Surviving the Retail Apocalypse: Commercial Lease Issues in Bankruptcy
| Publication year | 2018 |
By Johnathan C. Bolton
The term "retail apocalypse" began gaining widespread usage in 2017 following multiple announcements from many major retailers of plans to either discontinue or greatly scale back their retail presence, including some companies going out of business entirely.1 The list of retailers filing for bankruptcy relief in 2017 included: Charming Charlie, Styles For Less, Toys R Us, Aerosoles, Vitamin World, Perfumania, Alfred Angelo, True Religion, Gymboree, Payless, Gander Mountain, RadioShack, Wet Seal, The Limited and Rue21. Credit Suisse, a major global financial services company, predicted that 25% of U.S. malls remaining in 2017 could close by 2022. Hawaii has not been immune to this phenomenon and it is likely to continue.
Section 365 of the Bankruptcy Code addresses many of the issues that arise in a retail bankruptcy case. However, it is one of the most complicated provisions of the Bankruptcy Code and contains numerous special interest provisions and exceptions to the general rules. To add to the confusion, each circuit where a bankruptcy case is filed may apply its own interpretation of the Bankruptcy Code's provisions to a particular case. Many of the large chapter 11 retail cases have been filed in Delaware or New York.
This article will attempt to demystify the Bankruptcy Code's lease pro-visions most applicable to a retail bankruptcy case and will focus on application of the law in the Ninth Circuit. In this article, it is assumed that the bankrupt debtor is the tenant.2
I. Prepetition Termination of Leases
Many times, a retail bankruptcy case is commenced by a company following a landlord's attempt to terminate its lease agreement with the company and/or the filing of a summary possession action to obtain possession of the tenant's premises.3 Larger national chains often file for bankruptcy relief due to defaults under loan agreements with their senior lenders, because of bond defaults, inadequate cash flow or because of liquidity issues caused by poor sales.
As discussed below, if a lease is terminated prepetition, it cannot be revived by a bankruptcy filing.4 However, the issue of whether a lease was properly terminated before the bankruptcy filing is frequently contested.5
II. Chapter 7 versus Chapter 11 Bankruptcy
A chapter 7 bankruptcy case is a liquidation in which a trustee is appointed to liquidate the assets of the bankrupt business (the "debtor") for the benefit of its creditors. A chapter 11 bankruptcy case is a reorganization in which the company becomes a "debtor-in-possession" upon filing and the existing board of directors of the company is charged with formulating a plan for the reorganization or rehabilitation of the business and/or the restructuring of its debt that is voted on by the creditors and equityholders and confirmed by the Bankruptcy Court.
III. Unexpired Leases in Bankruptcy
Some of the most valuable assets in retail business cases are the leases6 that the company has with its landlords.
Section 365 of the Bankruptcy Code permits a trustee or debtor-in-possession to "assume or reject" any executory con-tract7 or unexpired lease of the debtor.8
Assumption of an unexpired lease means that the debtor will retain the lease according to its terms.9 Although undefined in the Bankruptcy Code, a "rejection" is universally understood as an affirmative declaration by the trustee or debtor-in-possession that the estate will not take on the obligations of a lease or contract made by the debtor.10
A. Pre-Assumption or Rejection Performance
The Bankruptcy Code states that "[t]he trustee shall timely perform all the obligations of the debtor, except those specified in section 365(b)(2), arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title."11 In other words, "[u]ntil the trustee assumes or rejects an unexpired lease of nonresidential real property, the trustee must perform obligations under that lease in accordance with 11 U.S.C. § 365(d)(3)." This includes the payment of rent and the performance of all other obligations under the lease.
If the debtor fails to perform its obligations under the lease and later rejects it, then all claims arising from the debtor's non-performance post-petition, pre-rejection, are entitled to administrative expense priority.12
Administrative expenses are expenses that come due post-petition and are generally paid as 100 cent dollars rather than prepetition unsecured claims which are generally paid in less than 100 cent dollars.
B. Standard for Assumption or Rejection
A motion to assume or reject an unexpired lease of nonresidential real property requires the Bankruptcy Court's approval, based primarily on the "business judgment" of the trustee or debtor-in-possession.13
Courts give deference to the decision of the trustee or debtor-in-possession and will generally deny approval of assumption or rejection only if the court finds that the trustee's decision is so "manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, whim, or caprice."14
C. Timing of Assumption or Rejection
Absent consent from the landlord, a trustee or debtor-in-possession has a maximum of 210 days from the date of the filing of its voluntary bankruptcy petition (the "Petition Date") to assume or reject a nonresidential real estate lease.
Specifically, section 365(d)(4)(A) of the Bankruptcy Code provides that an unexpired lease of nonresidential real property under which the debtor is the lessee "shall be deemed rejected, and the trustee shall immediately surrender that nonresidential real property to the lessor, if the trustee does not assume or reject the unexpired lease by the earlier of (i) the date that is 120 days after the date of the order for relief;15 or (ii) the date of the entry of an order confirming a plan."16
The 120-day period can be extended once for up to 90 days for "cause" "prior to the expiration of the 120-day period."17 Moreover, section 365(d)(4)(B)(ii) of the Bankruptcy Code provides that, "[i]f the court grants an extension under clause (i), the court may grant a subsequent extension only upon prior written consent of the lessor in each instance." 11 U.S.C. § 365(d)(4)(B)(ii).
A debtor often wants to wait and see how its bankruptcy case is proceeding before making its decision to assume or reject its leases. If the company will likely end up in liquidation, then the debtor will probably want to reject its leases. However, if the debtor is able to reorganize, it will likely want to assume its leases, unless the leases are "above-market" or the leased space is no longer required in its business.
As discussed below, if the debtor chooses to sell all or parts of its business, it can offer its leases to one or more buyers through assignment.
If the trustee or debtor-in-possession assumes a lease and then later rejects it, the lessor is entitled to an administrative expense claim equal to all monetary obligations due under the lease for the period of two years following the latter of the rejection date or the date of actual turnover of the premises.18 The remaining sums due under the lease are treated as a claim under...
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