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Landlords Aced By Retailer Bankruptcies

In the world at large, landlords - especially large commercial property owners - loom as fairly powerful entities, and with good reason. In most respects, those with property have more clout than those with none, and the more property they have, the more clout they have.

But when it comes to dealing with a tenant that is in bankruptcy, a landlord often finds itself low man on the totem pole.

"In a bankruptcy, the balance of power is with the debtor, not the landlord," says Steve Sernett, vice president of lease administration for Heitman Retail Properties, Chicago. "The laws are generally written to protect th e debtor against those he owes money."

Until a bankruptcy is filed, the landlord has all the rights spelled out in the lease. "But once a retailer files for bankruptcy, the landlord is halted from any say. He no longer has control over his own property," Sernett explains.

Bankruptcy effectively nullifies many provisions of a lease, says James Tiemstra, a principal with Walnut Creek, Calif.-based law firm Miller Starr & Regalia and chair of its bankruptcy department. "Many clauses and provisions of a lease are unenforceable in bankruptcy court. The tenant essentially controls the disposition," he says.

According to Ron Roberts, senior vice president and director of property management for Winmar Co., Seattle, retailer bankruptcies began to pose significant problems five or six years ago. The number of bankruptcies peaked about three years ago, he says, but bankruptcy continues to be an issue.

"It's a cost of doing business at this point because it has become a business strategy of companies to file bankruptcy. It's an ongoing concern for us," he says.

The growing use of bankruptcy when companies are not in financial straits angers many landlords. "These debtors often aren't in really bad shape. They just don't like the way some bad deals are hurting them and they look to bankruptcy as a way to keep profits from dropping," says Sernett.

According to Elizabeth Jarvis, president of Jarvis & Associates, a shopping center investment, management and consulting firm in San Francisco, some companies even use bankruptcy as a tool to boost profits. She describes the case of an Australian company that bought out a small Southern California retail chain specifically to take it into bankruptcy.

"They felt the real estate would produce more income than running the business. They planned to either sublet the space at a higher rent or get the landlord to buy the space back," says Jarvis.

To a large extent, the strategy worked. "I know some landlords who paid a significant amount of money to get the space back so they could have control over it," she says.

At the same time, emphasizes Kevin Anderson, a partner with San Jose, Calif.-based law firm Anderson & Blake, which represents several retail development and investment companies, it is not the most important issue retail landlords have to deal with. Nor is it one that threatens to make or break a shopping center owner, except under the most unusual circumstances.

Greg Maloney, senior vice president of property management for ERE Yarmouth Retail Group, Atlanta, agrees. "Bankruptcies are something we have to deal with, but we don't have a lot of spaces sitting empty because of them," he says.

The mechanics of bankruptcy There are three basic types of bankruptcy: Chapter 7, Chapter 11 and Chapter 13. Only small businesses may apply for Chapter 13, says Sernett, although few do. Most retailers use chapters 7 or 11.

Filing for Chapter 7 usually means an owner has decided to close the business and sell off all assets. Typically, this would involve retaining possession of the leased premises while those assets, including store fixtures, are sold, either by the retailer directly or through a third party that buys the assets in total.

The rent during this period comes from the proceeds of that sale, but if a retailer goes under, a landlord is lucky to get a few cents on the dollar because the tenant simply does not have enough money to pay off debts.

Filing for Chapter 11, on the other hand, signifies the retailer would like to continue operating the business but needs temporary protection from creditors while reorganizing.

The fact that the retailer would like to continue, however, does not necessarily mean it will be able to. The court or the company may eventually determine that the company lacks sufficient assets and capital to run the business on a profitable basis and pay off back debts. In this case, the court may rule to dissolve the company and sell off the assets.

A successful reorganization, says Anderson, usually entails an infusion of outside capital in the form of loans, investment or outright acquisition by another, usually similar retailer. In some cases, however, it may simply involve closure of underperforming stores and/or partial sale of assets.

>From the time of filing Chapter 11, a retailer has 60 days to decide whether to assume or reject existing leases. With each particular lease, the company can choose to continue or vacate it.

Once a retailer declares bankruptcy, operation of the business is subject to total oversight by the bankruptcy court. The court must approve all undertakings and expenditures. It may even make decisions for the business owner if the judge believes the owner or owner's manager is incapable of making sound business decisions or of making decisions in a timely manner.

Inconsistency of courts Bankruptcy falls under federal rather than state jurisdiction. Theoretically, this should make its application consistent from state to state and region to region. In practice, the opposite is true.

"One of the problems of the bankruptcy system," says Thomas J. Leanse, a partner with the Los Angeles-based law firm Katten Muchin & Zavis, "is that any judge can decide to have his or her decisions published. In cases involving national retailers, you'll get judges in, say, California, Texas and New York who make one decision, while judges in Nebraska, Idaho and Florida will make another. With hundreds of bankruptcy judges in the United States, you can come up with all kinds of contradictory decisions.

"No bankruptcy case has ever gone beyond the district court level, says Anderson, primarily because landlords have not considered it worth their while.

However, according to Dave Pollack, a partner with the Philadelphia-based law firm Pollack Meyers & Rosenblum, one landlord appears ready to take an appeal regarding the Levitz Furniture bankruptcy to the Supreme Court. He makes no prediction whether the justices will agree to hear the case.

Loss of income The first issue a landlord faces from a tenant's bankruptcy is likely to be loss of rent. "Typically, when retailers file for bankruptcy, they are already in arrears," says Anderson, who provides legal representation for several retail development and investment companies.

The law regards rent as an unsecured claim, which means a landlord cannot claim a tenant's assets for failure to pay rent. Under bankruptcy law, secured claims have priority over unsecured claims. As Sernett puts it, "The landlord comes toward the end of the line at the pay window."

Once a company files for bankruptcy, the tenant must pay rent, which now becomes an administrative expense of the bankruptcy and no longer falls under the category of unsecured claims. Failure to pay rent will lead to forfeiting the space.

However, notes Leanse, the bankruptcy code specifies the next rent payment is not due till the first day of the month following filing. Whether the portion of the rent covering the period from the date of filing through the end of the month qualifies as an administrative expense is open to question. He says most judges include it, but some classify it as part of the unsecured claim.

Also open to interpretation, he says, is the disposition of expenses related to rent, such as charges to cover the retailer's share of utility costs and property taxes. He points out that many states collect property taxes for the preceding rather the upcoming year. Thus, a tenant's payment for his 1997 share may not be due until April 1998.

If the tenant files for bankruptcy in March, does the tax count as an administrative expense, since it comes due after the filing? Or does it count as an unsecured claim, since it covers a period prior to filing? Again, says Leanse, different courts observe different rules.

When a retail company emerges from bankruptcy, it owes all back rents and additional charges, but only on current leases, says Pollack. "If a debtor owed two months' rent when he filed bankruptcy, the only way you're going to get it is if the debtor keeps the lease. If he rejects the lease, you can just forget about it," he says.

Furthermore, not all companies emerge from bankruptcy, even though they may have intended to survive at the time of filing. And if they don't survive, the landlord most likely will collect only a portion of the money owed. What portion is unpredictable.

"There are cases where you get 10 cents on the dollar or you have to take your payment in stock, but you can also get lucky. We've been paid 85 cents on the dollar for our unsecured claims against Best Products," says Pollack.

Loss of control When a retailer goes bankrupt, the landlord's biggest problem is not loss of income but loss of control of the real estate. Even though a retailer that files for bankruptcy has 60 days to decide whether to reject or accept current leases, says Leanse, judges routinely grant extensions - especially for major retailers with a large number of leases to evaluate. Decision periods of two years are not unusual, he remarks.

According to Sernett, Petrie Stores filed for bankruptcy in October 1995 and still has not concluded this process. "They rejected most of our leases, but we still have a few we're waiting on," he reports.

Until the retailer makes up its mind as to which spaces it will keep and which it will reject, a landlord can do nothing. "There's a lot of sitting around waiting," says Sernett.

Moreover, a tenant has the right to assign any lease to a third party, as long as that party, in the judge's opinion, meets certain criteria. In general, says Tiemstra, the bankruptcy code requires the assignee to have the equivalent use as the original lessee and match the financial strength of the lessee at the time the original lease was signed. Unfortunately, he adds, the judge's and landlord's views of equivalency often do not coincide.

Tiemstra notes that courts sometimes allow retailers to auction leases to the highest bidder. "Technically, the auction is subject to approval by the landlord, but when the court sees a fait accompli, it most likely will certify the results over the landlord's objections," he says.

Judges are lenient, says Anderson, because the court's imperative is to maximize the debtor's assets so it can pay off as many creditors as possible. "When the court sees an immediate source of income or relief of debt, it is reluctant to let it pass," he says.

For the landlord, the outcome may be not only a tenant that fails to contribute to the tenant mix but also one with greater problems than the original. "It's not unusual to find that someone forms a new company just to get locations and you end up with second bankruptcy," says Pollack.

As an example, he points to the bankruptcy of Imaginarium. The company that bought the leases is now on shaky grounds itself. "Those of us who do this call them Chapter 22s and Chapter 33s," he quips. "The cycle just keeps repeating."

Jarvis says this attitude incorrectly assumes rent is the landlord's only concern. "The judge looks on it just as a monetary issue, but from a landlord's viewpoint, merchandising is as important as rent. The worst thing in the world is for the landlord not to control the merchandising of the center," she says.

Leanse notes what he considers an alarming trend in recent cases involving Montgomery-Ward, Ernst Home Centers and Best Products. Judges allowed the retailers to assign leases to a company that planned not to use the spaces but to sublet them to retailers of its choice.

"That is the scariest prospect that currently exists," he says. "This removes the landlord one step further from control of his property."

Forestalling problems The best strategy regarding retailer bankruptcy is to anticipate problems. Anderson says he moves as soon as a tenant falls two months behind in rent.

"Some landlords allow tenants to get way far behind. I don't let them get far behind at all. If they're more than two months behind, it indicates there's more than a momentary glitch in cash flow," he states.

According to Maloney, if members of his team see a tenant heading toward bankruptcy, they try to get control of the space. "We would go in there and try to terminate the lease, especially if they want to leave. That happens quite often," he says.

If the tenant does not want to leave, Maloney says, ERE Yarmouth might consider some form of rent relief, depending on what kind of plans the tenant has for reversing its slide. Although some landlords would do this only with mom-and-pop retailers, Maloney says his company will do it with chains as well.

"If a retailer has 20 stores in our centers and they ask for rent relief, we will look at their request. We may or may not do it, again depending on their plan for improving the situation," he says. "We'd rather negotiate than have them go into bankruptcy and lose control of our space."

Roberts says Winmar will reduce rent only if the tenant agrees to spend the money saved for advertising, merchandising or other measure to improve business. Another possibility, he says, is moving the tenant to a smaller space, possibly by demising the existing store into two stores.

"Usually it's less expensive to retain than retenant. There's always down time in making a change from one tenant to another. Plus there are broker fees, tenant improvement costs and so on," he says.

Anderson points out that bankruptcies can have a good side. He says weak retailers that manage to hang on may be more detrimental to a center than those that go under. "With bankruptcy, a landlord at least has a chance of bringing in a stronger tenant," he says.

In some centers, he notes, the loss of a few smaller tenants may free up space for a larger, more contemporary retailer or for another tenant's expansion. "If you have a supermarket with 30,000 sq. ft., you know soon they're either going to want to expand or move, so you may be glad to have space for them to expand into," he says.

When bankruptcy does occur, says Leanse, the best defense is a good offense. "Assert your rights early and aggressively. Become such a thorn in the process that the debtor and the judge want to get your concerns out of the way so they can move on to other creditors. The worst thing is to be passive," he advises.

In addition, recommends Pollack, make leases as tight and specific as possible. The stronger the terms of the lease, he says, the less chance the court will ride roughshod over a landlord's rights.

Ironically, when a retailer, especially a major retailer, emerges out of bankruptcy, landlords often find themselves still having to eat humble pie. Because consolidation has reduced the number of tenants available to fill spaces, shopping center owners have little choice but to sign new leases - with no more protection than offered by previous leases - with tenants they have just been battling.

According to Sernett, when Edison Bros. emerged from bankruptcy, Heitman continued to do deals with the company as if nothing had happened, even though the multi-chain retailer had missed a sizable number of rent payments in Heitman properties.

"Typically nothing happens to the relationship afterward," he says. "There's almost no discussion of it anymore. It's back to business as usual."

The ICSC has injected a small ray of hope into the situation. Along with associations representing other commercial real estate landlords, it is currently lobbying Congress for changes to the federal bankruptcy code. The changes would deny companies the right to declare bankruptcy when they are not genuinely insolvent and force bankrupt retail tenants to adhere more closely to provisions of the lease when assigning it to other parties.

But even if Congress makes the changes, judges will still have considerable leeway in making decisions. So will the ICSC's efforts make a substantial difference?

"The emphasis of the bankruptcy court is debtor protection," says Anderson. "As long as that is the case, landlords will be at a disadvantage."

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