Lessor Rights in Retail Bankruptcy Cases

Brick-and-mortar retail businesses are struggling, and have been, for many years. Sears and Kmart notably filed for Chapter 11 relief in 2018. The COVID-19 epidemic, and resulting social distancing rules, will accelerate bankruptcy filings for many retail businesses. In the last month alone, JC Penney, Neiman Marcus, Gold’s Gym, Hertz, J. Crew Group and Tuesday Morning all filed for Chapter 11 relief. Many of these businesses operate out of leased locations, and lessors to these businesses often comprise the largest creditor group in their bankruptcy proceedings. In addition to retail cases, numerous restaurants and restaurant chains will likely file bankruptcy. To the extent that you have a tenant that files for Chapter 11 protection, you should be aware of your rights as a landlord under the Bankruptcy Code to maximize your recoveries and protect your rights.

The following is a brief summary of the leasehold issues that commonly arise in commercial retail and restaurant bankruptcy cases.

The Debtor-Tenant’s Options.

A Chapter 11 debtor is protected by the automatic stay from most creditor actions. A lessor may generally not demand rent, terminate a lease or enter the leased premises, once its tenant has filed bankruptcy. The Chapter 11 debtor will be afforded some time (at least 120 days) to decide whether to assume, or reject, a lease under Section 365 of the Bankruptcy Code. After that, unless an extension is granted, the lease is “deemed rejected.” If a lease is assumed, the debtor is required to cure all defaults, including payment of all pre-bankruptcy obligations to the landlord. To that extent, the assumption of a lease restores the landlord to the position that the landlord would have been in had there been no bankruptcy. If a lease is rejected, the landlord receives the leased premises back and receives the right to assert an unsecured claim (usually up to one year’s rent) for damages.

The debtor-tenant’s right to assume or reject a lease is straightforward for the parties to the lease, but complications arise when the debtor-tenant is taking its time (sometimes over many months) to decide whether to assume, or reject, a lease. Fortunately, the Bankruptcy Code states that the debtor-tenant is required under a commercial lease to “timely perform all the obligations of the debtor… until such lease is assumed or rejected.” However, the debtor-tenant’s obligation to perform “all” obligations is subject to inconsistent court rulings on the timing and nature of obligations that must be performed.

Bankruptcy courts will address many lease issues at the beginning of a bankruptcy case and apply its rulings to all subsequent landlord challenges. As a result, commercial lessors should engage counsel immediately to protect their rights upon the filing of bankruptcy of a commercial tenant. If a lessor sits back, it may rely to its detriment on other parties to protect the rights of all lessors.

The Non-Debtor Landlord’s Rights.

1)  Pre-Bankruptcy Termination Notices

The Bankruptcy Code does not give a debtor greater rights under a lease than enjoyed by the pre-bankruptcy tenant.  If a lessor (i.e., the landlord) has properly terminated the tenant’s rights under a lease prior to bankruptcy, the filing of bankruptcy does not generally void a proper termination notice that was already given to a tenant. But the language in the termination notice is critical. If the notice is conditional, or allows for a right to cure, the bankruptcy court may disregard the notice and allow the debtor-tenant to remain in possession of the space. Any notice related to a lease of a finically distressed tenant should be prepared or reviewed by counsel.

2)  Stub-Rent & Post-Petition Rent

Stub-rent occurs where a tenant files for bankruptcy after the payment date under a lease. For example, if the lease provides that rent is due on the first day of the month, and the tenant files bankruptcy mid-month, is the lessor entitled to payment in full for the first calendar month of bankruptcy, half of the first calendar month or nothing for the first month?  Courts are split, and some courts do not permit payment of rent for the first month unless the filing of bankruptcy occurred before the billing date under the lease. For example, if the rental obligation under the lease occurs on the first of the month, and the bankruptcy filing occurs after the first of the month, the lessor may not receive rent for the first calendar month.  Of course, if the lease is assumed by the debtor, the lessor should receive payment for all rent, including the payment missed in the first calendar month of the bankruptcy case.

The bankruptcy proceeding starts with the filing of a bankruptcy petition, and so, the period after the bankruptcy starts, and before the proceeding ends, is called the “post-petition” period.   The Bankruptcy Code makes somewhat clear that the tenant is supposed to honor all terms of its lease during the post-petition period, including while the debtor is still deciding whether to accept or reject the lease.  This would include, at least in theory, paying rent on time.   Unfortunately, some national case law is starting to suggest that rent payments may be delayed for many months, added up, and then paid later in arrears under a confirmed bankruptcy plan.   And the statute itself allows rent payments to be delayed for at least the first 60 days of a case.   Once again, landlords will encounter legal situations that are not black and white, but rather grey.   For landlords that do not want to be taken advantage of, or to have their rent payments fall through the cracks of a complicated legal proceeding, active participation in, and monitoring of,  the proceedings is critical.   The old adage that only a squeaky wheel gets the grease holds true in this environment. 

3)  Attorney’s Fees

A landlord may be entitled to payment of attorneys’ fees and expenses to the extent that the right to payment is set forth in the lease as additional rent, and the landlord meets certain requirements. Some courts will allow for payment of fees incurred in bankruptcy under a well-drafted lease, if the lease is assumed, provided that the fees the lessor seeks are for actions in which the lessor prevailed in bankruptcy. For example, if the lessor filed objections to actions of the debtor that the bankruptcy court sustained, the lessor may be entitled to recovery for fees if and when the lease is assumed. There may be other circumstances in which fees are allowed, depending on the bankruptcy court where the case has been filed.

4)  Restrictions on Assignment

Commercial leases typically limit the type of party to whom a tenant may assign its rights under the lease. Outside of bankruptcy, the party that assigns the lease remains liable to the landlord along with the party that takes over the lease. The Bankruptcy Code relieves the debtor-tenant from liability but contains numerous provisions that protect landlords from an unacceptable tenant. For example, the debtor must establish that its proposed assignee will be financially able to perform under the lease. Counsel should be engaged to challenge any proposed assignment if there is any question about the financial stability of the new tenant.

With respect to a shopping center lease, the proposed assignment will be “subject to the requirements in the lease regarding radius, location, use, or exclusivity, and will not breach any such provision contained in any other lease, financing agreement, or master agreement relating to the shopping center…and will not disrupt any tenant mix or balance in the shopping center.” In other words, the Bankruptcy Code should not let a restaurant tenant assign its lease to a bookstore if the restaurant is located next to a pre-existing bookstore. This assumes that the lease is properly drafted in the first place.

Traps in the Proposed Assumption of a Lease.

Bankruptcy cases are notorious for flooding creditors with a large number of dense notices and little time to react. Pay special attention to any mention of Section 365 of the Bankruptcy Code in any notice. One of the most important pleadings for lessors to look for is the proposed notice of assumption of the lease and corresponding notice on the cure of defaults.  When a debtor-tenant seeks to assume a lease, it must provide the landlord: (1) adequate assurance of future performance; and (2) cure of all defaults. In practice, most bankruptcy debtors make little or no affirmative showing of adequate assurance of future performance, and give the lessor a limited number of days to challenge the amount that the debtor thinks it owes to cure defaults.  As a result, the onus is on the lessor, through counsel, to challenge the proposed cure amount.

The lessor should be careful to not only raise every claim that it might have for rent, attorneys’ fees and the like, but also be aware of possible latent claims under a lease. For example, if the tenant has caused environmental damage to the property, and that damage results in a default under a well-drafted lease, the assumption of the lease should include environmental clean-up. If the lessor does not timely raise the claim for environmental damage, it may forever lose the right to damages.

Rights on Rejection of a Lease.

If the debtor-tenant rejects a commercial lease, it is likely the case that the landlord will not be required to file an eviction action in state court. The Bankruptcy Code requires the debtor-tenant to “immediately surrender [rejected] nonresidential real property to the lessor.” Many bankruptcy courts will exercise the power to require a tenant to leave the premises under a rejected lease without making the lessor file a state court eviction action.

Final Thoughts

The financial picture for retail stores and restaurants is bleak. There have been numerous filings in the last few weeks and more are expected in the next few months. This is an opportune time to review commercial leases and requests for rent concessions from tenants. Pedersen & Houpt has extensive experience in both documenting and enforcing commercial leases.

Please contact Attorneys John Delnero (312-261-2185) with any questions that you may have.