Bankruptcy and Shopping Center Leases
 
March 1, 2000
 
Stephen W. Snively- Orlando

Shunned in the past, leasehold mortgages are now accepted by institutional lenders in the shopping center industry. A retailer may mortgage its interest as tenant to finance the acquisition of store improvements, trade fixture and inventory. A shopping center developer that is the lessee under a ground lease may give a leasehold mortgage to obtain development and construction financing. Many lenders providing leasehold financing are not aware of the catastrophic bankruptcy risks inherent in leasehold mortgages.

A mortgage on a fee simple interest encumbers title to both the land and buildings and entitles the lender to foreclose and sell those tangible assets. A mortgagor's bankruptcy trustee can delay, but not defeat, the rights of the fee simple mortgagee. By contrast, a leasehold mortgage encumbers only an executory contract right, not tangible assets, and foreclosure entitles the lender only to enforce the contract and take occupancy of the leased premises. But a leasehold mortgagor's bankruptcy trustee can reject the leasehold interest and terminate the rights of the leasehold mortgagee. Termination of a lease by a bankruptcy trustee causes the collateral that the leasehold mortgage encumbers to simply vanish. If the collateral is a shopping center ground lease, then the subleases between the ground lessee and the retail tenants vanish, too.

Effect of Bankruptcy on Landlord and Tenant

Although the leasehold mortgage encumbers only the interest of the tenant, the bankruptcy of either a landlord or tenant threatens a leasehold mortgagee.

Automatic Stay. On commencement of a bankruptcy case, an automatic stay takes effect immediately. It prohibits any action to enforce lease obligations against a "debtor," whether landlord or tenant, except to the extent that the bankruptcy court otherwise authorizes. If a tenant is a debtor, a landlord cannot pursue eviction proceedings and a leasehold mortgagee cannot pursue foreclosure proceedings and a leasehold foreclosure proceedings without a lifting of the stay.

Assumption or Rejection. Bankruptcy Code § 365 concerns unexpired leases, and a trustee may invoke it on behalf of a debtor, whether landlord or tenant. This section provides a mechanism for a trustee to reject or assume leases. If a trustee assumes a lease in bankruptcy, the trustee may retain the lease as part of the bankruptcy estate or assign it. Generally, if the trustee does not affirmatively assume or reject a nonresidential lease of real property within 60 days after an order for relief, the lease is deemed rejected unless the bankruptcy court extends this deadline. Bankruptcy courts routinely grant such extensions. Until a lease is rejected, a debtor must continue to perform its obligations under the lease. As a condition to assuming a lease, a trustee must cure any monetary defaults and provide adequate assurance that any other defaults will be cured. A trustee seeks to maximize the value of the bankruptcy estate. For that reason, a trustee in bankruptcy for a tenant may choose to affirm a lease if it is at or below market rates and adds to the value of the bankruptcy estate, or to reject a lease if it is at or above market rates and burdens the bankruptcy for a landlord would react in an opposite manner.

"Shopping Center" Lease. Bankruptcy Code § 365(b)(3) provides special protection for "a lease of real property in a shopping center" if a bankruptcy trustee for a tenant elects to (1) assume a lease and retain it or (2) assume a lease and assign it to a third party. The determination of what constitutes a "shopping center" is made on a case-by-case basis.

Looks can be deceiving when deciding what is a "shopping center" for bankruptcy purposes. The legislative history for § 365(b)(3) describes a shopping center as "a carefully planned enterprise, and though it consists of numerous individual tenants . . . is planned as a single unit, often subject to a master lease or financing agreement." H.R. Rep. No. 95-595, 348-49 (1978). A group of stores may constitute a shopping center, depending on factors such as:

• a combination of leases held by a single landlord
• a commercial retail distribution of goods by tenants
• a common parking area
• purposeful development of the premises as a shopping center
• a master lease
• establishment of fixed hours during which all stores are open
• a joint advertising program
• contractual interdependence of tenants as evidenced by restrictive use provisions in leases
• percentage rent provisions in leases
• the right of tenants to terminate their leases if the anchor tenant terminates its lease
• joint participation by tenants in trash removal and other maintenance
• maintenance of a particular tenant mix
• contiguity of the stores

Generally, enclosed regional malls are "shopping centers" for bankruptcy purposes. Many urban retail developments and other retail projects also qualify, if there is at least a combination of leases held by a single landlord, businesses involving the retail distribution of goods and shared parking facilities. "Big boxes" and "power centers" with parcels that retailers independently own are prevalent today. Lacking a combination of leases held by a single landlord, these centers may not qualify for the special protection of § 365(b)(3). Ground leases also may not qualify.

Landlord Bankruptcy. If a landlord is a debtor in a bankruptcy case, a trustee may elect to reject the lease. If a lease is rejected, a tenant may react by either treating the lease as terminated and filing a claim for damages or remaining in possession and offsetting its damages against rent. "Possession" can be actual or, as in the case of subtenants, constructive.

Tenant Bankruptcy. Until a lease is rejected, a tenant must continue to perform its lease obligations, including payment of rent. Rent accruing after the order for relief is entered and until the lease is rejected is considered an administrative expense, which has priority for payment in a bankruptcy case. If a lease is rejected by the trustee of a tenant, the rejection is a lease default. A rent claim for the period after a lease is rejected has the lower status of a non-priority unsecured claim. Damages to a landlord for lease termination are limited to the sum of unpaid rent at the time that the bankruptcy petition was filed plus the greater of rent for one year or 15% of the rent due for the remainder of the lease term, but not to exceed three years. This measure of damages is a severe limitation for shopping center leases, which are typically longer in duration than most commercial leases. There is no corresponding limitation on liability to a tenant in a landlord's bankruptcy case.

A lease must be assumed before it is assigned. If a lease is assumed, the trustee must cure any existing defaults and provide "adequate assurance" of future performance. If the lease qualifies as "a lease for real property in a shopping center," the landlord is entitled to "adequate assurance" for certain specific obligations. "Adequate assurance" is intended to protect a landlord from a decline in value of the demised premises if a lease is assumed. It includes requirements that (1) the financial condition and operating performance of any assignee be similar; (2) percentage rent not decline substantially; (3) all other provisions of the lease apply, such as exclusive use clauses; and (4) the tenant mix or balance at the shopping center not be disrupted. "Adequate assurance" that a landlord will be compensated for any pecuniary loss in a condition to the assumption of a lease of real property in a shopping center.

Bankruptcy and Shopping Center Leases - An Illustration

Bankruptcy triggers a shockwave that ripples through the shopping center. In the following illustration, the shopping center developer holds a ground lease, has mortgaged its leasehold interest, has leased space to retail tenants (which also mortgaged their leasehold interests) and is a debtor in a bankruptcy case.

Interim Obligations. The trustee in bankruptcy has 60 days, plus any extensions, to assume or reject the leases. That term applies to both the retail leases and the underlying ground lease. In the interim, the trustee for the debtor continues to be responsible for ground lease payments and its obligations as landlord under the retail leases.

Assumption of Ground Lease. If the bankruptcy trustee assumes the ground lease, it remains an asset of the bankruptcy estate and the trustee for the debtor must pay rent and perform its obligations as ground lessee. The trustee may assume the ground leasehold interest and retain or assign it. If the trustee assumes the ground lease, it then must decide whether to assume or reject the retail leases.

Assumption of Retail Lease. If the trustee assumes a retail lease, it remains an asset of the bankruptcy estate and the trustee for the debtor remains responsible as landlord until the ground lease is assigned. The trustee's assignment of the underlying ground lease would be subject to any assumed retail leases. The trustee might assume some retail leases at the shopping center and reject others. If the trustee assumes a retail lease with a cotenancy requirement and rejects the lease referred to in the cotenancy clause, the tenant might still terminate the assumed lease, based on the landlord's failure to satisfy the cotenancy requirement.

Rejection of Retail Lease. If the trustee rejects a retail lease, the retail tenant must elect either to terminate the lease or to remain in possession. If the tenant terminates the lease, it may file a claim for damages. Damages would be treated as the claim of a general unsecured creditor and not limited in amount by the bankruptcy statute. On lease termination, a lender with a leasehold mortgage on the interest of the tenant would lose its collateral. If the tenant elects to retain its rights under the retail lease and remain in possession, it may offset damages against rent. The tenant then could not assert a claim in the bankruptcy case.

Rejection of Ground Lease. If the bankruptcy trustee for the ground lessee rejects the ground lease, then it may be deemed terminated. The claim of the ground lessor for ground rent accruing before rejection would have priority in the bankruptcy case as an administrative expense. The claim for additional ground rent and any other damages that the ground lessor sustained from the termination of the ground lease would be treated as that of a pre-bankruptcy, nonpriority unsecured claim and be limited to the lesser of rent for one year or 15% of the remaining lease term, not exceeding three years. A lender with a leasehold mortgage encumbering the interest of the ground lessee will lose its collateral.

Termination of Retail Leases. With rejection of the underlying ground lease, the ground lessee would no longer have any legal interest in the shopping center and therefore would be unable to act as landlord under the retail leases. In many states the retail leases would be extinguished by operation of law. Because the underlying ground lease is terminated, the retail tenant could not stay in possession and offset against rent under Bankruptcy Code § 365(h). Nonetheless, the retail tenant could assert a monetary claim for damages against the debtor in bankruptcy. A lender with a leasehold mortgage on the interest of the retail tenant would lose its collateral.

Bankruptcy Protection for Leasehold Mortgagee

Although the fallout of bankruptcy cannot be escaped completely, the parties can take precautionary steps. If a lease does not have bankruptcy provisions protecting a leasehold mortgagee, those provisions may be included in a subordination, nondisturbance and attornment agreement (SNDA) among a landlord, tenant and leasehold mortgagee. The SNDA customarily addresses matters such as notice and cure, rights to condemnation and insurance proceeds, lease amendments and termination. The following suggestions apply to landlord and tenant bankruptcies and are not limited to the assumed facts in the illustration above.

Notice of Bankruptcy. A tenant's leasehold mortgagee can require the tenant to provide prompt notice of any bankruptcy notices or filings by its landlord and the right to take control of the representation, on behalf of a tenant, in any such bankruptcy case.

Election to Stay in Possession. Section 365 provides that, if a trustee for a landlord rejects a lease, the tenant may elect to treat the lease as terminated or to stay in possession. Because a leasehold mortgagee may not have independent standing to intervene in a landlord's bankruptcy case, it should seek to control this election by its borrower, as tenant. The leasehold mortgagee can be granted the right to make any election to terminate a lease or remain in possession, if a trustee for the landlord rejects a lease. A leasehold mortgagee should perfect its security interest in any such assigned rights by filing a UCC financing statement.

Deemed Election to Remain in Possession. The lease can provide that, if a bankruptcy trustee for a landlord elects to terminate a lease, the tenant will be deemed to have elected to remain in possession under § 365(h)(1)(A) if it does not elect affirmatively to terminate the lease. If honored by a bankruptcy court, this provision would help preserve a leasehold estate from the consequence of tenant inaction.

Encumbrance of Statutory Rights of Possession. A tenant's leasehold mortgagee can encumber the right of a tenant to remain in possession of the premises under § 365(h)(1)(A) after rejection of a lease by a landlord's bankruptcy trustee.

Definition of "Possession." Although § 365(h)91) allows a tenant to remain in possession after rejection of a lease by a landlord's trustee in bankruptcy, it does not define "possession." A strict definition can require actual possession by a tenant and be problematic for a ground lessee that operates a shopping center with subleases to retail tenants. Accordingly, a landlord should agree in the lease or SNDA that "possession" is defined broadly to include subtenants of a shopping center.

The "Pick-Up Lease." A ground lessor and ground lessee's leasehold mortgagee can include a "pick-up lease" provision in their SNDA. This provision would obligate a ground lessor, if a trustee in bankruptcy for a ground lessee rejects a ground lease, to enter into a new lease directly with the ground lessee's leasehold mortgagee. The terms of the "pick-up lease" would be identical to those of the terminated lease that it replaces. A "pick-up lease" provision also can be included in the SNDA among a landlord for a retail lease (regardless of whether the landlord is a fee simple owner or ground lessee), a retail tenant and the tenant's leasehold mortgagee. As an alternative, a landlord and a leasehold mortgagee can execute a "back-up lease" at the time of a leasehold mortgage loan that does not become operative unless the primary lease is terminated. Strong provisions such as these, binding on a lessor and its mortgagee, may be the best protection available to a leasehold mortgagee in the event of a tenant bankruptcy.

Security Interest in Damages Claim against Landlord. A lender should require a security interest in a first lien on any claims, damages and other rights available to a tenant in a landlord bankruptcy case.

Retail Tenant's Enforcement of Exclusive Uses. Radius restrictions, exclusive uses and similar provisions are common to retail leases. Section 365(h)(1)(C) protects a retail tenant that remains in possession from the effects of rejection as follows:

The rejection of a lease of real property in a shopping center with respect to which the lessee elects to retain its rights . . . does not affect the enforceability under applicable nonbankruptcy law of any provision in the lease pertaining to radius, location, use, exclusivity, or tenant mix or balance.

A leasehold mortgage can also encumber such statutory rights of a shopping center tenant. Section 356(h)(1)(C) may not help if a retail lease is extinguished by operation of law as a result of termination of an underlying ground lease, because the retail lease technically will not have been rejected in bankruptcy.

Notice and Approval of Setoff Rights. The wrongful setoff by a tenant of damages against rent due a landlord will constitute a default and trigger a termination of a lease by a landlord's trustee in a bankruptcy case. Accordingly, a leasehold mortgagee can require that its consent be obtained for any such setoff.

Leasehold Mortgagee as Third-Party Beneficiary. A leasehold mortgagee is not a third-party beneficiary of bankruptcy provisions intended to benefit a tenant, such as the right to stay in possession or terminate a lease that a landlord's bankruptcy trustee has rejected. Nonetheless, the parties to a lease may wish to express their mutual intent that a leasehold mortgagee be a third-party beneficiary.

Subrogation to Landlord Rights. Lease guaranties and "adequate assurance" of tenant performance in a bankruptcy case are intended to protect a landlord. Nonetheless, a leasehold mortgagee might cure tenant defaults (e.g., make rent payments to the landlord) to reserve the leasehold estate. The lease or SNDA could provide that when a leasehold mortgagee cures tenant defaults under the lease, it is subrogated to the rights of the landlord under any lease guaranty and in any "adequate assurance" provided in the bankruptcy case.

Guaranty of Indebtedness. A leasehold mortgagee could require a third-party guaranty, such as that from a parent corporation or creditworthy individual, for the repayment of indebtedness that a leasehold mortgage secures. Such a guaranty would be enforceable even if a tenant were the debtor in a bankruptcy case. If a tenant objects to an unconditional guaranty, it can be conditioned on entry of an order for relief in bankruptcy.

Conclusion

A leasehold mortgagee must exercise extreme caution to reduce the risks posed by the bankruptcy of a landlord or tenant. Many shopping center leases lack bankruptcy provisions protecting a leasehold mortgagee. A well-drafted SNDA, based on an understanding of the roles of the parties and the basic principles of bankruptcy law, may help assure that bankruptcy is not a catastrophe for a leasehold mortgagee.

[This article appeared originally in Probate & Property, May/June 1999, a publication of the Real Property, Probate and Trust Law Section of the American Bar Association.]

Mr. Snively is the co-chair of Holland & Knight's Retail Development Group and a partner in the Orlando, Florida, office. He can be reached at 407-425-1112, and at ssnively@hklaw.com.