Podcast - Bankruptcy Provisions in Retail Leasing: What Landlords and Tenants Need to Know

Isabel Diaz: Welcome to this episode of "Real Estate Law Unlocked." My name is Isabel Diaz, and I'm here with my partner, Tyler Layne. I'm a partner in our Miami office with a focus on complex commercial real estate transactions. And a big part of my practice is leasing, including retail leasing. Tyler, do you want to introduce yourself?

Tyler Layne: Yeah, thanks, Isabel. My name is Tyler Layne. I'm a restructuring partner in Holland & Knight's Nashville office. I do all types of restructuring, but also a lot of real estate work in various sectors, including healthcare, retail, industrials and multifamily housing.

Isabel Diaz: Awesome. So today our Real Estate Law Unlocked session will focus on the importance of bankruptcy provisions in retail leasing. Let's jump right in. Tyler, you focus a lot of your practice on retail leases and bankruptcy provisions that are important to incorporate in those leases. Can you tell us a little bit why bankruptcy is such an important issue for landlords to be thinking about at the front end, when they're negotiating a lease, when a lease is being drafted?

Tyler Layne: Sure. So bankruptcy is important because it can really change the economics and timing of a retail lease quickly. We have landlord clients who will come to us and say, we've got a signed lease, we have these default remedies, we have the right to terminate if the tenant stops paying, but the rules change when a bankruptcy is filed. So the landlord still has rights, but they're filtered through the bankruptcy court process. The first point I would make is that bankruptcy really reshapes rights. A tenant that's in default gets breathing room from remedies. A landlord will be stopped from sending termination notices, commencing eviction proceedings, applying a security deposit or taking back possession, at least without court permission. And even provisions that seem very clear in the lease really don't operate the same way in bankruptcy. But that said, the lease language still matters a lot. Bankruptcy doesn't make the lease irrelevant. It's the starting point for determining the obligations between the parties and what rights the landlord does have. But the overlay is the statutory rules from the bankruptcy code. For instance, the bankruptcy code governs whether the lease can be assumed or rejected or assigned, what defaults have to be cured, what adequate assurance must be provided by the tenant and how quickly the debtor must make decisions about whether to assume or reject a non-residential lease. And then the final point that I would make is that retail landlords are uniquely impacted because the tenants are just not occupying four walls. The tenant really affects the entire project. And so a retail tenant's failure can impact tenant mix, foot traffic, the perception of a shopping center. And so if a bankrupt tenant assigns its lease to a different operator, the landlord will probably care deeply about whether that new operator fits the center, honors use restrictions and preserves the economic assumptions that the landlord agreed to. So the front-end takeaway is that bankruptcy planning isn't really just a remedy issue. It's a drafting issue, it's credit support issue and really an operational issue for the landlords.

Isabel Diaz: 100 percent agree with you on that. So let's now, you know, we drafted the lease, we've protected ourselves, the landlord hopefully included the right provisions in there to protect itself. Let's fast forward. The tenant files for bankruptcy. What's the first thing a landlord should understand once that happens? Sort of what's, like, the step-by-step process that a landowner should understand? What should they do at that point?

Tyler Layne: So the first thing is just to realize that the landscape has changed and that you may need to talk to somebody who works in the bankruptcy sector about what's going on. The tenants probably might still be in possession, the lease is still in effect, the rent's still coming due, but the landlord really needs to change how it will proceed. And so from a landlord's perspective, the first thing is to realize that there's two parts of the bankruptcy code that are generally implicated, Chapter 11 and Chapter 7, and they're very different. In Chapter 11, the tenant is trying to reorganize or sell assets, maybe close some stores, keep other stores or use the bankruptcy process to rationalize its lease portfolio. And for retail landlords, Chapter 11 is where you often see these going out of business or store closing programs, lease assumption and assignment processes, and negotiations over care amounts. Chapter 7, on the other hand, is a liquidation. It's always a liquidation. The tenant has either stopped conducting business or is going to stop in very short order, and a trustee is appointed to administer the assets. And so for landlords, Chapter 7 often becomes more about possession, how to recover as much unpaid rent as possible, removal of personal property, and so it's important to understand the difference between those in the first instance.

From there, I think the key concepts in the Chapter 11 is [whether] the debtor [is] planning to assume and assign or reject the lease. So assumption means the debtor wants to keep the lease and wants to keep it for itself. So to assume, the debtor generally has to cure monetary defaults, address certain non-monetary defaults, but not all of them, compensate the landlord for actual pecuniary losses and then provide what's called adequate assurance of future performance. Basically, that it's more likely than not that this situation is not going to arise again. Assumption and assignment means the debtor wants to transfer the lease to someone else, often as part of a larger sale. It's important in retail cases because valuable leases can be assets that the debtors [are] trying to sell. So even if the lease has an anti-assignment language, the bankruptcy law is going to limit the landlord's ability to rely on that language. That said, in shopping center leases, landlords do have additional protections related to adequate assurance related to tenant mix, use restrictions, exclusives, in addition to the financial conditions and operating performance of the assignee. Finally, rejection means the debtor is walking away from the lease. Rejection is treated as a breach, not necessarily a rescission of the lease or termination of the lease, but a breach, a material breach. And the landlord gets a claim for damages, but that claim may be capped. And practically, rejection really leads to the landlord recovering possession, releasing the space and filing a claim against the estate.

The last issue to be aware of, regardless of whether it's a Chapter 11 or a Chapter 7, is the automatic stay. Once a bankruptcy is filed, the landlord has to be very careful about how it proceeds because actions like terminating the lease, continuing an eviction, changing the locks, applying a security deposit or demanding any sort of payment may violate the stay unless an exception applies or the bankruptcy court grants a relief. And so that's where we see a lot of landlords get tripped up because actions that might be considered ordinary outside of bankruptcy can become really problematic once a bankruptcy is filed.

Isabel Diaz: Thank you, Tyler. And so on that point, you mentioned, you know, a lot of different options, a lot of different things that can happen depending on what type of bankruptcy is filed. How can, I guess, from a landlord perspective, what are some do's and don'ts that a landlord should think about when it comes to protecting itself, whether it's a Chapter 11 or a Chapter 7 bankruptcy, when it comes to drafting these bankruptcy provisions? Specifically, based on, like, sort of these different scenarios that you mentioned and what can potentially happen, whether it's an assumption, assumption of an assignment or a rejection, and then also with the risks or sort of the issues that may arise in connection with an automatic stay.

Tyler Layne: Yeah, so  I think the biggest do, I guess, is to draft the lease with bankruptcy in mind, but know that, you know, bankruptcy-focused provisions aren't always enforceable the way that they're written. A big one that's sort of non-bankruptcy-related is to really define rent obligations clearly. Make sure you're carefully describing exactly what's owed and when because clarity matters when disputes arise in bankruptcy. Necessarily, disputes will arise in a bankruptcy over what must be paid currently, what has to be cured and what forms a part of the landlord's claim. I would pay particular attention to assignment provisions. While bankruptcy law may override a simple anti-assignment clause, it doesn't necessarily wipe out all the shopping center protections that we talked about earlier. So being very specific about permitted uses, prohibited uses, signage, radius restrictions, anything that's important to the landlord will help in a bankruptcy in terms of getting the landlord what it wants.

Another thing to think about is credit support because I think security deposits, while you might be, as a landlord, stayed from exercising rights against the security deposit posted by the debtor tenant – security deposits, guarantees, letters of credit – those can materially improve the landlord's position. Each one works differently in bankruptcy, but the more recourse you can have against a non-debtor, the better. And then a big one that's just very practical is including provisions related to personal property in the premises. Because when a retailer fails, one of the biggest issues that I see is that the landlord's sort of left holding the back, right, dealing with the leftover merchandise, equipment, perishables, damaged premises, I mean, the litany of things. And so the more the lease can address those issues clearly, the less you're going to have to get relief from the bankruptcy court to do something.

And then on the sort of what you shouldn't do side is there are what are called ipso facto provisions in bankruptcy. And ipso facto provisions, the most clear one, is when the tenant files for bankruptcy, the lease terminates. Those provisions are generally unenforceable in bankruptcy. So you shouldn't rely on those as a material part of your protections as the landlord. I also think that calling something "additional rent" doesn't solve every problem. We see bankruptcy courts really dig in and analyze the substance of the obligation. And then finally, you can't really contract around the bankruptcy code. So we'll see provisions that say the tenant waives the automatic stay or this lease can't be assumed and assigned in a bankruptcy. There may be some nuance about whether those provisions are effective or not in a bankruptcy, but you can't assume that they're going to be effective as written. And so consulting with competent counsel about that is important upfront.

Isabel Diaz: Thank you, Tyler. That's really helpful. And it's a little bit, I guess, for the landlords that are listening in, it's not scary, I would say, but do my provisions really mean anything, right? So thank you for highlighting the do's and don'ts because there are ways, obviously, to still get protected, to still have protection as the landlord, even though the bankruptcy code may override what your lease says if there's a bankruptcy. And on that point, you kind of touched upon it a little bit, but if you want to maybe just briefly also discuss, like, OK, so there's a bankruptcy, like, what remedies do the landlords still have even though the lease provisions may not necessarily apply? Do you have anything else to add on that point?

Tyler Layne: Yeah, so the biggest one is that landlords are generally entitled to payment of post-petition obligations under non-residential leases until the lease is assumed and rejected. There can be some nuances to what constitutes a post-petition obligation with respect to stub rent and things like that, but the general rule is that the debtor has to pay post-petition rent. The second one that we haven't really talked about is considering what the landlord's preference exposure might be. If a landlord received payment shortly before the bankruptcy filing, those payments can be challenged as preferences. There are defenses to that – ordinary course, new value being the two most commonly used defenses – but the landlord shouldn't assume that the payments that they received prior to the bankruptcy are sacrosanct. So the common thread really is that you kind of need to play the game in bankruptcy court. You can't really self-help your way through a bankruptcy case. You just need to preserve your rights, monitor your deadlines, make sure that the debtors are paying what they need to pay, participate in the case and seek court relief if necessary.

Isabel Diaz: Got it. So now flipping the script a little bit because I know we have landlords listening, but there's also tenants, I'm sure, listening as well. What if the landlord is the one in bankruptcy? What are some things that the tenant should keep in mind with respect to drafting, with respect to just bankruptcy in general of a landlord when you have a long-term lease or even a short-term retail lease, right? And you want to make sure that you can continue to operate. What are some things that they can do?

Tyler Layne: Yeah, so this is becoming a bigger and bigger issue as more landlords have real financial problems, and tenants, I think, overlook this. And so if the landlord files for bankruptcy, just like when the tenant files for bankruptcy, the landlord's estate is going to consider the lease as an asset to be monetized. And so if the landlord assumes the lease, the tenant generally doesn't have anything to worry about, right? The landlord's committed to continuing performing. And you know there's really no change. It's as if the bankruptcy didn't really happen. [If] the landlord assigns the lease, then you're going to want to understand who the new landlord is, whether the deposits are being transferred, what lease rights are being preserved and whether there's any cure issues that the landlord has to comply with.

But the most important tenant protection in bankruptcy is when the debtor landlord rejects a lease. So, you know, debtor landlord may go into bankruptcy and say, I have all these below-market leases, I'm going to get rid of them and get new tenants at market rates. Rejection is a breach, but it doesn't mean that the tenant has to lose possession. So the tenant typically has a choice in that situation. One option is to treat the lease as terminated, vacate and assert damages against the landlord's estate. That may make sense if the space is no longer valuable or if the landlord's nonperformance under the lease is significant. The other option is to retain the rights under the lease for the balance of the lease term, which includes any renewal or extension rights. That allows the tenant to stay in possession, continue using the premises, as long as it continues to pay rent. But the landlord doesn't really have to perform. So if there's anything sort of ancillary under the lease that the landlord has to do other than allowing for quiet enjoyment of the premises, the landlord doesn't have to do that. Now the tenant may be able to offset those damages. For instance, if the landlord was supposed to provide some sort of service and they don't, the tenant can offset those damages against the continuing performance of rent, but it might not be the best situation for the tenant.

So I think, tenants, the same thing goes. When the landlord files for bankruptcy, you can't be passive. You've got to actively participate in the case. The bankruptcy is not just going to go away, and you need to make sure that you're asserting your lease rights promptly if necessary.

Isabel Diaz: How about with, like, guarantees and deposits and rent obligations? Everything pretty much stays the status quo, or does any of that get affected by the landlord's bankruptcy?

Tyler Layne: Yeah, everything should stay status quo, and at least in a Chapter 11 by pending rejection, right? So if the landlord actually rejects the lease, then the landlord doesn't have to perform under the lease other than making the space available to the tenant. But really nothing should change in the near term. If it does, that's a huge flashing warning sign that you really need to think about what's coming next for your space.

Isabel Diaz: Got it. So I know we're nearing the end here. If you could leave the landlords with one takeaway when just thinking about bankruptcy and a retail lease, what would that be? Or tenant, whichever one.

Tyler Layne: Yeah, so in both scenarios, you really need to consider the practical effects of bankruptcy before there is a bankruptcy. And don't assume that sort of the boilerplate bankruptcy provisions in your lease are going to protect you. So yeah, you're going to be operating in a highly structured environment with court oversight, deadlines, limits on your remedies, and so you need to consider what leverage you have and really draft for the distress that may be coming. And bankruptcy may never happen, but if it does, the lease that you may have negotiated 10 years earlier is going to determine what your practical outcome is.

Isabel Diaz: Thank you, Tyler, for sharing your insights. This has been incredibly valuable to me, and I'm certain it would resonate with many of our clients and listeners. I'd love to do a part two down the road, perhaps turning our focus to industrial leases or healthcare-focused leases, which I know is a significant part of your practice. I also want to thank all our listeners for joining us. As always, if you have any questions, please don't hesitate to reach out to Tyler or me. We hope you've enjoyed today's session. And thank you for joining us.