Handling Tenant Bankruptcies in a Shopping Center: Navigating Real Estate Issues in a Bankruptcy Context
December 20, 2004
It is a commercial landlord’s nightmare: a retail tenant files for bankruptcy protection and, immediately, the “automatic stay” goes into effect. According to 11 U.S.C. § 362, the landlord cannot evict the tenant/debtor nor bring a suit for any rent that may be in arrears or for any other outstanding defaults under the lease. The bankruptcy law strips the landlord of many ancillary rights and protections, including the ability to veto an assignment of the lease to a third party. The tenant/debtor, however, cannot act with complete impunity: the bankruptcy law requires the tenant/debtor to remain current on post-petition rent payments under the supervision of the relevant bankruptcy court, and the tenant/debtor must seek judicial approval for taking many actions, often against vigorous argument from the landlord. In a chapter 11 restructuring, the tenant/debtor is equally likely to exercise a number of different options with regard to the lease, depending on the economics surrounding the particular lease. This article discusses the various options, rights and remedies that both landlord and tenant/debtor enjoy, and the complex interplay between the provisions of a commercial retail lease and the United States Bankruptcy Code, with an emphases on the chapter 11 restructuring of a retail tenant.
The Tenant/Debtor’s Options
Upon filing for bankruptcy protection, 11 U.S.C. § 365 provides the tenant/debtor with three options in regard to its lease.
1. Assumption: The tenant/debtor keeps the lease. It is anticipated that the tenant/debtor will emerge from bankruptcy as a solvent, reorganized entity and continue its business operations at the leased premises.
2. Rejection: The tenant/debtor rejects the lease resulting in the release of the tenant/debtor from its contractual obligations under the lease. The rejection is deemed a breach of the lease under the Bankruptcy Code and the property reverts to the landlord who may then lease the property to a new tenant.
3. Assignment: The tenant/debtor “sells” the lease or, more accurately, assumes the lease and contemporaneously assigns the lease to a third party for value. A lease has value when the rent is below market or the space is particularly advantageous to certain potential purchasers. The bankruptcy court can approve the assignment of a lease notwithstanding any anti-assignment clause in the lease.
Depending on whether a tenant/debtor assumes or rejects the lease, the landlord may bring various claims against the bankruptcy estate:
After a rejection, the landlord may bring three types of claims against a tenant/debtor bankruptcy estate: a claim for the actual amount of unpaid pre-petition rent, a claim for any unpaid post-petition rent, and a claim for any post-petition damages that the landlord suffers as a result of the rejection, such as the expected rental income. With regard to any unpaid post-petition (but pre-rejection) rent, the landlord may assert an administrative expense claim. In other words, if a tenant holds a lease post-petition, that tenant must continue to pay rent as it comes due. With regard to pre-petition rent claims and post-rejection damages, the landlord is a “secured creditor” only to the extent that the landlord holds a security deposit, and must compete with other “unsecured creditors” for any excess claim beyond the amount of the security deposit. Furthermore, the landlord’s claims for damages relating to rejection of the lease are subject to certain limits: for a lease of real property, rejection damages are capped by 11 U.S.C. § 502(b)(6) to the amount of rent reserved under the lease for a one-year period, or 15 percent of the rent reserved for the entire remainder of the lease term (not to exceed three years), whichever dollar amount is greater. In addition, the landlord has a duty to mitigate post-rejection damages by attempting to re-lease the subject property.
If the tenant/debtor assumes the lease, whether for its own use or in anticipation of assignment to a third party, the tenant/debtor will be obligated to pay the actual unpaid pre-petition rent, and to provide “adequate assurance of future performance” (11 U.S.C. § 365(b)(3)). In the shopping center context, “adequate assurance” must include, among other things, an assurance that the source of the rental payments (i.e., the tenant’s business operations) will produce sufficient revenue to pay the base rent and that the percentage rent will not decline significantly.
Controlling the Space
As a general rule, a landlord cannot take control of the space until (and unless) the tenant/debtor rejects the lease. Unless a debtor/tenant assumes its nonresidential real property lease (or obtains an extension of time to assume or reject such lease) within the first 60 days of the bankruptcy case, the lease is deemed rejected and the debtor/tenant is required to immediately surrender the property to the landlord (11 U.S.C. § 365(d)(4)). However, a landlord can file a motion to compel the debtor/tenant’s assumption or rejection of the lease within a shorter period of time. The court makes these special exceptions on a case-by-case basis, so there can be no guarantee of success for such a request. Examples of relevant circumstances include casualty to the property, the tenant/debtor holding over in the space beyond the natural expiration of the lease, the impairment defaults of landlord’s interests pursuant to a mortgage, the inability of tenant/debtor to cure defaults and a bleak possibility for a reversal of fortune, or other similar circumstances. Such motions are most appropriate to situations in which the debtor has been granted leave to assume or reject leases beyond the initial 60-day time limit set forth in 11 U.S.C. § 365(d)(4). (This is most commonly seen in large, complex bankruptcy cases).
Controlling the Fixtures
“Fixtures,” in this context, is a reference to the trade fixtures – signs, counters, cabinets, etc., and not items such as permanent HVAC systems or additional support beams, which are considered to be a part of the real estate. The tenant/debtor can assume or assign fixtures along with the lease. If the fixtures can be removed without damaging the premises, the tenant/debtor can treat the fixtures as personal property by removing them and selling them for value. If the tenant/debtor rejects the lease, the debtor may abandon the fixtures in place. If the landlord incurs costs in removing abandoned trade fixtures, the landlord can assert those costs as a claim against the estate. If a thoughtful landlord realizes during the initial lease negotiations that the tenant has valuable trade fixtures, the landlord might consider negotiating for the right to file a “fixture filing” in order to place a lien on the tenant’s fixtures, furnishings and equipment (FF&E). Though most common in lending situations, a fixture filing can also be useful in a leasing context because it provides the landlord with a secured claim to the FF&E. A bankruptcy court will usually defer to state law with regard to the perfection, enforceability and priority of liens, and these laws vary by locality. A knowledgeable real estate lawyer can help to determine whether the lien on FF&E is enforceable and whether that lien will be a first priority lien. Appropriate insurance is also an option. Although title insurance companies have traditionally focused on real property, many title insurance companies have also begun to insure the priority and enforceability of liens on personal property.
Will the Lease Terms Survive the Bankruptcy Process?
The question of whether the terms of a lease will survive a tenant’s bankruptcy is important, complex, and, possibly, in flux due to a recent case, In re Trak Auto Corporation, 367 F.3d 237 (4th Cir. 2004) (hereafter, Trak Auto). Pursuant to 11 U.S.C. § 365(f)(1), a tenant/debtor is allowed to assign a lease notwithstanding any anti-assignment provision contained within the lease. In the specific case of a shopping center lease, if a tenant/debtor elects to assume the lease, whether for its own use or in anticipation of assignment, the tenant/debtor must assume all of the provisions of the lease, including any radius, location, use and exclusivity provisions, and furthermore, such assignment may not be in breach of any such provision contained in any other lease relating to such shopping center (11 U.S.C. §365(b)(3)(C)). These two statutes present a conflict: how can an assignment be subject to “all” provisions of the lease if the Bankruptcy Code also provides that the court can invalidate any anti-assignment provision contained in the lease? On April 22, 2004, the Fourth Circuit Court of Appeals addressed this conflict in Trak Auto.
In Trak Auto the “tenant/debtor” was a tenant in a shopping center known as “West Town Center.” The tenant/debtor’s lease limited the permitted use of the demised premises to the “sale at retail of automobile parts and accessories and such other items as are customarily sold by tenant at its other Trak Auto stores.” When the tenant/debtor attempted to sell the lease in bankruptcy, it received no bids from any auto parts retailers. Subsequently, the tenant/debtor sought an order authorizing it to assume the lease and assign it to A&E Stores, Inc., a family apparel retailer. In its motion, the tenant/debtor argued that it was impossible for the tenant/debtor to assign the lease to any party that would fit within the use restriction contained in the lease. The tenant/debtor argued that under such circumstances the use restriction amounted to an anti-assignment provision, and was, therefore, subject to invalidation under 11 U.S.C. § 365(f)(1).
The Fourth Circuit described the ability to invalidate anti-assignment provisions as “one of the important purposes of chapter 11" because it allows business tenant/debtors “the opportunity to reorganize, revive their operations and continue in existence.” The Fourth Circuit also noted that, “shopping center leases are in a special category, however, because Congress has made it more difficult for debtor-tenants to assign these leases in chapter 11.” Ultimately, the Fourth Circuit denied the tenant/debtor’s motion to assume and assign the lease, holding that use restrictions survive the bankruptcy process. However, the Fourth Circuit also noted that 11 U.S.C. § 365(f)(1) could be used to invalidate a use restriction in certain circumstances. For example, if a lease limited use to operation under a specific trade name, such a restriction would effectively prohibit all lease assignments, and would, therefore, be subject to invalidation under 11 U.S.C. § 365(f)(1) as an anti-assignment provision.
Can a Landlord Draft a Lease in a Way That Will Provide Some Measure of Protection in the Event of Tenant Bankruptcy?
Whenever a landlord enters into a lease agreement with any tenant, there will always be some measure of business risk. However, a knowledgeable attorney can use legal protections to mitigate the business risks and strengthen the landlord’s position in the event of a bankruptcy. Some examples of legal protections include the following:
• Third-Party Guaranty
The obligations of an outside guarantor are separate from the bankruptcy of the tenant/debtor. A word of caution: a landlord should make sure the guarantor is financially stable as well as financially and legally distinct from the tenant. When a company files for bankruptcy, its related or subsidiary companies often file for bankruptcy as well. If the guarantor files for bankruptcy, the guaranty will be subject to the automatic stay and will have limited value to the landlord.
• Default Clause
Leases often contain a clause that defines filing for bankruptcy, or related acts (such as assignment for the benefit of creditors) as “Events of Default.” The automatic stay typically prevents the landlord from exercising any default remedies and such lease provisions may not be enforceable against the tenant/debtor under the Bankruptcy Code. However, it is useful to draft this clause into the lease because a state of default will allow the landlord to immediately draw on various types of security, such as third party guaranties. Also, as discussed earlier, in certain special circumstances the landlord might be able to petition for court authority to exercise certain limited default remedies.
• Anti-Assignment Clause
Although a bankruptcy court can invalidate an anti-assignment clause, such clauses still provide important protections. Prior to bankruptcy, an anti-assignment clause can prevent an unexpected tenancy. For example, a stable tenant might wish to assign its position under the lease to an unstable tenant who subsequently files for bankruptcy protection. An anti-assignment provision should ensure that the original tenant remains liable for its obligations under the lease even after an assignment, unless the replacement tenant meets certain financial criteria such as adequate credit rating and revenues.
• Lender Style Mechanisms – the “Early Trigger“
An “early trigger” creates a state of default before a deteriorating financial situation reaches bankruptcy court. For example, if the tenant is obligated to maintain certain minimum revenues or credit ratings, and if the tenant breaches that obligation, the lease automatically is in default. Though most commonly seen in a lending situation, “early triggers” can also be quite effective leasing tools. For example, when the tenant is in a state of default, a landlord may exercise a variety of remedies, such as eviction, demanding additional security, or even foreclosing on any valuable FF&E that is encumbered by a fixture filing.
• Anti-Assignment Provisions and Use Restrictions
A bankruptcy court can invalidate an anti-assignment provision, but use restrictions will generally survive the bankruptcy process in appropriate circumstances, as demonstrated by Trak Auto. A shopping center lease should include a carefully drafted and highly specific use restriction that adequately protects the landlord’s tenant mix. However, if such a provision is so restrictive that it essentially acts as an additional anti-assignment clause, a bankruptcy court might invalidate that provision entirely.
A Note on Ethics and Disclosure
While there is no specific legal requirement to disclose the bankruptcy of an anchor tenant, a landlord should take such a bankruptcy into account in any projections of revenues, customer traffic or other figures that induce prospective tenants to lease space. If such figures do not take the bankruptcy into account, or if the landlord makes statements that are otherwise false or misleading, there is a possibility that a landlord could be liable for fraud. In addition, bankruptcies are public knowledge and a landlord should assume that prospective tenants might independently discover the bankruptcy. If the discovery of an anchor tenant bankruptcy comes as a surprise to a prospective tenant, this knowledge could adversely affect the business relationship or even cause lease negotiations to deteriorate.
In Conclusion
Bankruptcy and real estate are each complex, specialized areas of law and business. When a tenant declares bankruptcy, there is no substitute for expert legal and business assistance based on a thorough understanding of both of these practice areas. Ideally, a team of bankruptcy and real estate attorneys will work in close coordination. With constant communication, an open mind and a creative spirit, it is truly possible for such a team to help their landlord client survive, succeed and even thrive throughout and beyond the ordeal of a retail bankruptcy.
For more information, e-mail Daniel M. Pomerantz at
daniel.pomerantz@hklaw.com or call toll free, 1-888-688-8500.
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