The last several years have seen bankruptcy filings from prominent retail chains such as Borders, Circuit City, Blockbuster, Movie Gallery and Ritz Camera. Many of these cases have resulted in liquidation. For commercial landlords, retail bankruptcy cases present a number of potentially damaging issues, including non-payment of rent, assignment of the lease to an unworthy tenant, vacant space in an otherwise popular location and going-out-of business sales.

A commercial landlord faced with a tenant's bankruptcy will want to know, as soon as possible, what will happen to the lease. Under the Bankruptcy Code, the debtor or bankruptcy trustee has a period of 120 days from the commencement of the case to determine whether to assume or reject a commercial lease. If a decision to assume or reject is not made during this time period, the lease will be deemed rejected. However, the period may be, and often is, extended for an additional 90 days by order of the Bankruptcy Court. As leases are often some of the most important assets of a retail debtor, this deadline often drives the schedule of a bankruptcy case. Specifically, retail debtors often only have a few weeks or months to sink or swim before it becomes necessary to employ store-closing or going-out-of business sales to liquidate inventory.

Administrative Rent

The date that a bankruptcy case is filed (known as the "petition date") is a very important date for both the debtor and its creditors for many reasons. Obligations of the debtor arising after the petition date may be classified as administrative expenses and are generally paid in full. In contrast, pre-petition claims are paid pro-rata at the end of the case.

This distinction is important for landlords. Many commercial leases provide that rent comes due on the first of the month. A company that is planning to file for bankruptcy typically will not pay rent for the month in which it plans to file bankruptcy, but will seek bankruptcy protection prior to a landlord's ability to terminate the lease for non-payment. The rent for the period beginning on the petition date through the end of the first month of a bankruptcy case is often referred to as "stub rent."

Bankruptcy courts in different jurisdictions treat stub rent differently. Courts that have adopted the "proration" approach hold that the debtor is obligated to pay the pro-rated amount of rent from the petition date through the end of the first month. In these jurisdictions, the court will typically require payment of stub rent shortly after the petition date.

Other courts have held that because rent becomes due on the first of the month, the rent for the entire month is a pre-bankruptcy obligation. This means that in such "billing date" jurisdictions, the landlord generally must affirmatively file an application for an administrative claim and must establish the value of the debtor's use and occupancy of the premises during the stub rent period. In addition, payment of stub rent is often delayed in such jurisdictions and subject to the risk of administrative insolvency.

Once a tenant files for bankruptcy, a landlord should determine whether the case was filed in a "proration" or "billing date" jurisdiction and seek counsel regarding the payment of administrative rent during the "stub" period.

Store-Closing Sales

Often a retail debtor's reorganization strategy is to eliminate unprofitable locations, liquidate inventory, reject above-market leases and assign any below-market leases to new tenants. The first step in this strategy is typically to obtain bankruptcy court approval of store-closing or going-out-of business sales at these locations. The debtor will often enter into an "agency agreement" with a liquidator to conduct the sales. Generally, under these agreements, the liquidator will pay the debtor a percentage of the cost value of its inventory (often with some upside if the sale goes well) and conduct the sales at the debtor's premises.

Commercial leases often have provisions restricting or prohibiting such sales. However, bankruptcy courts have approved these sales notwithstanding such lease provisions. In addition, the debtors or their agents often propose to conduct the sales under conditions that are troublesome to landlords, and in many cases violate the lease or local ordinances. Signage, augmentation of inventory, duration of sales and insurance are some of the items about which landlords may be concerned. A landlord should review proposed sale procedures with counsel and take the appropriate steps to preserve its rights.

Assignment of Leases

While most commercial leases prohibit assignment without the consent of the landlord, these provisions are unenforceable in bankruptcy. Thus, debtors will attempt to monetize any below-market leases by assigning them to new tenants, whom they have located for a fee. In some cases, the debtor will conduct an auction of the relevant leaseholds to be assigned. Another way in which debtors monetize commercial leases is to sell the "designation rights" to the leases. This means that the debtor sells the right to direct the debtor to assume/assign or reject leases to a third party.

In order to assign a lease, the debtor must first cure any monetary defaults such as past-due rent. While the debtor is not required to cure past non-monetary defaults, such as violations of "going dark" provisions, it is required to provide assurance that the new tenant will comply with all provisions of the lease going forward, including non-monetary provisions. In addition, the bankruptcy code includes certain protections for shopping centers to preserve tenant mix and balance and to ensure that the new tenant does not create a breach of any other lease in the shopping center (for instance exclusivity and agreements with other tenants).

Rejection of Leases

Leases for locations which the debtor does not desire to retain and for which the debtor cannot find a buyer will be rejected. The rejection of a lease is treated as a breach of the lease effective immediately prior to the time the debtor files for bankruptcy. Upon the rejection of the lease, a landlord should file a proof of claim with the bankruptcy court setting forth its damages incurred as a result of the rejection. Often the bankruptcy court order approving the rejection of a lease will include a deadline to file this claim.

The bankruptcy code limits lease-rejection damages by way of a statutory cap. Generally, landlords are allowed to claim the greater of one year's rent or 15 percent of the rent for the remaining term so long as that 15 percent does not exceed 3 years. One element of dispute is how the claim amount is calculated. Some bankruptcy courts have found that the landlord is only entitled to the rent due for the first 15 percent of the remaining lease. This means that the landlord does not receive the benefit of any rent escalations in calculating its rejection claim. Other courts have held that landlords are entitled to 15 percent of the total remaining rent. A landlord's rejection damages are added to the landlord's pre-petition claim to establish the landlord's unsecured claim in the bankruptcy case.

Guaranty Claims

In some cases, a landlord will have obtained a guaranty of payment from a third party such as a corporate affiliate or owner. Unless the guarantor has filed for bankruptcy, the landlord is generally within its rights to pursue that guarantor for all amounts due under the lease. Where the guarantor has also filed for bankruptcy, courts have held that the guarantor is entitled to the same limitation on rejection claims as the tenant.

In some recent cases, related corporate debtors have proposed substantive consolidation of their assets and liabilities in connection with a plan of reorganization or liquidation. Substantive consolidation results in the combination of assets and liabilities such that guaranties are rendered worthless. However, the legal requirements for substantive consolidation are strict, and landlords with guaranties should consider objecting to consolidation to preserve rights under a guaranty.

Conclusion

Retail bankruptcy cases continue at a high rate. These cases involve many complex issues for commercial landlords. A landlord is advised to engage counsel and assert itself early in the bankruptcy process to protect its rights.