A practical guide for landlords with a bankrupt retail tenant

Retail chapter 11 cases have dominated the mid-market retail space in the last 12 months, with most retail experts expecting more bankruptcies to be filed in the next year. Retailers such as RadioShack, Caché, Coldwater Creek, Ashley Stewart, and Brookstone are among just a few of the casualties. As larger retailers have hundreds or thousands of locations, commercial leases are generally an important component of the bankruptcy. Accordingly, for commercial landlords, the bankruptcy filing by one of their tenants raises a number of issues and several challenges. With some preparatory steps, coupled with prompt and careful post-bankruptcy actions, a landlord can protect its rights and minimize its losses.

Since the enactment of the bankruptcy reform legislation of 2005, retailers have had a significantly more difficult time restructuring and emerging from bankruptcy under the same ownership. Many practitioners believe that this is in large part due to the tightened time frames imposed on debtors by the reform legislation of 2005. Under the amended law, a retailer who files for bankruptcy relief has no more than 210 days to determine what to do with its portfolio of stores—meaning whether to keep them open or closed. Accordingly, more often that not, the mandated time frame to either accept or reject the leases drives the schedule for these types of cases.

Upon learning that one of its tenants filed for bankruptcy, a landlord will likely have a number of concerns that range from nonpayment of rent, possible assumption/assignment or rejection of the lease, and going-out-of-business sales that may lead to empty store fronts. The following is what commercial landlords should expect in a retail bankruptcy.

Rent payments

One of the first issues that a landlord will encounter is whether they will be paid rent for the month that the bankruptcy case is commenced. A basic tenet under the bankruptcy code is that rent needs to be paid until the lease is accepted or rejected. The date on which a bankruptcy case is filed is known as the petition date, and this date has special significance as it separates how claims are treated. A creditor’s claim arising prior to the petition date is treated as a general unsecured claim and typically is not paid in full. A creditor’s claim arising after the petition date is treated as an administrative claim and is entitled to be paid in full.

Most commercial leases provide that rent is due on or near, the first of the month. Typically, a debtor will not file for bankruptcy on the exact date that rent is due for the forthcoming month. Instead, a debtor will file for bankruptcy after rent for that month has already come due—without having paid rent for that month. So the question becomes what amount the debtor owes to the landlord for the period after the petition date until the first postpetition rent payment is due (also known as “stub rent”).

Bankruptcy courts differ on how they treat stub rent. Most courts hold that when the rent includes the time prior to the bankruptcy filing, the debtor must pay a prorated amount based on the portion of the amount that the postpetition occupancy bears to the entire period for which the payment relates. Generally, in these jurisdictions, the debtor must pay the stub rent soon after the filing. Other courts have found that stub rent should be treated as a prepetition debt, even though a portion of the rent relates to the tenant occupying the space postpetition. One way for a landlord to potentially maximize its recovery in these jurisdictions, and obtain an administrative claim, is to file a proof of claim under section 503 of the bankruptcy code. When filing such a claim, the landlord will need to establish the value of the debtor’s use and occupancy of the space during the stub rent period. By doing this, the landlord will increase its rights to be paid in full for the stub rent period.

Accordingly, it is important for an affected landlord to quickly determine which billing method applies to protect its interest in the property. By doing so, the landlord will be able to file the appropriate papers with the court increasing its chances of maximizing its recovery.

Assumption or rejection of the lease

The second question that a landlord will likely face is whether the retailer will keep the location open and continue with the lease, or close. For the retailer to keep the location open, it will need to assume the lease; if the retailer decides to close the location, it will need to reject the lease. The debtor must assume or reject a lease of a commercial property by the earlier of (a) the date that is 120 days after the date of filing for bankruptcy relief or (b) the date of entry of an order confirming a reorganization plan. If the decision to accept or reject the lease is not made during this time period, the lease will be deemed to be rejected. The period, however, may be extended by 90 days by the court for cause. Courts have adopted various procedures to protect the interests of a landlord during the extension of time for the debtor to assume or reject the lease. These include:

1. Granting extensions conditioned on the debtor’s compliance with postpetition lease obligations;
2. Requiring the debtor to continue operating for additional time (e.g., operating through the Christmas season); and
3. Requiring the retailer to make rental payments beyond the time the debtor would elect to reject the lease.

Any extension beyond the 90 days must be approved by the landlord. The landlord can decide to agree to an additional extension with its tenant if the landlord believes it is in its interest to do so. Additionally, if the landlord does not want to wait the 210 days for the tenant to decide what it plans to do, it can file a motion to compel the assumption or rejection of the lease. Courts will generally decide on a case-by-case basis whether such request by a landlord should be granted.

If the debtor decides that it will accept the lease, it must cure the default (any past due rent amounts), provide the landlord adequate assurance of future performance, and obtain court approval within the specific time frame as set forth above. Also, a landlord should note that if the retail space is located in a shopping center and the retailer decides to assume and/or assign the lease, there are specific criteria that must be proven by the retailer. The retailer must provide the landlord adequate assurance that includes:

• The source of rental payments (i.e. the retailer’s business operations will produce sufficient revenue to pay the base rent);
• That the percentage of rent will not decline substantially;
• That the assumption or assignment will be subject to all the terms of the lease and will not breach other leases, financing agreements, or master agreements relating to the shopping center; and
• That the assumption or assignment of the lease will not disrupt the tenant mix. This provision in the bankruptcy code is intended to protect the mix of tenants and the overall appeal of the shopping center.

The landlord also should be aware that while most commercial leases prohibit assignment of leases without consent of the landlord, anti-assignment clauses are unenforceable in bankruptcy. The debtor may seek bankruptcy approval to assign the lease to a third party or may conduct an auction for the lease. While the debtor is not required to cure past due non-monetary obligations, it is required to provide assurance to the landlord that the new tenant will comply with all the provisions of the lease going forward. In some cases, this will limit assignability.

Conversely, if the debtor decides that a location is not profitable and it cannot find a buyer, it will most likely reject the lease. When this happens, the rejection of the lease will be treated as a breach that occurred immediately prior to the debtor filing for bankruptcy. The landlord at this time should calculate its damages and file a proof of claim setting forth its damages resulting from the rejection of the lease.

Because lease rejection claims pertaining to long-term real property leases can be relatively large compared to other unsecured claims, the bankruptcy code limits the maximum recovery for a landlord’s claim arising from termination of a lease. The limitation provides that landlords are allowed to claim the greater of one year’s rent or 15 percent of the rent for the remaining term, so long as that 15 percent does not exceed three years. Courts differ as to whether the 15 percent should be calculated based on time remaining or the rent remaining under the lease. For courts that find the calculation should be based on time rather than rent, the landlord will not receive the benefit of any rent escalations when calculating its rejection damages claim. It is important to determine which calculation will be employed as it likely will make a significant difference when calculating the amount that is to be set forth in the landlord’s proof of claim.

Store closing sales

A retail debtor will often conduct store closing sales or going-out-of-business sales. Landlords may be concerned because the signage associated with such sales often will not comply with the signage allowed pursuant to the provisions of the lease. Further, depending on the duration of the sale, it may detract from an otherwise popular location. It is wise at the commencement of the bankruptcy for a landlord to review the lease provisions to ensure that they understand the rights and interests afforded them under the lease and what is allowed and not allowed.

Many times a retailer will file, either with its first day papers or early in the case, a motion to establish the procedures for store closing or going-out-of-business sales. Therefore, it is important for a landlord to understand its rights immediately rather than waiting until later in the case. If the sale procedures violate the lease, then a landlord can file the appropriate papers with the bankruptcy court to protect its rights. A court may ultimately approve the sale, but if a landlord takes the appropriate steps, a court will likely be mindful of that and modify the retailer’s proposed sale procedures to balance the interests of both the landlord and the tenant.

For more information, please contact the attorney listed below.