Tenant Bankruptcy a Sign of the Times

September 14, 2009

By HunterMaclean Attorneys

Published in Business in Savannah

In the recent economic slowdown, many national and regional retail chains — like Steve and Barry’s, Linens ‘n Things and Goody’s Family Clothing — have resorted to bankruptcy courts to downsize or liquidate.

Additional filings are likely to occur before this economic cycle is over. Landlord preparedness and knowledge is key when it comes to protecting assets and minimizing risk.

Recent trends in retail bankruptcy have strained landlord-tenant relationships as mall and shopping center owners are hit with multiple tenant filings, many of which have ended in liquidation. Retailers are using Chapter 11 because the Bankruptcy Code gives them tools to modify the landlord-tenant relationship and shed nonperforming leases on favorable terms. However, landlords can protect their rights and maximize outcomes in Chapter 11 by keeping a vigilant watch on these fast-moving bankruptcy proceedings, especially in the early stages.

The tenant’s bankruptcy filing operates as an immediate automatic stay of any action to evict the tenant or to collect back rent. The landlord cannot sue the tenant for back rent or file an eviction action, unless the landlord gets an order from the bankruptcy court lifting the stay.

Generally, the court will not lift the stay in favor of the landlord as long as the tenant is paying post-bankruptcy rent. The Bankruptcy Code requires the debtor-tenant to pay all obligations “arising from and after the order for relief” in a timely fashion. However, courts disagree on how to treat the month within which the bankruptcy is filed. As a result, many retailer bankruptcies are filed early in the month, allowing the retailer to avoid or at least postpone paying rent for that month.

In a Chapter 11 reorganization, the debtor has the ability to “assume” or “reject” leases. Assuming the lease means the tenant reaffirms the lease and must promptly cure any default, as well as provide adequate assurance of future performance. Debtors can also assign the assumed lease to a third party. Subject to certain restrictions and the requirement to provide some evidence of the assignee’s financial wherewithal (which the courts often enforce flexibly), the landlord generally is not able to veto the debtor’s choice of successor tenant.

Rejecting a lease means the debtor is giving up the lease and vacating the property. The landlord has a claim against the tenant for breaching the lease. However, the landlord’s claim has only the status of a pre-bankruptcy unsecured claim, which are often paid at pennies on the dollar. There is also a cap on claims for long-term leases.

Crucially, these actions often take place very quickly in the first few days and weeks of a tenant’s bankruptcy case. Frequently, there is a first wave of store closings and lease rejections at the very outset. Landlords must act quickly to review the procedures proposed by the tenant for conducting going out of business sales. Landlords whose leases have been rejected must also observe the claims filing deadlines set forth either in the rejection order itself or in a claims bar date notice in order for their rejection damages claims to be eligible for payment.

Most lease assumptions are proposed in the context of motions to sell assets to a third party or to conduct an auction of the debtor’s lease rights. These motions usually set a very tight timetable for the sale process, in which landlords must review the proposed “cure amounts” for their leases and raise any objections, lest they lose the opportunity to collect all delinquent amounts at the time of assumption.

Although bankrupt tenants have up to 120 days to decide whether to assume or reject their leases, which the court may extend for up to an additional 90 days, in practice very few tenants wait that long. Most recent cases have started with a round of downsizing and then move quickly to an asset sale or auction process for the remaining stores. Frequently, if no buyer is identified at that stage, liquidation follows.

Some have attributed this trend to limited availability of long-term debtor-in-possession financing in today’s market. Others have blamed the 2005 Bankruptcy Code amendments which took away the court’s power to extend the lease assumption deadline indefinitely. Legislative proposals to repeal that change have been made, but have been sidetracked by other priorities in Congress.

Another possible outcome of a tenant bankruptcy is a renegotiated lease. Many tenants propose rent reductions or other concessions, while threatening rejection if the give-backs are not agreed to. As with all other aspects of the process, it is important for landlords to know what their rights are in bankruptcy to evaluate and counter any such tenant proposals.

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