A Landlord’s Primer For An Uncertain Retail Environment

Landlords are often among the very first to feel the impacts of their tenant’s financial woes. In today’s unpredictable economic environment, many businesses are forced to shut their stores temporarily while the risks of COVID-19 continue to play out. Within the last few days many large and small retailers have unilaterally announced publicly that they would not be paying upcoming rent. In these unprecedented times, landlords must be aware of the risks they face in light of what is certain to be a previously unheard of level of tenant defaults. Noted below are a number of things that landlords should take into consideration and be aware of, both in anticipation of a tenant’s bankruptcy and following such an event. Of course, the discussion below is intended only to highlight certain points and careful consideration must be given to each in the particular circumstances that a landlord may find itself.

Prior to a Tenant’s Bankruptcy.

• Termination. Landlords should consider whether termination of a lease with a troubled tenant is beneficial. If so, and if circumstances permit, care must be taken to properly terminate the lease prior to the commencement of the tenant’s bankruptcy. Such termination should be absolute and cannot be subject to cure periods that extend beyond the filing of the petition. In these uncertain times, many landlord’s will be faced with requests for extensions of payment terms or other standstills with respect to the rights under defaulted leases. Where opportunities arise, landlords should take advantage of opportunities to negotiate more favorable termination provisions in their leases. For example, providing for termination automatically upon default or upon notice from the landlord. Eliminating (or shortening) a cure period may allow a landlord a better opportunity to terminate the lease prior to a bankruptcy filing. If defaults exist, a termination of the existing lease, coupled with a replacement short term lease may be preferable. Importantly, a lease that has been properly terminated prior to a tenant’s bankruptcy may not later be subject to assumption and assignment (as discussed below).

• Shifting Risk. Landlords should look to shift risk to third parties where available. This may be accomplished through a full or partial guarantee of the lessee’s obligations. The Bankruptcy Code’s automatic stay (as discussed below) is generally unenforceable with respect to non-debtor third parties. Letters of credit may also serve to shift risk from a landlord to an issuing bank. Letters of credit are not property of a tenant’s bankruptcy estate and the automatic stay should not prevent a landlord from drawing on the letter of credit once a bankruptcy is commenced. Generally, claim limitations discussed below do not limit a landlord’s ability to recover against a guarantor or ability to draw on letter of credit. Under certain circumstances, however, the maximum available under a letter of credit may be limited by the damages cap. Increasing security deposits are also helpful but will be treated as property of a tenant-debtor’s bankruptcy estate and therefore cannot be setoff (without leave from the Bankruptcy Court). A security deposit will be treated as a credit against the landlord’s allowed claim and also give a landlord the benefit of a secured claim in the amount of any such deposit.

• Additional Rent and Use Clauses. For reasons discussed below and the importance of rent in the calculation of a lender’s claim, a landlord can improve its leases by including or expanding “additional rent” clauses. For example, payments of real estate taxes, common area maintenance charges, insurance and utilities can be categorized as “additional rent” and may provide greater protection in the event of a bankruptcy and assumption of the lease. Landlords should review their leases for any tenant obligations that might be payable in arrears and make adjustments to payment terms when available. Landlords should also narrow any overly broad “use clauses” in their leases to provide better protection should a tenant file bankruptcy and later seek to assign the lease to an entity in a different industry, for example. Use clauses often limit the types of business that can be performed on the premises, define the hours of operation, require continuous use, limit the number of people allowed on the property, and prohibit the sale of certain products, among other things. Because a tenant must assume a lease in its entirety, narrow use clauses may improve a landlord’s negotiation or litigation leverage at a later date.

• Integrated Agreements. Documents that reflect any agreements between a landlord and tenant should be in the form of amendments to the underlying lease. Doing otherwise risks allowing a tenant debtor to argue that the parties’ agreements are separate and do not need to assumed in whole. If separate, a tenant might argue that it is entitled to assume some, but not all, of the agreements between the parties. A “non-severability” or “integration” clause is important in this respect.

• Limiting Preference Risk. Lease payments received during the 90 days prior to a tenant’s bankruptcy may constitute preferential transfers and be subject to avoidance in certain instances. A landlord may have a defense to such avoidance if the payments were received in the ordinary course of conduct between the parties. Certain collection actions on the part of a landlord may eliminate its right to take advantage of this critical defense. Accordingly, landlords should take care to minimize the risks that lease payments be subject to avoidance, limiting their prepetition collection activities where practical. Of course, the receipt of a preferential transfer is not illegal and landlords should not forego payment on the sole ground that such payment may later be subject to recoupment by a debtor or trustee.

Following a Tenant’s Bankruptcy.

• Automatic Stay. Upon the filing of a bankruptcy petition, the automatic stay goes into effect generally restricting actions taken against the debtor or its property. Landlords must be careful to cease all collection efforts and cannot attempt to seize any property owned by the debtor (including, in most cases, offsetting a deposit). Landlords must also be cautious to avoid taking any steps to evict the tenant-debtor whether or not they believe that the lease was properly terminated. A willful violation of the automatic stay could expose a landlord to sanctions imposed by the Bankruptcy Court.

• Ipso Facto Clauses. Leases often include a right to terminate based on the tenant’s financial condition or bankruptcy filing. These include situations where a tenant becomes insolvent, breaches financial covenants of the lease, or there occur other insolvency events such as the appointment of a receiver appointed or the filing of a bankruptcy petition. Under Section 365(e)(1) of the Bankruptcy Code, ipso facto clauses in leases are generally unenforceable following the tenant’s bankruptcy case (but not before). Where other breaches occur following a bankruptcy filing, a landlord should seek relief from the automatic stay before acting unilaterally to terminate a lease.

• Staying Informed. It is important that landlords closely follow a tenant’s bankruptcy proceeding, particularly with respect to “first day” motions where relief is requested an emergency basis with limited notice. It is unusual, although not unheard of, to have motions to assume or reject leases scheduled for the first day hearing. Bankruptcy Rule 6003 limits requests for orders assuming or assigning leases during the first 21 days of a case unless the debtor can show immediate and irreparable harm. Such harm might be suggested in the context of going out of business sales, for example. Other first day pleadings will often provide a landlord with important background information and the tenant’s restructuring strategy and are worth reading closely.

• Timely Performance of Post-Petition Obligations. Under Section 365(d)(3) of the Bankruptcy Code, a tenant is required to timely perform its post-petition obligations under any lease of non-residential real property until assumption or rejection, and must begin doing so within the first 60 days after the petition date. What constitutes a post-petition obligation is often in dispute and the answer to that question often depends on the jurisdiction where the tenant filed its bankruptcy. For example, rents, taxes and CAM charges are often billed in advance and cover periods that spread across the pre- and post-petition periods. In those jurisdictions that apply the “proration method” payments will be prorated such that only those allocated to the post-petition period will be payable. In other jurisdictions that apply the “billing method” the determination is based on the date that the payments were due. In the case of stub rent, for example, landlords may nonetheless have a claim for the post-petition period as an administrative expense if it can show benefit to the tenant under Section 502(b)(1) of the Bankruptcy Code.

• Assumption or Rejection. An important right afforded to any tenant in bankruptcy is to determine whether to assume or reject a lease. Under Section 365(a)(4) of the Bankruptcy Code, a lease of non-residential real property must be assumed or rejected within 120 days of the petition date. That deadline can be extended by up to 90 days upon a showing of cause but any further extensions require the consent of the landlord. Landlords should pay attention to any attempt by a tenant to retroactively reject a lease in an effort to avoid payment of any post-petition amounts as an administrative claim. A tenant may exercise its “business judgment” to assume or reject a lease. Indeed, this right is one of key rights afforded to debtors in the Bankruptcy Code. If a tenant assumes a lease, and such assumption is approved by the Court, all rents and other charges that accrue from and after the date of its request are treated as an administrative claim and entitled to priority over other unsecured creditors. Administrative claims must also be paid in full in connection with the confirmation of any plan of reorganization. If a tenant later elects to reject a previously assumed lease, a landlord will be entitled to an administrative priority claim for two years from rejection under Section 503(b)(7) of the Bankruptcy Code. Note that the landlord may have a duty to mitigate its damages in any such circumstance.

• Adequate Assurance. In the event of a pre-petition default, a tenant may only assume the lease if it, among other things, (i) cures the default or provides “adequate assurance” that it will promptly do so, (ii) provides “adequate assurance” that the landlord will be compensated for any loss arising from the default, and (iii) provides “adequate assurance of future performance” to the landlord. With respect to non-monetary defaults that cannot be cured, the landlord must be compensated for its losses resulting from such breach. If there is no default but the lease is being assigned, the tenant (and assignee) must provide adequate assurance of future performance under the lease. What does or does not constitute such adequate assurance is based on the facts and circumstances in any case, often providing the landlord an opportunity to negotiate with the successor tenant. Given their unique, dependent nature, landlords in shopping centers benefit from greater clarity and are entitled to adequate assurance (a) of the source of the rent, (b) that any percentage rent will not decline substantially, (c) that assumption remains subject to location, use and exclusivity provisions, among others, and (d) that assumption will not interfere with the tenant mix (the term “shopping center” is not defined in the Bankruptcy Code).

• Damages. Generally, a tenant is free to reject a non-economic lease that is burdensome (it is very difficult for a landlord to contest rejection). In the event of rejection, landlord will have, generally, (i) an administrative claim for unpaid rent from the petition date through the date on which the lease is rejected and (ii) a general unsecured claim that is limited to the greater of (a) one year’s rent reserved under the lease or (b) 15% of the rent reserved for the remaining term of the lease (up to three years). A logical rule of thumb is to choose one year of rent If a lease term is less than six years.