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Surviving The Retail Shakeout: A Primer For Real Estate Pros
When commercial tenants step through the looking glass and
into the wonderland of liquidation or reorganization, you should know the ground rules of the U.S. Bankruptcy Code.
BY SEAN W. GILLIGAN AND ADAM F. ZWEIFLER
In recent months, a number of retailers have filed for
bankruptcy to either liquidate or restructure. They include
both national and region chains such as Montgomery Ward,
Bradlees, Filenes Basement, Caldors, Merry-Go-Round, Golf
Day and Woodworkers Warehouse.
Among them, these retailers lease an enormous amount
of space. Many landlords have been affected, and many
lenders hold investments that will be impacted by these
filings. This article reviews the basic ground rules that apply
when a commercial tenant steps through the looking glass and
into the wonderland more commonly known as Chapter 7
(liquidation) or Chapter 11 (reorganization) of the U.S
Bankruptcy Code.
Once a tenant files for bankruptcy, it may choose among
three basic alternatives:
- reject its lease(s) immediately,
- wait as long as 60 days (or perhaps longer, with the
consent of the bankruptcy court) and then reject or assume the
lease(s), or
- assume the lease(s) and assign them to a new tenant.
Rejection terminates the lease. Assumption reinstates it.
The bankruptcy court must approve either a lease's rejection
or assumption.
Immediate rejection
Why would a tenant immediately reject a lease? In most
cases, a lease is immediately rejected if:
- the tenant lacks operating cash flow,
- the lease is unimportant from an operational standpoint
and the obligations under the lease will burden the tenant's
plan to reorganize, or
- there is no sublet value for an unwanted lease.
If the landlord objects to a proposed rejection (because it
is above market), the bankruptcy court will scrutinize the
tenant's decision under the business judgment rule. Unless it
is clear that there is no clear business reason to reject, the court
will approve the tenant's decision.
In a Chapter 7 case (liquidation), the Chapter 7 trustee
will immediately reject a lease if it has no sublet value or there
is no cash to pay current rent.
Upon rejection, the tenant must immediately vacate the
premises. Following rejection and surrender, the landlord has
a general unsecured claim for:
- all unpaid rent that accrued before the bankruptcy, plus
- the greater of one year's rent or 15% of the remaining
rent due under the lease, limited, however, to a total of three
years' rent (Bankruptcy Code section 502(b)(6).
This "cap" on the landlord's damages is absolute and
cannot be modified by the bankruptcy court. It is intended to
compensate the landlord, while not creating such a large
unsecured claim that other unsecured creditors receive
virtually nothing. If the lease is not rejected the day the case is
filed, the landlord will also have an administrative priority
claim for unpaid rent which accrues from the date of filing for
bankruptcy through the date of surrender.
If the landlord is holding a security deposit, whether cash
or a letter of credit, the deposit amount is applied against its
claim, subject to the "cap." If the security deposit exceeds the
cap, plus any unpaid post-bankruptcy rent, the landlord must
return the difference to the bankrupt tenant (ouch!).
Bankruptcy courts have limited landlords' recoveries by
narrowly defining rent. Even though virtually every
commercial lease defines rent as every conceivable monetary
expense, items such as default interest, late fees, termination
commissions, costs of collection and attorneys fees are not rent
under the Bankruptcy Code.
Such charges are not included when calculating the cap.
The definition of rent most commonly used by bankruptcy
courts is:
- the amount designated as "rent" under the lease,
- an amount related to the value of the property, and
- a fixed, regular or periodic charge.
On the plus side, if the lease is guaranteed, the cap will
not limit the landlord's ability to collect from the guarantor,
unless the guarantor itself is a debtor in bankruptcy. In that
case, the cap on the landlord's damages will apply to the
guarantee as well.
Wait 60 days to assume or reject
The Bankruptcy Code gives a tenant 60 days to assume or
reject a commercial lease. This 60-day window can be
extended by the court, for cause.
Whether an extension is granted depends upon the
"equities" of the case (i.e., what strikes the judge as fair Ð all
things considered). It is highly likely the judge will grant an
extension so the tenant can benefit from below-market leases.
Even if an extension is granted, the tenant must start
paying rent at the end of the 60-day period. Failure to pay
results is an automatic rejection, and the property must be
surrendered. In very rare cases, the court may extend the 60-
day deadline for paying rent. The court must find that there is
cash to pay the rent.
A bankruptcy court will typically give a Chapter 7 trustee
time to analyze the value of all leases and decide whether they
should be rejected or assumed and assigned. This is subject to
two rules. First, the trustee must assume or reject within 60
days after the filing (unless the time period is extended by the
court).
Second, the trustee must start paying rent no later than
60 days after the filing of the bankruptcy case. Failure to pay
rent after the 60th day constitutes a rejection.
If after the 60-day period (or an extension) the lease is
rejected, all rent not paid during bankruptcy becomes an
administrative priority claim, which must be paid in full before
general unsecured creditors or stock holders receive anything.
During the gap between the bankruptcy filing and the
60th day, the landlord may be deprived of much-needed cash
flow. The landlord may default under its financing, or may
have to seek some type of debt relief from its lender.
Rejection
After 60 days (or an extension), if the tenant rejects the
lease, the landlord has:
- a general unsecured claim for unpaid rent before
bankruptcy,
- an administrative claim for unpaid rent from the start of
bankruptcy through the rejection and property's surrender,
and
- a general unsecured claim for the greater of one year's
rent or 15% of the remaining rent due, limited to a total of
three year's rent.
Of the three, the administrative claim has the highest
priority in bankruptcy and must be paid in full before
unsecured creditors and stockholders receive anything. As
mentioned above, if there is a security deposit, it is applied to
the landlord's claim.
Assumption
After 60 days (or an extension), if the tenant wishes to
assume the lease, it must:
- promptly cure all defaults,
- promptly compensate the landlord for all pecuniary
losses arising from such defaults, and
- offer adequate assurance of future performance.
In other words, non-monetary defaults must be resolved,
unpaid rent and all costs arising from the default must be paid,
and the tenant must prove that it has sufficient cash to pay
current and future rent. A landlord can object to a proposed
assumption, but the bankruptcy court will normally defer to
the tenant's business judgment.
Given the bankrupt tenant's obligations, assumption can
be good for the landlord. It reinstates the parties' original
agreement, and all delinquent rent is paid in full. It can,
however, also be disastrous. A stigmatized tenant remains in
the property. Payment may be too late for the landlord. And, if
the lease is below market, the landlord has missed a chance to
realize the true value of its property.
There is one other potential benefit to assumption. The
landlord may be able to enhance its position in the bankruptcy
food chain. An assumed lease becomes a contract with the
debtor-in-possession. If the lease is later breached during
bankruptcy, all damages under the lease become an
administrative priority claim, which must be paid before
unsecured creditors and stockholders receive anything.
A Chapter 7 trustee will assume a lease and immediately
assign it. Thus, the trustee will not assume and later breach. If,
however, the case is converted from Chapter 11
(reorganization) to Chapter 7 (liquidation), the Chapter 7
trustee may reject a lease assumed during Chapter 11. In this
case, the landlord is entitled to a Chapter 11 administrative
priority claim in the Chapter 7 case.
"Alice in Wonderland" provisions
One of the "Alice in Wonderland" aspects of bankruptcy
applies to assignment of the bankrupt tenant's interest in the
lease. Even if a lease contains language limiting or even
prohibiting assignment, the Bankruptcy Code provides that a
bankrupt tenant or Chapter 7 trustee may assign an assumed
lease. A lease will be assigned if it can generate a return for the
bankruptcy estate.
If the landlord objects, and seeks a court ordered
rejection, the bankruptcy court will usually allow the tenant to
keep the lease, unless the tenant cannot pay rent during
bankruptcy.
Under the Bankruptcy Code, shopping center leases are
treated differently. The test for assignment is more stringent.
The bankrupt tenant must demonstrate that:
- the source of future rent is adequate and assured,
- the new tenant's condition and operating performance
is adequate,
- the financial condition of new guarantors (if any) is
adequate,
- future percentage rent will not decline substantially,
- the new tenant will not breach provisions, related to
radius, location, use or exclusivity provisions and
- the new tenant will not disrupt the tenant balance in the
shopping center.
The landlord, however, is not deprived of all of its rights. A
lease must be assumed before it can be assigned. As discussed
previously, prior to assumption, all existing defaults must be
cured and accrued rent and pecuniary losses paid.
The bankrupt tenant and the new tenant must also
demonstrate that the new tenant can and will perform under
the lease. This is done by proving that the new tenant is as
solvent as the original tenant, and has cash flow equal to the
solvency and cash flow of the original tenant at the time the
lease was signed.
If the lease is guaranteed, the tenant's assignment does
not affect the guarantee. It remains in place until all pre-
assignment defaults have been cured. Once cured, the original
guarantee becomes unenforceable because the original lease is
gone. This result can be changed by drafting a guarantee that
covers all assignments and transfers of the lease.
Working with a new tenant
The landlord can insist that the new tenant execute and
deliver a comparable guarantee from an equally solvent
guarantor. If the security deposit was set off, or the bankrupt
retailer demands its return, then the new tenant must
replenish it.
A new tenant receives all of the benefits of the original
lease, including options to renew, extend or purchase.
However, the new tenant must also accept all of the prior
tenant's obligations and burdens under the lease.
Rent paid by the new tenant in excess of the original rent
is retained by the bankrupt tenant and is not paid to the
landlord. In virtually all cases, the new tenant makes a lump-
sum payment to the bankrupt tenant, instead of monthly
installments.
The amount will roughly equal the present value of the
difference between the new (higher) rent and the old (lower)
rent. Even if the original lease compels the tenant to turn over
all increased rent, the money paid by the new tenant remains
with the debtor's bankruptcy estate. This is one aspect of
bankruptcy that deprives the landlord of a valuable property
right.
Sometimes there is a silver lining for the landlord. The
new tenant to whom the lease is assigned may enhance the
property and its value. For example, a number of Caldors'
leases were assumed and assigned to Wal-Mart. Generally, the
Wal-Marts increased customer traffic, which created
opportunities to increase rent at adjacent stores.
Sean W. Gilligan is a partner with the law firm of Pepe &
Hazard in its Boston, office. Adam F. Zweifler is a partner with
the firm in its Hartford, Conn. office.
This article was previously published in the March 2001 Issue of Commercial Mortgage Insight
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