Law360, New York (August 9, 2017, 4:09 PM EDT) -- According to industry reports, retailers have announced well over 3,000 store closings already this year, nearly double the total for all of 2016. Retail landlords must navigate a wide variety of legal risks as turmoil in the retail business intensifies. Through an integrated, multidisciplinary legal approach, landlords can help minimize loss and maintain their ability to do what they do best — position real estate for maximum returns.

From negotiated workouts to bankruptcies, this article examines key issues and strategic considerations for landlords to consider as they face mass store closings. As discussed below, a coordinated approach employing transactional, litigation and bankruptcy strategies will pay dividends for landlords facing unfavorable market headwinds.

Negotiated Workouts 

Negotiated workout deals with distressed tenants can substantially reduce goingforward legal risk for landlords. In many instances, a landlord has significant leverage when dealing with a distressed tenant — leverage that did not exist when a lease was originally signed. Thus, landlords may be able to negotiate favorable terms that minimize future losses associated with anticipated landlord-tenant litigation or bankruptcy. 

The need for a workout deal may first become apparent when a tenant requests rent reduction or abatement or the right to close certain stores across a landlord’s portfolio. But landlords should also pay attention to other signs of distress, such as net worth reporting (or failure to report) by tenants or public financial disclosures. By continuously evaluating the financial strength of their tenants, landlords may be able to identify opportunities to do advantageous workout deals with distressed tenants that would not otherwise get done. 

Workout deals can achieve a number of positive results:

  • Landlords may be able to preserve a tenancy that might otherwise be lost by reducing rent and extending the term of the lease, or by reducing the amount of space leased to the distressed tenant.
  • By pursuing workout deals with tenants, landlords may be able to buy time with lenders who would otherwise seek remedies for loan defaults triggered by distressed tenants.
  • Landlords may be able to strike problematic exclusive use and co-tenancy provisions from existing leases. Such provisions can give tenants a contractual basis to threaten costly litigation against landlords or interfere with efforts to reposition multitenant properties. 
  • Landlords may be able to add recapture provisions to leases, which permit landlords to terminate leases as to a portion of space occupied by existing, underperforming tenants and then re-lease that space to higher-performing tenants.
  • Landlords can strengthen lease terms that will improve landlord leverage in future legal proceedings, such as tighter financial covenants, shortened cure periods, stronger termination rights, rent acceleration, affiliate netting, cross-contract setoff rights, attorneys’ fees for prevailing parties, stipulated damages and expedited alternative dispute resolution processes, all of which may improve outcomes if litigation or bankruptcy materializes.
  • Landlords can negotiate for additional security, such as security deposits, letters of credit, or guarantees, or landlords can convert cash security deposits to letters of credit, all of which may provide value in the event of default, even if a tenant declares bankruptcy. 

No matter what terms are included in a negotiated workout, landlords should recognize that in some circumstances a bankruptcy court might later set aside a lease amendment or termination of a lease as an avoidable transfer. To avoid that result, landlords may be required to prove that the tenant received fair value in exchange for the lease amendment or termination.

Litigation

Landlords faced with distressed tenants sometimes have to engage in litigation and eviction proceedings. Indeed, litigation may not only be useful to obtain damages or an eviction remedy, but also to increase pressure and gain leverage over tenants in workout situations. 

If a distressed tenant defaults on rent obligations, a landlord may bring an action to recover unpaid rent, and either evict or keep the tenant. Eviction is typically preferable if replacement tenants are available in the market. But eviction is not always preferable, particularly if there is a creditworthy guarantor. As an alternative to eviction, landlords may consider bringing solely an action for damages if there is a creditworthy guarantor, and avoid disputes concerning the lessor’s mitigation of damages and other defenses typically raised by an evicted defendant. No matter what course of action is chosen, if a distressed tenant fails to pay rent on time, a landlord should make sure to send default notices promptly and reserve all rights. In most instances, default notices are required before an action may be commenced. 

Even if a tenant is still paying rent, eviction may be advantageous (although more difficult) if it appears a tenant may declare bankruptcy and there is sufficient time to complete an eviction proceeding before bankruptcy. In that event, landlords may use nonmonetary lease defaults, such as a requirement for a tenant to maintain a minimum level of net worth or continuous operations, as a basis to terminate the lease and evict the tenant.

In any event, whether a landlord is contemplating an action for unpaid rent, eviction, or both, landlords should take advantage of any rent acceleration provisions and consider the landlord’s duty to mitigate any damages that might be sought.

In addition to proceedings initiated by a landlord, distressed tenants may be prompted to sue landlords for various reasons. For example, distressed tenants may start disputes over exclusive use and cotenancy requirements, physical conditions, efforts to exercise recapture rights, or claims of fraudulent inducement. Tenants sometimes bring such litigation to gain leverage over landlords in workout deals or to buy time before beginning bankruptcy proceedings. 

Bankruptcies

Bankruptcy provides distressed tenants certain tools to wield against landlords, and therefore the specter of bankruptcy should guide landlord strategy when negotiating workouts and litigating with distressed tenants. 

To begin, a tenant’s bankruptcy triggers the bankruptcy code’s automatic stay. The automatic stay severely limits the landlord’s ability to take action against a distressed tenant, such as pursuing eviction or bringing an action for unpaid rent, although rent due after the bankruptcy case is commenced is an administrative expense that typically must be paid if the tenant remains in possession of the premises.

Certain forms of security provide better protection to a landlord in the event of bankruptcy. In particular, a letter of credit typically will be the best form of security. Unlike a security deposit, a letter of credit usually is not subject to the automatic stay and may be drawn upon notwithstanding the bankruptcy. However, even a letter of credit is not without some risk. Depending on its nature and the timing of delivery of the letter of credit to the landlord, the posting of the letter of credit might be subject to avoidance as a preferential or fraudulent transfer.

If a lease has not been fully terminated in accordance with the terms of the lease and state law at the time of bankruptcy, the debtor (or trustee) generally may either assume a lease or reject it. Lease assumption sometimes provides benefits to landlords, particularly where replacement tenants are unavailable. If a debtor assumes the lease, the debtor must provide a landlord adequate assurance of future performance; a lease assumption also generally provides the landlord with a defense to any action seeking to avoid pre-petition lease payments as preferential transfers. If the debtor rejects the lease, however, the landlord typically will have only a general unsecured claim against the debtor for unpaid pre-petition rent, and damages for future rent owed under the lease will be capped. Further, lease rejection does not necessarily give the landlord a right to evict — the landlord may still be forced to seek modification of the automatic stay, and then pursue an eviction proceeding in state court. Last, a debtor often may assume and assign the lease to a third-party, in which case the third party will be responsible for future lease payments and performance. 

If the lease has been fully terminated pre-petition, the tenant’s rights cannot be reinstated and the landlord will be in significantly better position to seek possession of the leased premises from the bankruptcy court. However, if the lease was valuable, there is a risk that that the termination will be challenged as a preferential or fraudulent transfer, and the lost value of the lease may be sought to be recovered by the bankruptcy estate from the landlord. 

Conclusion 

Landlords facing increasing turmoil in today’s retail environment must take active steps to minimize loss. The most effective way to do that is adopt a cross-disciplinary, coordinated legal strategy — including the transactional, litigation and bankruptcy fields.