Client Update – Potential Tenant Bankruptcies Looming Large for Commercial Landlords

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The retail industry was already hurting badly in 2019 (it was often referred to as a “retailpocalypse”), leading to bankruptcy filings by Model Sporting Goods, Pier 1 Imports, Barneys New York, and Payless ShoeSource, just to name a few… and that was before the COVID-19 pandemic. No industry is immune from the impact of the current crisis. The restaurant industry lost an estimated $25 billion in sales in the first 22 days of March, as the coronavirus outbreak caused 30,000 restaurants to close, with another 110,000 expected to shutter in the next month according to estimates by the National Restaurant Association.

As addressed in DarrowEverett LLP’s previous Client Alert, recent amendments to the Bankruptcy Code made it easier for businesses to file for Bankruptcy. This client alert examines the benefits a landlord may realize by terminating a lease before a tenant files for bankruptcy.

If the lease is terminated prior to the tenant filing for bankruptcy, then the lease will not become part of the “bankruptcy estate”, and thus will not be subject to the bankruptcy. This is important because, as discussed below, a landlord loses control to the premises, and the lease (in terms of the ability to terminate the tenant, and to prevent an assignment of the lease to a tenant that the landlord does not approve of), once the lease is subject to the bankruptcy proceedings.

If a tenant files for bankruptcy prior to the landlord terminating the lease, then the landlord will lose control of the premises and the lease for period likely lasting several months. There will be an “automatic stay” that prevents the landlord from terminating the lease, or indeed, giving notices of any kind to the tenant. Any termination after that will require approval of the bankruptcy court and almost certainly be denied (unless it is advantageous for the tenant to terminate the lease). Moreover, it will be at the election of the tenant (or, strictly speaking and depending on the type of bankruptcy, the bankruptcy “trustee”) whether to either (a) “reject” (i.e., terminate) the lease; (b) assume the lease (i.e. continue to be the tenant under the lease); or (c) assign the lease to a third-party and pocket (as an asset of the bankruptcy estate) whatever consideration the tenant is able to obtain from the assignee. If the tenant chooses option (b) or (c), then the landlord must be given certain assurances of future performance, and the tenant must continue to pay rent during the bankruptcy proceeding.

Having the tenant and the lease go into bankruptcy proceedings may ultimately work out to the landlord’s advantage if the tenant assumes the lease (meaning, as stated above, that the tenant itself continues with the lease), since the landlord will receive rent during the proceeding, will receive certain assurances of future payment, and will come out with the same tenant as before, and, indeed, a tenant who is freed of much of its other debt and thus should be better able to meet its rent obligations. It might also work to the advantage of the landlord if all the foregoing occurs except the lease is assigned to another tenant, so long as the landlord is satisfied with the other tenant. Indeed, a topic to keep a look out for in our future client alerts is whether, in an already “retailpocalypse” market further depressed by COVID-19 and its after-effects, a landlord might actually be in a better position by having the tenant go into bankruptcy, at least in a situation where, realistically, the tenant was not going to pay rent anyway, and it would be extremely hard for the landlord to find a replacement tenant anytime soon.

However, it is never a pleasant experience for a landlord to lose control of your premises and your lease. Also, with COVID-19-related bankruptcies it is probably more likely that the lease will be “rejected”, because a tenant with multiple sites will likely be looking to shed many more of those sites than it would in “normal” times in order to focus solely on the absolute best or most profitable locations. The issue with a lease being “rejected” is that, in addition to losing control of the premises and the lease for several months, a landlord whose lease has been “rejected” by a tenant is likely put in a worse position than if the lease was terminated outside of bankruptcy. Hopefully, a landlord who terminates a lease pre-bankruptcy will be able to relatively quickly re-let the premises to another tenant, and resume receipt of rent. Even if that is not the case given COVID-19, there are still benefits to terminating a defaulted lease before bankruptcy. In bankruptcy, the landlord is an unsecured creditor, at the bottom of the pecking order in terms of potential payments to creditors, and likely receive no money, or just a few pennies on the dollar if the landlord is lucky. If a lease is terminated pre-bankruptcy and the termination occurs far enough in advance of the bankruptcy that the landlord is able to obtain judgment for damages from the applicable “eviction” or “summary process” court, and attach that judgment to the tenant’s assets, the landlord will be a secured with respect to those assets, not-unsecured creditor. The landlord would likely be at the bottom of the pecking order of secured creditors, but that is still better than being an unsecured creditor.

Further, if the tenant assigns the lease in connection with the bankruptcy, to an assignee that the landlord would never have approved under the assignment provisions of the lease, then the landlord will be stuck with that new, unsatisfactory tenant. (Note that the Bankruptcy Code puts certain restrictions on the tenant’s right to assign the lease during bankruptcy if the lease is part of a “shopping center”, but there has been much litigation about what exactly constitutes a “shopping center”, and not all retail tenants are in shopping centers).

An additional benefit of terminating a lease prior to bankruptcy is that retail landlords can avoid the negativity of having a “going out of business” or liquidation sale at its location if the tenant ultimately liquidates its assets or closes its store.

If the lease is terminated prior to a tenant’s bankruptcy, then an added advantage for the landlord is that it avoids the legal fees and costs of having to hire an attorney to represent it in the tenant’s bankruptcy proceeding. For national chains, the bankruptcy would likely be in Delaware or New York City.

The landlord must be sure that such termination will be effective if the landlord does decide to terminate a pre-bankruptcy lease. The landlord must strictly comply with all of the lease terminations requirements in the lease and any additional requirements that exist under relevant state law, including any notice and opportunity to cure provisions. Also, the landlord must be sure to send the notice in strict accordance with the “Notice” provision of the lease (for example, sending notice by certified mail or regular mail), which may be different from the manner in that the landlord typically communicates with the tenant. Failure to strictly comply with these terms may result in the tenant claiming the lease termination was not valid.

Also, a landlord who terminates a pre-bankruptcy lease runs the risk that any payment made by the tenant in connection with the lease termination (that is to say, any payment of lease termination damages) may be voidable as a “preference” (which means a pre-bankruptcy payment by the tenant could be able to “clawed back” from the landlord as part of the bankruptcy proceeding) if the tenant files for bankruptcy within ninety (90) days after payment. However, in this time of COVID-19 it is highly unlikely that the terminated tenant would pay any lease termination damages voluntarily, and may not be able to pay such damages even if ordered to by a court.

DarrowEverret LLP’s attorneys can assist landlords in evaluating tenant defaults and other issues in order to maximize its available options and minimize its risk and potential disruptions caused by a tenant’s bankruptcy filing.