by Brian Free

After a rise in retail bankruptcies in 2016, retailers have continued to see challenges in 2017. Through the first quarter of this year, nine major retailers have sought bankruptcy protection. According to CNBC, this puts 2017 on pace to tie 2009's record, when 18 chain retailers filed for bankruptcy protection. In the second quarter, Payless Shoes and Rue21 and have already filed Chapter 11 bankruptcies. As a further cause for concern, the number of retailers on Moody's distressed list is at its highest level since the Great Recession.

Retailers are struggling with the rise of online markets, and many have heavy debt loads as a result of leveraged buyouts. Retailers and their landlords are also coping with the overexpansion of retail space in the 1990s and early 2000s. Retail square feet per capita in the United States is more than six times that of Europe or Japan, which suggests that there may be a bubble in the retail property market. Malls have been especially hard hit, with growth in department store earnings lagging behind all retail for the last five years. When a store closes in a mall, this can also have a domino effect on the remaining tenants and the complex.

A jurisdiction’s treatment of partial monthly rent (or “stub rent”) may determine when a tenant elects to file bankruptcy. Jurisdictions vary on whether a landlord is entitled to administrative priority for stub rent.  Accordingly, in these jurisdictions, tenants often choose to file bankruptcy in the early part of the month, leaving the landlord with an unsecured claim for the remainder of that month’s rent.  

Commercial landlords cannot prevent their tenants from filing bankruptcy. But they can take the following steps to make bankruptcies less likely, and to protect themselves if a tenant does file for bankruptcy protection:

1. Conduct due diligence during the leasing process. Consider the strength of the tenant and its national brand. If sales are declining and stores are closing, a bankruptcy may be on the horizon.

2. Build in protections in your lease agreement. A landlord’s recovery of past due rent is subject to certain statutory limits in a bankruptcy, so it is important to negotiate appropriate protections in the lease. A significant security deposit—or even better, a letter of credit—can help protect a landlord if a tenant files bankruptcy.

3. Plan for a tenant bankruptcy filing. If a commercial tenant begins to struggle, a landlord may be able to delay or even avert a bankruptcy with a forbearance agreement or re-negotiated terms. For example, clothing retailer Bebe is shutting down all of its 175 stores after negotiating with its landlords to avoid a bankruptcy. It is important for landlords to work with counsel to structure terms that protect them, including understanding what payments can be clawed back as “preferences” if a tenant does file bankruptcy.

4. Cease collection of pre-petition debt. If a tenant does file bankruptcy, it is important that a landlord work with its bankruptcy counsel to understand the automatic stay. If a landlord attempts to collect on certain debts, it can be held liable for damages. 

5. File a proof of claim for damages. A commercial landlord should work with its counsel to ensure that a tenant’s bankruptcy schedules properly identify the lease obligations. If a debt is contested or is not properly scheduled, a landlord must timely file a proof of claim with the bankruptcy court to recover pre-petition debt. Landlords should also work with bankruptcy counsel to understand if they can recover for damage caused to the premises, which is often a contested issue.

6. Enforce post-petition obligations. After a commercial tenant files bankruptcy, it has to timely perform all its lease obligations. (The bankruptcy court can extend the time for the tenant’s performance for up to the first 60 days of the bankruptcy if the tenant can show cause for such extension.) Post-petition rent is entitled to an administrative priority under the Bankruptcy Code, so landlords should work with their counsel to ensure that they receive ongoing rent after bankruptcy begins, and that they understand the jurisdiction’s rules for “stub rent.”

   Even if a tenant has pre-petition lease defaults, it can remain in possession until it assumes or rejects its lease so long as it complies with its lease terms after filing bankruptcy, including making all required post-petition rental payments.

7. Understand the tenant’s bankruptcy strategy. Landlords should work with their bankruptcy counsel to understand how the tenant plans to proceed in the bankruptcy. After filing a bankruptcy petition, a tenant has 120 days (commonly extended to a total of 210 days) to determine whether it will assume or reject its lease. If no action is taken, the lease is rejected, the tenant must vacate, and the landlord is entitled to damages. If a tenant intends to close a store, the landlord should prepare for a liquidation sale of inventory.

   If the tenant intends to assume its lease, it must cure all lease defaults, including the payment of past due rent. A lease may then be assumed by a third party, even if the lease prohibits assignment without landlord consent. To protect its interests, a commercial landlord can require a proposed assignee to demonstrate that it can perform upon an assumed lease. Landlords of shopping center properties are entitled to special bankruptcy protections, including the ability to make proposed assignees demonstrate that the percentage rent will not decline substantially and that the proposed assignment will not disrupt the shopping center’s tenant mix or balance. 

With changes in the national economy, retail bankruptcies are likely to continue.  But with advance planning and the assistance of experienced bankruptcy counsel, commercial landlords can mitigate their losses during these proceedings.

Brian's practice focuses on commercial litigation, with a focus on representation of financial institutions, securities firms, and commercial landlords. He has extensive experience in all aspects of bankruptcy, receiverships, insolvency, restructuring, and creditor-debtor work. He can be reached at 206.470.7646 or brian.free@hcmp.com.