Brace for Impact: Best Practices for Commercial Landlords to Navigate Tenant Defaults Due to the COVID-19 Pandemic
Written by: Amy A. Zuccarello and Nathaniel R.B. Koslof
The novel coronavirus COVID-19 pandemic has the potential to impact the U.S. economy at a level which could ultimately rival or surpass the global financial crisis of 2009. Reports from commercial landlords suggest that a majority of retail and restaurant tenants, perhaps as many as 75%, failed to make payments of rent due on April 1st. In some instances, these tenants broadcast their intentions not to pay rent weeks before it became due, a certain signal of unapologetic distress from the battered retail and restaurant industries struggling to survive forced closures and social distancing measures brought about by the global pandemic.
Already facing high vacancy rates following a wave of retail bankruptcies and store closures in a phenomenon known as the "retail apocalypse," we advise commercial landlords to prepare for their tenants’ inevitable continued struggles in the current climate and to mitigate losses through careful planning, both before and after the occurrence of defaults, in order to maximize available remedies inside and outside of a tenant’s potential bankruptcy.
Stay up to date on applicable eviction moratoria.
The federal government, through The Coronavirus Aid, Relief, and Economic Security Act (the CARES Act), introduced a 120-day moratorium on eviction which applies to certain classes of residential property subject to federally-backed loans. CARES Act § 4024, et seq. During this period, landlords are also prohibited from charging fees or penalties on account of non-payment of rent, and at the end of the moratorium, the landlord is required to provide 30-days’ written notice in order to evict the tenant. Many authorities at the state and local levels have enacted laws, regulations and emergency orders which impose similar requirements. Some of these extend protections to commercial tenants as well. In some states, the defaulting tenant may benefit from de facto protection, where court closures effectively stay eviction, as there is no ability for a landlord to prosecute the action. These moratoria, particularly at the state and local level, are changing rapidly, and for this reason, it is vital that the commercial landlord remain informed about all current moratoria which may affect its ability to evict a tenant or otherwise exercise remedies under the lease documents.
Protect your rights from the outset and use forbearance to improve your deal.
As Ben Franklin once said, "[a]n ounce of prevention is worth a pound of cure." Prior experience with defaults has taught the savviest landlords to push for the protections they will need at the outset of a deal to protect themselves in the event tenants encounter financial challenges during the lease term.
Even if the commercial landlord didn’t (or couldn’t) do this at the outset, there very well may be an opportunity to renegotiate now for better treatment down the road, through a lease restructuring, out of court workout or forbearance. Some have speculated that because the distress caused by the COVID-19 pandemic to certain retail and restaurant sectors may be temporary, rent relief in the form of temporary rent deferrals, rent forgiveness or restructuring and/or conversion to alternate rent payments may help the tenant to weather the economic storm without the need for a bankruptcy filing. Commercial landlords should have significant leverage to negotiate better lease terms, cure any deficiencies, modify or eliminate picky or problematic provisions and improve their overall protections in the underlying lease documents.
Since landlords have more limited options to protect their interests once their tenants commence bankruptcy, landlords should consider the following when negotiating new tenant relationships or renegotiating lease terms in a forbearance or workout:
- Review and Know Your Documents. Whether entering into a new tenant arrangement or heading into a forbearance or workout negotiation, commercial landlords should review their existing lease documents (as well as any form documents) with experienced counsel, paying careful attention to the default and security provisions of the documents including:
- definitions of tenant default and Event of Default;
- applicable notice and cure provisions;
- provisions which excuse performance (including force majeure, discussed further below); and
- clauses which address or impose duties to mitigate damages
- Secure Lease Obligations with Letters of Credit. Landlords should seek to secure monetary lease obligations with a third-party letter of credit instead of a cash security deposit. Unlike a cash security deposit, a letter of credit is generally not considered part of a tenant-debtor’s bankruptcy estate. Therefore, in the event of a payment default, the landlord’s ability to draw upon the letter of credit will not be restrained by the automatic stay of a bankruptcy proceeding.
- Obtain Secured Guarantees. Landlords already know that seeking personal guarantees of tenant obligations under leases from the principals of their tenants is optimal under any scenario. Surprisingly, even when the landlord obtains a guarantee, the guarantee is rarely secured, so that in the event of a bankruptcy filing by the guarantor, the landlord is entitled to only an unsecured claim against the guarantor. The better result is to obtain a secured guarantee – and to be sure to perfect the security interest in the assets which secure the claim under the guaranty. Doing this will increase the likelihood that a landlord will receive a substantial recovery on its claim under the lease, particularly if the tenant and the guarantor both commence bankruptcy proceedings.
- Define the Term "Adequate Assurance" in the Lease. This term is undefined in the Bankruptcy Code (except in the shopping center context) and is therefore often subject to judicial interpretation. By addressing bankruptcy scenarios and including a definition of "adequate assurance" in the lease, landlords increase their ability to assert control over the process of assumption and assignment of the lease in bankruptcy (discussed below) and can also save costs of litigating the issue.
- Avoid or Eliminate Tricky Cure or Notice Periods. Landlords should try to avoid tricky cure periods that prolong or obscure when a tenant’s breach under the lease documents empowers them to take immediate action. For example, if a default or breach does not become an "Event of Default" until a landlord sends notice, a landlord could inadvertently forego default interest or lose the ability to take action on account of what would have been a pre-bankruptcy Event of Default based upon its failure to send a notice. To the extent possible, therefore, default should be defined to be self-executing, deemed to have occurred after a failure to honor an obligation when due without the requirement of notice. Moreover, long cure periods are also impractical in this climate as landlords are generally better served by acting quickly.
- Draft Tight Force Majeure Language. Finally, landlords should insist on using tight force majeure. Whenever possible, landlords should limit these clauses to specific categories, and avoid catch-all provisions that broadly excuse a tenant’s performance of the lease in the event of "other" occurrences that are "similar" to the delineated list. Further, landlords should strive to make explicit in their leases that (i) a tenant’s financial inability to perform obligations shall not constitute force majeure, and (ii) force majeure shall not excuse a tenant’s obligation to pay rent.
Pay attention to pre-bankruptcy defaults – monetary and non-monetary.
Commercial landlords should be vigilant in identifying defaults under their lease documents and asserting their rights. This requires that landlords (i) become experts in their own lease documents, (ii) carefully monitor the conduct of their at-risk tenants, and (iii) take swift action when their tenants first show signs that they are experiencing financial difficulties.
Landlords should familiarize themselves in advance with any notice, cure, or other requirements and/or procedures they must follow in the event of a tenant default. For instance, the lease may require that the landlord provide written notice of a missed payment, which triggers a period of cure, before the landlord may conclude that an Event of Default has occurred and begin to exercise remedies. If so, the landlord should be sure to send an appropriate notice, in the form, by the method and to the address(es) specified in the lease, as soon as possible. This is true even if the landlord hopes to negotiate a workout or does not yet intend to exercise another remedy. By sending the notice out as soon as the default is identified, the landlord can maximize flexibility, avoid delays and minimize the risk of inadvertently waiving remedies that are not immediately exercised.
Know the economics of the deal and what you want.
The commercial landlord is at a distinct disadvantage when it is unprepared for a lease default and hasn’t kept abreast of the changing market conditions in the rental climate. As vacancy rates soar, landlords should enter tenant negotiations with maximum information. Some questions that landlords should ask and attempt to answer prior to tenant negotiations include the following:
- (If applicable) how much flexibility is there with the landlord’s existing lender or partners to renegotiate lease terms? Are approvals required?
- If the property is located in a shopping center or other multi-tenant development, are there ramifications to renegotiation or termination of the lease which will impact landlord’s obligations to other tenants, or other tenants’ obligations or rights under their respective leases?
- If the landlord terminates the lease, are there other potential tenants interested in the space? What is the likelihood of an extended vacancy of the property?
If the landlord desires to terminate the lease, it may be to its advantage to terminate at its earliest opportunity. As detailed below, in the event that the tenant ultimately enters bankruptcy, a debtor-tenant’s rights with respect to a lease which expired or was terminated prior to its bankruptcy filing are substantially more limited.
Bankruptcy - understand the rules of the game.
The Automatic Stay
When a tenant files for bankruptcy protection, the tenant receives the benefit of what is known as the "automatic stay," which prevents all creditors from enforcing their rights against the debtor. 11 U.S.C. § 362. It is an incredibly powerful debtor-protection tool that all creditors, including commercial landlords, must respect. A landlord’s violation of the automatic stay will result in the landlord owing the debtor-tenant actual damages, attorneys’ fees, and even punitive damages (if the violation is deemed intentional). Accordingly, before taking any affirmative steps to pursue remedies against a tenant-debtor, landlords should seek advice of bankruptcy counsel who can advise you whether you first need to obtain relief from the automatic stay, and whether the court would be likely to grant you relief under the circumstances. Generally speaking, it is difficult for a commercial landlord to obtain relief from stay to terminate a lease or evict a debtor-tenant over the objection of the debtor-tenant at an early stage in a bankruptcy case, as the bankruptcy court will defer to the debtor’s business judgment in its assessment that the leased property is of potential value to the debtor, or necessary to achieve the debtor’s reorganization.
Assume, assign, or reject?
In bankruptcy, a commercial tenant has three options concerning its lease: (i) it can assume the lease and continue performing all of its obligations under the lease, (ii) it can assume and assign the lease to a third party, in which case the third party will become responsible for performing the remaining obligations under the lease, or (iii) it can reject the lease and surrender the premises immediately. In order to assume a lease (or assume and assign), the tenant-debtor must (i) cure all defaults prior to assumption or provide "adequate assurance" to the landlord that the tenant-debtor (or the assignee, in the case of an assumption and assignment) will promptly do so, (ii) compensate, or provide "adequate assurance" that they will compensate, the landlord for any "actual pecuniary loss" resulting from such default; and (iii) provide "adequate assurance" of future performance under the lease. 11 U.S.C. § 365(b)(1)(A)-(C). In bankruptcy, a tenant who meets these requirements can assign its rights under the lease notwithstanding any restrictions on assignment contained in the lease itself.
In a Chapter 11 reorganization case, the tenant-debtor has up to 120 days to decide whether to assume or reject its commercial leases (although this period can be extended by up to 90 days on motion of the tenant-debtor for cause with approval of the bankruptcy court, and even longer with the consent of the landlord). 11 U.S.C. § 365(d)(4)(A)-(B). In a Chapter 7 liquidation case, the same is true with respect to commercial leases, yet trustees have a maximum of 60 days to decide whether to assume or reject residential leases, after which such leases will be deemed rejected, unless the period is extended by the bankruptcy court. 11 U.S.C. § 365(d)(1).
During the post-petition period, prior to assumption/rejection, the tenant-debtor remains obligated to pay rent, and is required to make these payments as they become due according to the terms of the lease. The landlord’s collection of rent checks does not violate the automatic stay, and no court order is required to deposit checks as they are received.
Moreover, if a tenant-debtor fails to pay post-petition rent, the landlord can (and should) promptly file a motion with the bankruptcy court seeking (i) relief from the automatic stay to enforce its remedies in the property, (ii) an order from the bankruptcy court compelling the tenant-debtor to make timely payments, and/or (iii) an order from the bankruptcy court granting the landlord administrative priority for any unpaid post-petition rents. 11 U.S.C. § 365(d)(3).
If the tenant-debtor assumes (or assumes and assigns) its lease, the landlord should make sure its tenant (or assignee) can provide "adequate assurance" that it can meet the tenant-debtor’s ongoing lease obligations and cure or resolve all outstanding lease claims. If the landlord is dissatisfied with the proposed assurance, the landlord can oppose assumption (or assumption and assignment) on the basis that the tenant-debtor has failed to provide "adequate assurance." As discussed above, although "adequate assurance" is not defined in the Bankruptcy Code (except with respect to shopping centers), landlords can (and should) proactively shape the protections they receive by clearly defining "adequate assurance" in their leases.
In the shopping center context, the Bankruptcy Code provides some overt protection to landlords, defining "adequate assurance" in this context to include requirements (i) that in the case of assignment, the "financial condition and operating performance" of the proposed assignee are similar, (ii) that the "percentage rent due under such lease will not decline substantially," (iii) that assumption or assignment will not violate any "radius, location, use, or exclusivity provision[s]" of the lease or any such provisions contained in any other agreements related to the shopping center, and (iv) that assumption or assignment "will not disrupt any tenant mix or balance" in the shopping center. 11 U.S.C. § 365(b)(3). Landlords of shopping center properties can use these protections in the Bankruptcy Code to oppose an assignment of leases where one or more of the above requirements is not met by the proposed assignee.
How to handle rejection: the statutory cap on rejection damages
If the tenant-debtor elects to reject a lease, (i) the tenant must immediately vacate the premises, and (ii) the landlord is entitled to "damages resulting from the termination of a lease of real property" (e.g., lost rent, the costs of reletting the premises, attorneys’ fees and other similar amounts, to the extent provided under the lease). However, the landlord’s damages are capped according to a formula contained in Section 502(b)(6) of the Bankruptcy Code. 11 U.S.C. § 502(b)(6). Although somewhat complex, landlords should understand the basic mechanics of the cap so that they can better understand the economic impact of rejection.
According to Section 502(b)(6), a landlord’s lease rejection claim shall be limited to an amount equal to the greater of: (i) one year’s rent or; (ii) 15% of the remaining rent due under the lease, up to a maximum of three years of rent. 11 U.S.C. § 502(b)(6)(A). In each case, the term "rent" generally includes reimbursement for capital expenditures, taxes, and CAM charges, to the extent as provided in the lease. The "remaining term" is measured "following the earlier of (i) the date of the filing of the petition; and (ii) the date on which such lessor repossessed or the lessee surrendered the leased property." Id. In addition, the landlord is entitled to "any unpaid rent due under such lease, without acceleration, on the earlier of such dates." 11 U.S.C. § 502(b)(6)(B).
Importantly, not all claims against a tenant in bankruptcy are subject to the cap. As set forth in the statute, only claims "resulting from the termination of a lease" are subject to the cap. 11 U.S.C. § 502(b)(6). This phrase plainly includes lost rental income, but courts have found that this might also include other categories of damages, including attorney fees, arbitration fees, and the cost of the removal of abandoned furniture and fixtures from the leased premises. According to the Ninth Circuit, "A simple test reveals whether the damages result from the rejection of the lease: Assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it?" Kupfer v. Salma (In re Kupfer), 852 F.3d 853, 858 (9th Cir. 2016). If the landlord would have the same claim regardless of the tenant’s rejection of the lease, the landlord’s damages with respect to such claim are not subject to the cap. Although elegant, unfortunately, bankruptcy courts across the country do not apply this "simple test" consistently in every jurisdiction, and whether the cap will apply depends on the particular facts of a given case.
Finally, we note that landlords should also be aware that where the lessee’s obligations are collateralized by a letter of credit, courts generally require that the landlord apply the proceeds from the letter of credit against the cap to reduce a landlord’s overall rejection damages claim. See, e.g., In re PPI Enters. (U.S.), Inc., 324 F.3d 197 (3d Cir. 2003).
The dreaded "Going Out of Business" sale
Another issue commonly faced by commercial landlords in an economic downturn is the dreaded Going Out of Business ("GOB") sale. When times are tough, tenant-debtors may seek to conduct hasty GOB sales in an effort to cut costs, generate quick cash flow, and otherwise "right the ship." Even in the face of strongly-worded prohibitions against GOB sales contained in leases, and over the objection of landlords, tenant-debtors will often seek court approval of these GOB sales at the outset of their bankruptcy cases, perhaps as part of their "first day" motions and almost always prior to their deadline to assume or reject leases. Courts typically see these sales as important in maximizing the assets of the estate and therefore allow them to proceed. Accordingly, landlords may find themselves in a precarious situation where the tenant-debtor’s GOB sale has the potential to negatively impact their other tenants.
Unfortunately for landlords, there are limited options to entirely prevent a tenant-debtor from having a GOB sale. However, there are steps landlords can take to protect their own interests and limit the impact of these sales. Landlords can and should work cooperatively with tenant-debtors to minimize the impact of a GOB sale. The objectives of negotiations should be to (i) negotiate a finite time period for the sale; (ii) monitor the signage and advertising to ensure that it doesn’t disrupt other tenants; (iii) monitor the sale to ensure compliance with all facility guidelines, including noise levels, capacity and cleanliness; (iv) negotiate items to be sold so that the store maintains overall standard of quality; and (v) monitor premises to ensure proper maintenance.
If tenants fail to work with landlords or fail to maintain any negotiated standards, the landlords can (and should) go to the court to limit the sales and force tenant compliance. Because landlords owe a duty to all tenants to ensure that a GOB sale by one does not disrupt business for others, courts tend to be receptive to a commercial landlord’s pleas for reasonable restrictions on GOB sales (e.g., quality of goods sold and maintenance requirements). Bankruptcy courts have "the discretion to condition the time, place and manner of GOB sales, thereby providing adequate safeguards to protect the … landlords … while allowing the Trustee to fulfill its fiduciary obligations." In re Ames Dept. Stores, 136 B.R. 357, 359 (S.D.N.Y. Bankr. 1992).
Court-ordered deferral of rent
Not only will the COVID-19 crisis surely increase the frequency and magnitude of tenant defaults, certain Bankruptcy Courts have already taken the unprecedent step of suspending the bankruptcy process entirely while debtors (and the world) seek clarity on what lies ahead. This will have an outsized impact on commercial landlords, as tenant-debtors are using these suspensions to defer making rent payments otherwise due immediately.
For example, In re Modells Sporting Goods, Inc., the United States Bankruptcy Court for the District of New Jersey suspended all proceedings and case deadlines through April 30, 2020, including all milestones associated with the debtors’ on-going store closing sales. Similarly, in In re Pier 1 Imports, Inc., the United States Bankruptcy Court for the Eastern District of Virginia temporarily suspended all proceedings and deadlines, explicitly noting that the debtors are authorized to "temporarily defer making all . . . rent payments to landlords" throughout this time, further noting that "the Debtors’ failure to make [these payments] . . . shall not constitute a rejection. . . ." Case No. 20-30805-KRH, Docket No. 493. Whether other bankruptcy courts will follow suit and also allow temporary suspension of rent payment remains unknown.
As such, landlords should take this opportunity to become masters of their lease documents and explore opportunities to proactively improve their lease documents with defaulting tenants (through workouts, restructurings or otherwise) wherever possible.
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We are currently living in unprecedented times. The long-term impact of the COVID-19 pandemic remains unknown, yet the social and economic disruption will surely be significant. While unemployed consumers seek out new jobs and others adjust their budgets in light of pay cuts and decimated savings, businesses, both large and small, will struggle for the foreseeable future. As a result, many commercial tenants will struggle to meet their lease obligations and find it necessary to seek bankruptcy protection. Now, more than ever, it is essential for commercial landlords to understand their rights and obligations in the event of that possibility.
As highlighted by this alert, there are a number of complex rules, procedures, and processes for commercial landlords to navigate in order maximize the efficiency and quantity of their return from bankrupt tenants. Sullivan’s team of bankruptcy, real estate, and litigation professionals are here to provide further advice and help our clients navigate that maze. Should you have any questions, please feel free to contact us.
This alert is intended to be a general guide for commercial landlords to use in navigating their tenants’ potential/actual bankruptcy proceedings. However, commercial landlords should seek specific legal advice concerning their unique factual situation.
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Sullivan has developed a rapid response team of attorneys to help our clients and our communities cope with the impact of the COVID-19 pandemic and understand the implications of the CARES Act and other actions taken by state governments and the federal government. Please refer to Sullivan’s resource center at www.sullivanlaw.com/COVID19 for more information and for access to Sullivan’s library of related advisories.
Please know that Sullivan is focusing substantial efforts to provide assistance to businesses and individuals affected by COVID‑19 and benefited by the CARES Act. If you have questions about how to move forward and navigate the novel legal issues raised by COVID‑19 and/or the CARES Act, please contact your primary Sullivan attorney or send a message to CARES@sullivanlaw.com.