, and procedures must be followed correctly to maximize such tools.

Letters of credit and personal guarantees are among the best protections, said Monaghan. That view is seconded by attorney Michael J. Goldberg of Hill & Barlow. In a recent missive to clients, Goldberg outlined strategies property owners can employ to bolster their position, opining that a commingled security deposit is among his favorites. There are two basic forms of security deposits, he said: segregated ones that must be set aside at the outset of a lease and commingled funds that the landlord can spend immediately. Under the bankruptcy statute, an automatic stay usually prevents a segregated deposit from being applied to satisfy unpaid rent.

“Once the landlord receives the deposit … it is permitted to commingle it with other funds and to spend it,” he explained. “Thus, if the tenant ever files for bankruptcy, the funds are typically long gone, and the automatic stay irrelevant.”

As technology woes emerged at the outset of 2000, landlords became stringent on financial guarantees, but many selected vehicles were rendered useless by the bankruptcy code. Ironically, now that the issue is clearer, the swing in the market gives building owners less clout to mandate security terms. Tenants may not like letters of credit, for example, because they are required to pay interest to maintain the account, according to Meredith & Grew Associate Jeremy M. Roy.

In a recent M&G report, Roy acknowledged that “security deposits are on the minds of everybody engaged in lease negotiations today.” Roy offered strategies landlords can employ, including one approach of “leveraging existing banking relationships” to obtain favorable terms on a letter of credit. The landlord might also agree to a so-called burning down of the security deposit, Roy added. Under that formula, the landlord accepts a decreasing deposit as the tenant proves over time its ability to pay the rent or to meet certain financial milestones.