The Effects of Chapter 11 Bankruptcy on Landlords and Tenants

As the old saying goes, “be careful what you wish for because it just might come true.” WeWork, a pioneer of remote work, simply didn’t anticipate that “remote” work would one day go beyond “hot desks” to include no office at all. In conjunction with the pandemic, remote work created the perfect storm for the decline of WeWork. WeWork’s founder’s vision was bold – without question – but it missed something that would ultimately lead to its demise. This article is intended to educate and inform both landlords and tenants, and more importantly to warn and motivate them to WORK IT OUT, or else potentially deal with the awesome power that is Chapter 11 bankruptcy. Plain and simple. The realities of the commercial real estate market and the economy at large are too clear for either side to ignore or avoid dealing with. It is in the best interest of both landlords and tenants of all kinds to face the music and understand what everyone’s rights are if you don’t reach an out-of-court work out and find yourself in the debtor or creditor seat of a bankruptcy proceeding. So, let’s break it down with WeWork’s recent filing in the backdrop.

On Monday, November 7th, the collaborative workspace provider WeWork filed for Chapter 11 bankruptcy in New Jersey Federal Court. That filing may not come as a surprise to many. Since the beginning of 2023, WeWork’s stock price has fallen by over 95%, and overall demand for physical workspace has declined drastically since the Covid pandemic and subsequent rise of remote work. However, WeWork seemed untouchable just a few years prior. The startup’s business model of leasing and renovating offices for shared use by customers enjoyed initial success; in 2019, WeWork even attempted to go public at a valuation of $47 billion before eventually going public in 2021 at a valuation of $9 billion. WeWork had hundreds of leases in many different cities throughout several countries, including New York and the United States. So, what can landlords and tenants do to prevent situations like WeWork’s, where tenants are unable to pay rent and landlords are left with vacant property? The bankruptcy filing leaves many landlords and lenders unsure of the security of their leases and other executory contracts they may have with the once sought after tenant.

But first, what is a Chapter 11 Bankruptcy? What is an executory contract?

A case under Chapter 11 of the U.S. Bankruptcy Code is frequently referred to as a “reorganization bankruptcy.” This is because the debtor remains “in possession” and continues to operate its business. The filing proposes a reorganization of the business and allows affected creditors to vote on the plan. The first step in a Chapter 11 case is the filing of a petition with the bankruptcy court. The petition may be voluntary, as in WeWork’s case, where the petition is filed by the debtor, or involuntary, where the petition is filed by creditors. In filing the petition, the debtor must also file schedules of assets and liabilities, income, executory contracts and leases, and a statement of financial affairs.[1] Filing for bankruptcy is a drastic measure for a tenant to take, but it is also a measure that expensive or protracted leases can force tenants to resort to.

An executory contract has been interpreted by courts to refer to a contract where there may be unperformed obligations by both parties when a bankruptcy is filed. For example, supply contracts are executory because the supplier has an obligation to continue to supply the goods, while the purchaser has an obligation to pay for those goods. In their petition, WeWork claimed to be the “party to thousands of contracts,” that range from leases to vendor supply contracts.[2] 11 U.S.C. § 365 provides that the trustee may assume, assign, or reject an executory contract or expired lease. In deciding whether to grant a motion to do so, bankruptcy courts defer to the bankrupt’s business judgment, and typically will grant the motion absent bad faith. Non-debtors are left with limited options in this case. To exercise any rights to terminate a contract, they must obtain relief from the automatic stay granted by the bankruptcy filing. For more information on executory contracts and automatic stays, see our prior article here: Executory Contracts and Leases in Bankruptcy - KI Legal.

Who does Chapter 11 bankruptcy apply to?

One may be inclined to think that Chapter 11 bankruptcy applies exclusively to large, corporate companies like WeWork because these are the bankruptcies that often garner the most public attention. However, Chapter 11 also contains a subchapter that allows small businesses to file for bankruptcy.[3] Subchapter V went into effect in 2020 and has helped countless small businesses reorganize during the difficult times the COVID pandemic presented. For reference, in September 2023, small business filings under Subchapter V had approximately double the percentage of confirmed plans and half the percentage of dismissals, along with shorter time to confirmation when compared to non-subchapter V small business filings.[4] Not only this, but small businesses make up more than 99% of the businesses in the U.S. (over 30 million businesses).[5] Therefore, the powerful tool that is a Chapter 11 filing extends to small businesses through subchapter V.

But what is a “small business” for the purposes of a subchapter V filing? A “small business debtor” is defined under 11 U.S.C. § 101(51D) as “a person engaged in commercial or business activities . . . that has aggregate noncontingent liquidated secured and unsecured debts . . .” not exceeding $3,024,725 as of the date of filing under subchapter V, subject to some exceptions. As one might imagine, there are tens of millions of small businesses throughout the United States eligible to file for subchapter V bankruptcy so they can benefit from the protections it offers, as well as the expedited and cheaper processing.

So, how does tenant bankruptcy affect landlords?

In recent years, there has been an increase in commercial vacancy rates, including in New York. Commercial vacancy rates in New York office spaces have climbed from twelve percent (12%) in 2017 to over sixteen percent (16%) in 2022.[6] WeWork even tried to renegotiate “nearly all” of its office leases with their landlords in September 2023.[7] The possibility of a Chapter 11 or subchapter V bankruptcy by the tenant always remains a possibility, especially when the lease is not sustainable for the tenant. The long-term effects of the filing on WeWork’s landlords and lenders are still uncertain, as the company will look to continue operating as it works out creditor repayments through the chapter 11 filing.

One thing is clear: WeWork demonstrates the importance for landlords to take note of the power that Chapter 11 (and subchapter V) bankruptcy grants to tenants in the context of executory contracts.

In its initial filing, WeWork already announced that it is seeking approval to reject more than 60 of its commercial real-estate leases, most of which are in New York. The other 400-plus landlords who lease their space to WeWork may have already accepted lower rent in recent years and may now be left with vacant real estate if they do not renegotiate their lease terms. The ability to choose which leases to reject and which to assume grants WeWork leeway in restructuring their company because they can be quite selective with the executory contracts they assume or reject. Going forward, landlords must consider this reality when entering into executory contracts to limit vacancies in the future.

How does tenant bankruptcy affect tenants?

Tenants, on the other hand, can also learn from WeWork’s bankruptcy filing. For the same reason that landlords must exercise care when entering into executory contracts, tenants should understand how Chapter 11 and subchapter V filings serve to protect them in the event of bankruptcy. Specifically, Chapter 11 and subchapter V filings allow tenants to “reorganize” to hopefully survive the bankruptcy. By being able to choose to assume, reject, or assume and resign their executory contracts, tenants can choose the contracts that they believe will help them the most. In the case of WeWork, the company can evaluate which floors of which leases to assume and which to reject. Tenants also may consider out-of-court work outs, which provide other benefits compared to bankruptcy filings, such as expediency, lower costs, and minimizing public scrutiny. This type of resolution involves the debtor contracting with their creditors to resolve debt obligations. Therefore, there are different options available to debtors involved in executory contracts facing financial trouble, including Chapter 11 and subchapter V bankruptcy filings and out of court work outs.

Conclusion

Overall, WeWork demonstrates how a Chapter 11 bankruptcy can serve as a tool for tenants involved in executory contracts. In a market reeling from recent shifts toward remote work and away from the need for office space, landlords and lenders need to be aware of the effects that burdensome leases and executory contracts can have on them and their tenants. If those tenants do opt to file a petition for bankruptcy, they are granted the benefit of their choice to assume, reject, or assume and assign these leases. If you or your business are currently in distress, or you are currently considering a Chapter 11 or subchapter V bankruptcy, kindly contact KI Legal for help at (212) 404-8644 or by email at info@kilegal.com, and we can discuss your options.

This information is the most up to date news available as of the date posted. Please be advised that any information posted on the KI Legal Blog or Social Channels is being supplied for informational purposes only and is subject to change at any time. For more information, and clarity surrounding your individual organization or current situation, contact a member of the KI Legal team.

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