Cole Schotz P.C.
Today’s Changing Retail Market
By all accounts, today’s retail market is in the midst of a noteworthy period of time and change. As the overall economic climate and consumer spending continue to improve from the 2008 collapse, the priorities and demands of consumers and retailers are in a state of flux. Among the shifts in the market is the heightened focus on technology, where the ease and comfort of online shopping are fueling a decline in the demand for traditional bricks-and-mortar retail space. Shoppers are not going out to malls and shopping centers with the same excitement as in the past, instead preferring to surf the Internet from their couches or on their smartphones. Furthermore, where many retailers were once focused on expansion through adding physical storefronts across a particular region or throughout the country, they are now either downsizing individual store locations or eliminating them in favor of concentrating their efforts on marketing to the growing population of online shoppers, with lower overhead costs. This combination of decreased shopper foot traffic and downsizing retailers has resulted in many shopping centers struggling with defaulting tenants and dark spaces.
Given this instability in the market, it is perhaps more critical now than ever before for shopping center owners to be aware of the ways that they can best prepare and protect themselves against defaulting or bankrupt tenants. There is no substitute for a shopping center owner conducting up-front due diligence and attempting to extract personal guarantees or other credit enhancements from tenants at the outset of a lease, but no crystal ball will be able to account for all of the unpredictable twists and turns that may arise over the term of a lease. This is not to suggest that shopping center owners cannot still enjoy success and profitability in their investments, but they need to be prepared to place themselves in the best possible position to wade through today’s changing market.
This article outlines many steps that shopping center owners can, and should, consider taking when presented with a retail tenant who has defaulted on its lease and/or filed for bankruptcy. While there is no “magic wand” that will keep tenants’ lights on and shopping centers operating at full capacity, shopping center owners armed and ready to take quick proactive steps with the right arsenal of tools will have a substantial advantage over their tenants and competitors. As the saying goes, sometimes the best defense really is a good offense.
Straddling the Line When a Retail Tenant Defaults Under Its Lease
Despite a shopping center owner’s hopes for a successful long-term tenant, a tenant may default under its lease, particularly in the recent state of market uncertainty. This most often arises out of a simple failure to pay rent, either in full or on time. Tenant defaults present commercial landlords with a number of competing concerns and remedies that they must navigate, always cognizant of the possibility of the 800-pound gorilla in the back of the room named “Bankruptcy” if they squeeze the tenant too tightly.
One remedy for landlords (outside of bankruptcy) is to seek eviction of the defaulted tenant, with the goal of reclaiming possession of the property. When a tenant is paying below-market rent under its lease or when a shopping center landlord is flooded with telephone calls from brokers and prospective tenants expressing interest in the property, deciding to evict is an easy choice. However, the decision can become much more difficult when the defaulted tenant is the shopping center’s signature anchor tenant. Leaving a sizable dark space in the shopping center after eviction may trigger certain clauses in other tenants’ leases—for example, co-tenancy or termination rights—that might relieve them of having to open, pay full rent or continue to operate. Vacant storefronts in a shopping center, particularly large ones, are also visually unattractive to shoppers, may decrease foot traffic (and in turn cause increased crime at the property) and may deter prospective tenants.
As an alternative, shopping center owners may prefer to work with the struggling tenant and help keep it afloat as long as possible, whether by reducing rent or by relaxing certain anti-assignment or anti-subletting prohibitions in the lease. This might be the landlord’s goal when other stores in the shopping center are already vacant or if the lease calls for above-market rent. Such a stopgap measure may also buy the landlord time to locate a new tenant and then decide to evict, or help keep an attractive store operating during a temporary time of hardship. A landlord owning several properties with a common national retail tenant may also not want to evict in order to salvage that relationship across all of its centers. In these circumstances, landlords may consider decreasing the rent due under a lease, restructuring the lease’s terms altogether or extracting additional credit enhancements and personal/corporate guarantees. At the same time, the landlord may also wish to keep the tenant at the property, sue for unpaid rent from the tenant and/or any guarantors and enforce any default rates of interest provided under the lease (as opposed to suing to evict).
Shopping center landlords considering these options need to ask themselves many questions:
These are a number of the serious questions for commercial landlords to consider when faced with a defaulted tenant in the current economic climate, always remaining aware that pushing the tenant to the brink might lead to the complex world of a tenant’s bankruptcy case.
Proactively Navigating a Tenant’s Bankruptcy
Unfortunately, in today’s changing and unstable market, many retail tenants continue to file for bankruptcy relief. Whether dealing with a bankrupt mom-and-pop store or a national retailer, shopping center owners are essentially faced with a similar set of circumstances that are complicated within the rubric of a bankruptcy proceeding.
The Automatic Stay and Payment of Rent
Upon commencing a bankruptcy case, § 362 of the United States Bankruptcy Code imposes an automatic stay that precludes the landlord (as well as any other creditors of the debtor-retailer) from evicting or taking any other legal action against the tenant’s property or assets. The idea behind the automatic stay is to maintain the status quo temporarily to give the debtor some breathing space until the bankruptcy process can begin to take its course. In certain situations, Bankruptcy Code §362(d) permits a landlord or creditor to obtain relief from the automatic stay. Examples of such circumstances include when a debtor has filed a bad-faith bankruptcy petition or when a debtor-tenant fails to pay post-petition rent (more on this below). The automatic stay typically does not preclude a landlord from pursuing legal claims against non-debtor guarantors. Consequently, a landlord’s ability to extract strong personal and/or corporate guarantees (either at the outset of a lease or while renegotiating lease terms pre-bankruptcy) can be an important weapon in a commercial landlord’s arsenal.
While the bankruptcy process in many ways favors debtor-tenants, a landlord (as a creditor) is also afforded many protections under the Bankruptcy Code. From the outset of a tenant’s bankruptcy case, if the tenant remains in possession of the premises, it must continue to perform under the lease and is obligated to pay for its use of the space as rent comes due until it either rejects or assumes the lease. It is key that a debtor-tenant not only pay post-petition rent but also stay current with those payments; otherwise, the landlord will have a potential basis to seek relief from the automatic stay to pursue a prompt eviction, or to terminate or compel a tenant to reject the lease. In addition to a potential basis for stay relief, a debtor-tenant’s failure to pay post-petition rent will also give the landlord a priority administrative claim for such payments. Allowing these payments to comprise an administrative claim is an important protection for landlords because when distributions are made from the debtor’s estate, those payments are payable before the general unsecured claims. Generally, administrative claims must be paid in full in order for the debtor to confirm a Chapter 11 plan. As a word of caution, a debtor’s administrative creditors may receive no value at all for their claims if the estate is administratively insolvent. In contrast to post-petition unpaid rent, however, a debtor-tenant’s unpaid pre-petition rent is treated as a general unsecured claim. Commercial landlords should be cognizant of the differences between the treatment of pre- versus post-petition unpaid rent, as well as the types of formal claims, motions and objections that must be filed in the bankruptcy case to preserve their rights.
Lease Assumption or Rejection
From a commercial landlord’s perspective, one of the most closely watched aspects of a debtor-tenant’s bankruptcy case is the tenant’s ultimate decision either to reject or assume its unexpired lease. Under the current iteration of the Bankruptcy Code, a Chapter 11 debtor-tenant has 120 days to make this decision, which can be extended in most cases for up to another 90 days for a total of 210. For any further extensions, a debtor-tenant must obtain express consent from the landlord. A landlord looking to protect its rights when a debtor is not paying rent might be wise to file an application that instead shortens the debtor’s decision-making time frame, which is a possible form of available relief when the tenant fails to comply with the terms of its lease post-petition.
When a debtor-tenant “rejects” its lease, it is technically breaching the lease/contract and triggers a default thereunder. Although this does not serve to terminate the lease, it does force the tenant to “immediately surrender” the premises. As a quick aside, many commercial leases include ipso facto clauses that essentially state that if a tenant files for bankruptcy, it triggers an automatic “event of default” that will permit the landlord to exercise all of its rights under the lease. These ipso facto clauses are generally unenforceable, and another breach or default under the lease will need to stand as the predicate basis for obtaining relief. As noted above, though, the automatic stay precludes that outcome, at least until the lease is rejected or the landlord obtains relief from the automatic stay. The landlord may then install a new tenant in the space under a new lease, which is particularly beneficial if the debtor-tenant’s lease was below market.
The rejection of a debtor-tenant’s lease provides the landlord with an unsecured claim for all damages caused by the breach to the extent permitted by applicable state law, but subject to a cap fixed by the Bankruptcy Code. In addition to unpaid pre-petition rent, the Bankruptcy Code caps a landlord’s lease rejection damages to the greater of (i) 1 year’s rent (not accounting for any acceleration of rent), or (ii) 15 percent of the rent due on the remaining lease term up to a maximum of 3 years’ rent. As a general rule of thumb, if there are less than 80 months remaining on the term of the lease, then the 1-year cap will apply. If there are more than 80 months but less than 240 months remaining on the lease, then the 15 percent cap will apply. Finally, if the lease has in excess of 240 months remaining, then the landlord’s claim will be capped at 3 years of rent.
On the other hand, if the debtor-tenant “assumes” its lease, it can mean one of two things: the debtor-tenant either wants to continue operating its business or it wants to assign the lease to a new tenant. Commercial landlords are protected in either of these scenarios because in order for a lease to be assumed, the Bankruptcy Code compels all existing lease defaults to be cured. The cure amounts will be paid for either by the existing debtor-tenant or the incoming assignee, depending on how the deal is structured. Assignment of the lease may be facilitated directly between the debtor-tenant and the new end user or, alternatively, through a third party who acquires bankruptcy designation rights. A third-party designation rights purchaser acquires the rights to direct the debtor-tenant to assume its unexpired lease and then assign it to the third party’s designee. This commonly employed tool in retail bankruptcy cases is designed to maximize the value of a debtor’s bankruptcy estate and reduce the overall expenses associated with rent payments that are continuing to accrue. In these situations, the designation rights purchaser and ultimate assignee have certain rights to suspend enforcement—albeit temporarily—of certain provisions of the subject lease (i.e., striking anti-assignment and continuous operation provisions) that do not typically exist outside of the bankruptcy process.
When a lease is assumed and then assigned, the assignee/new tenant steps into the existing tenant’s shoes and will operate under the same lease terms. But landlords should be aware that assignments through the bankruptcy process generally invalidate as unenforceable any lease terms that deem an assignment to trigger an event of default. The other side of this coin, however, is that the Bankruptcy Code requires an assignee to provide adequate assurances that it can perform under the terms of the existing lease post-assignment. There is no “magic demonstration” as to what will qualify for such adequate assurance of future performance, but a landlord has ample opportunities to raise concerns in most cases if the landlord feels uncertain about the assignee’s prospects. Landlords therefore can—and should—use this as another opportunity to demand personal and/or corporate guarantees, letters of credit, a large up-front security deposit or other credit enhancements. Indeed, the Bankruptcy Code allows the landlord to “require” a deposit or other security for the performance of the lease obligations substantially the same as would have been required by the landlord upon leasing to a similar tenant (even in the absence of having actually received one from the debtor when it entered into the lease). In the absence of adequate assurance, a landlord can object to the proposed assignment.
Unique to shopping center tenancies, the Bankruptcy Code provides special adequate assurance protections for retail landlords. Pursuant to Bankruptcy Code § 365 (b)(3), adequate assurance of future performance of a lease of real property in a shopping center includes each of the following:
With these additional shopping center adequate assurance protections, a landlord’s property that fits within the Bankruptcy Code’s shopping center definition can ensure that any co-tenancy and exclusive-use restrictions remain in full force and effect. This is an invaluable protection for landlords, given the frequent use of master agreements and the common interplay among individual shopping center tenant leases. Without these additional protections, a landlord’s shopping center could theoretically be thrown into total disarray by a debtor-tenant’s assignment of its lease to a nonconforming tenant or a tenant that infringes upon an existing tenant’s exclusivity or use rights. Scrutinizing and demanding the heightened adequate assurance information from debtor-tenants or assignees, while maintaining the integrity of a shopping center, is yet another way that commercial landlords can, and should, play an active role in a tenant’s bankruptcy in today’s market.
Overcoming the Uncertainties of Today’s Retail Market
In today’s evolving retail market landscape, shopping center landlords need to protect themselves at all stages of a tenant’s occupancy. If the landlord is savvy and in a position of strength to demand guarantees, letters of credit and other credit enhancements during lease negotiations, these tools will be invaluable leverage points if or when the tenant later defaults. Shopping center landlords must also understand that a tenant’s filing for bankruptcy is not necessarily the death knell for the tenant’s business and does not exclude the landlord from playing an active role in the process. To the contrary, landlords—and shopping center landlords in particular—are afforded a number of rights under the Bankruptcy Code to best protect their interests and the overall vitality of their shopping centers. Landlords should be prepared to consider and employ all of the tools and remedies discussed in this article as the retail market further evolves and the overall economy continues to recover from recession.
Jason R. Finkelstein is an associate in the Litigation Department of Cole Schotz P.C., Hackensack, NJ, where he focuses his practice on handling complex litigation matters involving commercial real estate and construction disputes, employment matters and partnership/shareholder disputes.