Legal Tip 384: Bankruptcy and Leases

What happens to a lease if the tenant becomes bankrupt? A lease is a contract between a tenant and a landlord. If a person becomes bankrupt the trustee in bankruptcy will step into the shoes of the bankrupt and take over their property. They will therefore become a party to the lease.

If the lease had a remaining term it would be burdensome for the tenant to keep the contract so s 133 of the Bankruptcy Act allows the trustee in bankruptcy to disclaim the lease. They can essentially get out of the contract. The landlord can then re-lease the premises and become a creditor for whatever is owed to them.


Example

Homer sets up the Mr Plough business as a sole trader and he leases some land for the business to operate from. It is a 2 year lease. After 1 year Homer becomes bankrupt and stops paying the lease well before that.

The trustee in bankruptcy takes over Homer’s affairs and disclaims the lease. Homer owes 1 year and 4 months rent to the landlord, and they become an unsecured creditor for this amount.



s 133 of the Bankruptcy Act
BANKRUPTCY ACT 1966 - SECT 133 Disclaimer of onerous property

 

But if you operate a russian airline you can retain the plane and keep flying.
Wonder when Boeing / Airbus announce a "remote kill switch" it its aircraft flight software that allow a parked plane to stay parked ?

A landlord with Commercial property may invoke a rental bond or a bank guarantee to limit their loss. It is a form of security which helps to defray some impact. It doest lapse when insolvency commences. In some cases the bank may act swiftly to end the guarantee if its a undrawn advance but not when its a cash deposit.

 

Biggest issues for commercial properties are a) unpaid rent and b) make good costs.

However banks can’t cancel a bank guarantee that’s been issued just because the borrower / tenant went bankrupt. It’s as good as cash unless it expires before it’s claimed.

 

Bankruptcy law only applies to individuals. Not sure if it would be common to get personal guarantees when an individual is the tenant.
It would be for company tenants, but then the corporations act applies rather than bankruptcy act, and there would be similar provisions for companies.

 

Banks certainly can suspend or not honor a guarantee when a entity is in administration or liquidation or other covenants to the facility. The entity is not lawfully able to use finance. Imagine that ..drawing down finance and its a free kick? Bankruptcy is a personal matter.

 

Nope, they can’t suspend or cancel it. That is the point of a bank guarantee… to guarantee the tenant’s obligation for a fixed amount when they don’t pay. Finance is used / accounted for when bank issues the guarantee, not when it’s called on.

Bankruptcy is a personal matter, but any one or entity can secure a bank guarantee

 

A bank guarantee is designed to be security for the guarantee, usually the landlord. If the lease has been disclaimed the bank guarantee can be called up. If the tenant went bankrupt and the landlord has lost out they could call on the guarantee and keep it to cover there loss.

But the question is if the trustee in bankruptcy can take this guarantee - if it was secured by cash of the tenant. Is it property of the bankrupt? There was a case years ago involving the corporations act where it was considered an unfair preference payment, but I can't remember how it turned out

 

Would that be dependent upon when the guarantee was provided?

A guarantee provided at commencement of a 5 year lease, the lessor would/should have completed their due diligence on the tenant, 3 years later, things may have soured or circumstances changed.

 

I don't really know. I guess the guarantee amount, if a cash deposit, would belong to the tenant until it was called upon.

 

Assuming the bank guarantee is cash secured and not unsecured, the cash is property of the borrower/tenant but is charged by the bank i.e. the bank has priority over it for a contingent liability, so not available to the tenant’s creditors. But if they tenant is bankrupt/wound up you’d expect there to be outstanding rent or make good costs anyway so probably no difference one way or the other.

The preference case is where repayment of bank debt in preference to other creditors provides a benefit to a related party i.e. release of director’s property etc. If a tenant charged cash for a bank guarantee that was previously unsecured, you could probably argue the bank received a preference.