Retail Bankruptcy: Is it a license for an anchor to "go dark?"
 
December 1, 1999
 
Stephen A. "Steve" Bogorad- Washington

Notwithstanding the booming economy of the last several years, shopping center owners have continued to suffer from retail bankruptcies of their tenants. Shopping center owners are the beneficiaries of numerous provisions of the Bankruptcy Code specifically designed to protect them. These provisions require tenants to pay post-petition rent as a condition of their continued occupancy and allow shopping center landlords to enforce use and tenant mix provisions in connection with proposed lease assignments by debtor tenants. Despite the statutory protections afforded them, however, shopping center landlords often find themselves on the defensive in retail bankruptcy cases, most commonly in connection with proposed lease assignments.

Proposed lease assignments pose the greatest problems when the debtor tenant is an anchor of a shopping center. Although the rent paid by anchors is less, on a square-foot basis, than the rent paid by the smaller, in-line retail tenants, every shopping center owner knows that anchor tenants make or break a shopping center. Successful anchor tenants enable shopping center owners to lease up the balance of their centers to smaller retailers at much higher rental rates. Moreover, successful anchors draw customers in sufficient numbers to generate the sales necessary to trigger percentage rent, under both the anchor tenant's lease and under the leases of smaller tenants throughout the shopping center. For these reasons, most anchor leases contain continuous-operations provisions which allow the landlord to declare a default if the tenant goes dark. Although the Bankruptcy Code, on its face, appears to require that debtor tenants comply with continuous-operations provisions, Bankruptcy Courts are often reluctant to allow a landlord to recapture a marketable lease based on a tenant going dark. As a result, debtor tenants that have shut their doors are often afforded an opportunity to market their leases to prospective assignees notwithstanding the ongoing violations of the continuous-operations clauses in their leases.

A much bigger problem for shopping center landlords, however, is the effort of retail tenant debtors to have Bankruptcy Courts declare that continuous- operations clauses and other non-monetary lease provisions are unenforceable on a going-forward basis, after an assignment of the lease by the debtor. For example, debtors have asked Bankruptcy Courts in conjunction with proposed assignments of anchor leases to declare unenforceable continuous-operations clauses and clauses requiring the landlord's consent for structural improvements and renovations to the leased premises. Retail tenant debtors have argued that the proposed assignees require structural improvements to the affected stores to fit the proposed assignee's concept, and that the proposed assignees needed to keep the stores closed for extended periods of time to make the necessary improvements. Such debtors have argued further that unless the court rules that the offending lease provisions are unenforceable against the proposed assignee, the proposed assignee will not purchase the leases and the estate will be deprived of a valuable asset, i.e., its equity in its leases.

The statutory authority cited by debtors in support of the foregoing relief are Sections 365(f)(1) and (3) of the Bankruptcy Code, which provide that anti-assignment provisions in leases are unenforceable in bankruptcy. Section 365(f)(1) renders unenforceable lease provisions that prohibit, restrict or condition assignment of the lease by the debtor tenant. Section 365(f)(3) renders unenforceable lease provisions that terminate, modify or permit a party other than the debtor to terminate or modify a lease or a right or obligation under a lease because of an assumption or assignment of the lease. In asking courts to declare unenforceable certain operative provisions of a lease against a proposed assignee, such as a continuous-operations provision, debtors inevitably argue that the offending provision, if enforced, would have the practical effect of preventing any assignment of the lease and, therefore, runs afoul of the Bankruptcy Code protections against anti-assignment provisions.

Fortunately for landlords, there are no reported cases that hold that continuous-operations clauses or clauses requiring landlord consent for structural modifications to the demised premises are unenforceable anti-assignment provisions. Indeed, all of the lease provisions invalidated under Sections 363(f)(1) and (3) fall into four categories: (1) lease provisions which expressly prohibit or condition the right of the tenant to assign the lease; (2) lease provisions which so narrowly limit the use of the premises that they constitute a disguised anti-assignment provision, the effect of which would be to prohibit any assignment; (3) lease provisions which require the debtor to pay all or a portion of the proceeds of an assignment to the landlord; and (4) lease provisions which require the assignee to pay increased rent upon an assignment or require the assignee to pay a fee as a condition to the assignment. The Bankruptcy Courts have held that these types of provisions are unenforceable because they have the direct effect of prohibiting the debtor tenant from realizing its equity in a below market (or otherwise beneficial) lease, which is precisely what Sections 363(f)(1) and (3) of the Bankruptcy Code are designed to prevent.

Notwithstanding the absence of reported cases supporting a Bankruptcy Court's right to declare continuous-operations provisions unenforceable against a proposed assignee, debtors continue to seek such relief and are sometimes successful in obtaining it, particularly when the debtor is an anchor tenant in a shopping center. As a practical matter, an assignee of an anchor lease will need some reasonable amount of time to remodel the store before it opens for business. If the lease at issue has a continuous-operations clause that prohibits the store from closing for any period of time, the assignee will have no way of remodeling the store and opening for business without defaulting under the lease. Some Bankruptcy Courts have therefore concluded (albeit not in published decisions) that absolute prohibitions on "going dark" are unenforceable in the context of an assignment by the debtor tenant. Such rulings can be devastating for the shopping center owner and the other tenants in the affected shopping center. Once a Bankruptcy Court has concluded that the continuous-operations clause in a lease is unenforceable against the assignee, the assignee can take as long as it desires to remodel the store before it re-opens for business. Assignees typically wish to open new stores just prior to the Christmas holiday shopping season, even if it requires that the store remain dark for an extended period of time. In shopping centers with a small number of anchors, a dark anchor for an extended period of time can be the death knell for the center, reducing customer traffic to a level where percentage rent is no longer payable by any of the tenants, and where some of the smaller retailers are driven out of business completely.

Dark anchors also can trigger provisions in other leases, with devastating results to the shopping center owner. For example, some leases of in-line stores provide that if an anchor goes dark for a specified period of time the tenant has the option of (i) terminating its lease without penalty or (ii) receiving a significant rent reduction. If a substantial number of in-line leases in a shopping center contain these types of provisions, the landlord in a center with a Bankruptcy Court-sanctioned dark anchor quickly can find itself with insufficient cash flow to operate and pay its mortgage, and with no remedy against the defaulting anchor tenant that caused the problem.

The best way for a landlord to protect itself from such rulings is to incorporate flexible continuous-operations provisions in their leases that allow the tenant to go dark for a short period of time for renovations. For example, if a lease provides that the landlord's right to terminate is triggered only if the store goes dark, and stays dark, for a period in excess of 60 days, the landlord can argue more effectively to the Bankruptcy Court that the provision does not preclude assignment because an assignee can take up to 60 days to renovate the premises and prepare for reopening. While some assignees might need more time to get the premises ready for their particular concept, there are certain assignees that might be willing to move in without the type of significant renovations that would take a longer period of time. Since flexible continuous operations provisions are easier to defend, the landlord has a much better chance of either prevailing before the Bankruptcy Court in a dispute as to the enforceability of the provisions, or negotiating a deal with the proposed assignee about a reasonable period for the necessary renovations.

Landlords should be careful to ensure that their continuous-operations provisions are consistent with provisions in the leases of their other tenants that may be triggered by a dark anchor. For example, if anchor leases allow the tenant to go dark for up to 60 days for renovations, any escape clauses in the lease of the smaller tenants, e.g., provisions allowing the tenant to terminate the lease or receive a rent abatement in the event an anchor goes dark, should not be triggered unless the anchors have stayed dark for a period in excess of the permitted renovation. If a landlord is able to present a Bankruptcy Court with such consistent, interrelated lease provisions, and thereby demonstrate that the harm caused by a dark anchor tenant is both real and substantial, the Bankruptcy Court will be much more reluctant to declare continuous-operations and similar provisions unenforceable against an assignee of the debtor.

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