(Excerpted from “Retail Bankruptcies – Protections for Landlords,” Practical Law Journal, May 2018, by Lars Fuller)

Due to increasing competition from online sellers, recent years have seen a dramatic uptick in Chapter 11 bankruptcy filings by multistate brick-and-mortar retailers – some that have dozens, or even hundreds, of storefronts. These bankruptcies create challenges for the commercial landlords that own the shopping centers, malls and other establishments that those retailers rented.

A major issue in most retail bankruptcies is which of the retailer’s stores will close and which stores, if any, will be retained or sold to another tenant through an asset sale. Debtor-tenants are usually burdened by unsustainable rent obligations that can weigh down a Chapter 11 case, increasing operational deficits that threaten administrative insolvency and create urgent demands for payment from commercial landlords.

So what is a landlord to do? While the Bankruptcy Code provides landlords with unique protections in bankruptcy, these rights can be lost if not properly asserted. Landlords must therefore carefully monitor bankruptcy proceedings to enforce their rights and maximize their recovery. This post lays out some of these challenges.

Automatic stay

Once a debtor files a petition in bankruptcy, a stay is triggered that automatically stops substantially all acts and proceedings against the debtor and its property. After the automatic stay is triggered, a landlord must obtain the bankruptcy court’s permission before it can take any action interfering with the debtor’s rights under the lease. Actions requiring bankruptcy court approval include:

  • Changing the locks on the premises or engaging in other self-help remedies.
  • Commencing or continuing to prosecute an action to evict the debtor.
  • Sending notices to the debtor to terminate the lease or revoke a right of lease renewal (even if the lease allows the landlord to take that action).
  • Demanding payment of past due rent.

A landlord that takes these actions (or others prohibited by the Bankruptcy Code) against a bankrupt tenant without first obtaining relief from the stay risks being subjected to fines or damages or even being held in contempt of the bankruptcy court.

First-day issues for landlords

During the initial days of a large-scale Chapter 11 case, critical decisions are made about the administration of the bankrupt company. A Chapter 11 debtor typically files several motions on or soon after the petition date. These so-called first-day motions often include motions to use cash collateral, to approve debtor-in-possession (DIP) financing, and for the authority to approve lease rejection procedures and to reject leases as of the petition date. Each of these can have profound impacts on a landlord’s rights and position.

Cash collateral

Debtors often enter bankruptcy with most of their assets, and particularly their cash, pledged as collateral. Before the debtor can utilize any of its cash on hand for its day-to-day obligations, the debtor must negotiate an agreement with its secured creditors for authorization to use the creditors’ collateral. These agreements can significantly impact the landlord-creditor relationship.

A standard component of cash collateral agreements is an agreed-on operating budget, setting out the particular operating and administrative expenses the debtor is allowed to incur and pay using the secured creditors’ funds during the case. In bankruptcy, the lender often seeks to tighten the restrictions on the debtor’s expenditure of cash and closely monitors the debtor’s use of cash collateral. Accordingly, landlords must review the cash collateral order and budget to determine whether they provide for the payment of rents as an administrative expense and grant liens that are senior to the landlord’s liens.

DIP financing

In addition to the use of cash collateral, debtors will often seek additional postpetition financing – an accommodation the Bankruptcy Code is designed to encourage. The debtor’s request for DIP financing is typically a first-day motion. DIP facilities also contain a budget, or 13-week cash flow, that landlords must review (along with the DIP motion and proposed order) to ensure that funds are available to pay accruing rent obligations. Landlords should also review budgets because they often provide the first signal regarding the debtor’s intentions for the Chapter 11 case, including whether it will be maintaining or closing stores and on what timetable.

Leases under section 365: landlord considerations

A commercial landlord’s recovery generally hinges on whether the debtor-tenant rejects or assumes its lease under 11 U.S.C. § 365. Section 365 affords a debtor substantial discretion in dictating the treatment of its leases in bankruptcy. Debtors can reject burdensome leases, they can assume or assume and assign leases to third parties (notwithstanding prepetition defaults or anti-assignment provisions in the leases if defaults are cured and the assignee provides adequate assurance of future performance), or negotiate amendments to the terms of its leases.

Key issues for landlords regarding the treatment of their leases in bankruptcy include:

  • Ensuring payment of postpetition rent and other lease charges, including stub rent.
  • The effect on the landlord of an assumption of the lease versus a rejection of the lease.
  • The circumstances under which the debtor can assign the lease, including the conditions particular to assigning shopping center leases.
  • Timing and other strategic considerations.

Postpetition lease obligations and stub rent

From the petition date until the date the debtor assumes or rejects a lease, 11 U.S.C. § 365(d)(3) requires the debtor to pay rent and common-area charges and perform other tenant obligations under the lease. Unpaid rent and other lease charges incurred postpetition are “administrative expenses” of the estate and are entitled to payment priority over unsecured claims – they receive preferred treatment to a debtor’s prepetition unpaid rent and lease charges, which are given only general unsecured status.

Section 365(d)(3) does not specify any consequences if the debtor fails to timely perform its postpetition obligations. Enforcement of these obligations differs among judges and is based on the circumstances of the individual Chapter 11 case. For example, some judges force conversion or dismissal of the Chapter 11 case, while other judges only admonish debtors to comply.

When debtors file for bankruptcy after the rent due date, debtors have argued that section 365(d)(3) does not apply to stub rent – i.e., the amount of rent due for the period between the petition date and the end of the rent period – because it cannot be paid timely. As a result, notwithstanding section 365(d)(3), landlords still find themselves in the frustrating position of having to pay attorney fees in order to be paid their postpetition rent. If a landlord does not insist on rent payments, the debtor is not incentivized to timely make these payments.

Assumption vs. rejection

Under 11 U.S.C. § 365(d)(4), leases of nonresidential real property must be assumed or rejected within 120 days of the filing of the bankruptcy petition, which may be extended by an additional 90 days on motion of the debtor or landlord, for a maximum period of 210 days. A debtor’s ability to reject leases that impose burdensome obligations and retain those favorable and important to the reorganization of the debtor’s business furthers the goal of rehabilitating the company. For landlords, assumption of the lease is generally a positive result relative to the other possible outcomes.

Rejection of the lease often means the landlord’s recovery is minimal. Even if the debtor rejects the lease, the landlord must take affirmative steps to be able to pursue eviction in state court to recover possession from a holdover debtor tenant, such as filing a motion for relief from stay.

If the debtor assumes the lease, it is typically because:

  • The lease has a below-market rental rate, making it desirable.
  • It plans to assign a prime retail location to a prospective buyer.

Conclusion

Depending on the debtor’s intentions in the Chapter 11 case, it may be preferable for individual landlords to pursue their own rights and remedies, particularly when the debtor is looking to reject some leases and assume others. It is common for debtors with multiple landlords to choose desirable leases over undesirable ones, and focus limited resources on those leases that might be sold. The landlord should carefully review the debtor’s pleadings to discern its intentions for its leases and then evaluate the benefit of joining forces with other landlords or pursuing rights individually.