March 23, 2020
Countries across the world are actively taking measures to stem the spread of COVID-19 by encouraging and, in some cases, forcing social distancing. One of the most common measures employed so far is the closing of non-essential stores, bars and restaurants for several weeks, if not longer. Several large retailers, such as JCPenney, Ross Stores, Kirkland’s Inc., Marshalls and TJ Maxx, have announced store closings for two weeks in efforts to help stop the spread of COVID-19.
Prior to this pandemic, the retail industry was already facing challenging times. Store closures reached record levels in 2019 primarily driven by “big name” store closures. A large factor contributing to the existing difficulties facing the retail industry is the rise of e-commerce, which is predicted to continue and accelerate as nonessential stores are forced to temporarily close. The existing challenges facing the retail industry will clearly be exacerbated by the outbreak of COVID-19.
With retail bankruptcies expected to continue to rise, parties in the retail space, especially landlords and vendors, need to closely monitor their counterparties to best position themselves in the event of a bankruptcy. Section 365 of the Bankruptcy Code provides debtors with the ability to assume or reject executory contracts and unexpired leases and lease rejection damages are capped, but there are some specific protections built in for landlords of commercial real estate.
First, as with any contract or lease that is assumed or assumed and assigned, all defaults, including payment defaults, must be cured before assumption and the debtor must establish adequate assurance of future performance. These provisions protect the nondebtor counterparty by ensuring it is made whole upon assumption and establishing that the debtor (or a new counterparty in the case of assumption and assignment) will perform under the lease going forward.
Additionally, section 365 of the Bankruptcy Code provides a deadline by which commercial real estate leases must be assumed or assigned. Specifically, section 365 provides the debtors with 120 days to make a decision on assumption or rejection of a commercial real estate lease, subject to extension of up to 90 days. Importantly, once the debtor has received a 90-day extension of the initial deadline, additional extensions will only be granted upon consent of the nondebtor counterparty. Accordingly, unlike other parties to executory contracts or unexpired leases, a counterparty to a commercial real estate lease can force the debtor to make a decision on assumption or rejection within 210 days of the bankruptcy filing, creating leverage that other contract counterparties do not typically have.
Further, section 365 provides special protection for landlords of shopping center leases. Chief among these protections is that, as part of establishing adequate assurance, the debtor must establish that, among other things, any “percentage rent” will not decline substantially, assumption and assignment will not disrupt any tenant mix or balance in the shopping center, and assumption of the lease will be subject to any lease requirements concerning matters such as radius requirements, location, use of premises and exclusivity provisions. These provisions of the Bankruptcy Code provide a landlord with assurance that the lease will be used in a similar manner and subject to existing restrictions for a shopping center lease.
Having shorter termination rights upon default can also provide a benefit. If a contract is terminated prior to a bankruptcy filing, it remains terminated and cannot be revived as a result of the bankruptcy. Further, letters of credit supporting leases can be drawn on notwithstanding a bankruptcy filing, and security deposits are typically allowed to be set off against claims that arose prior to the bankruptcy.
It is likely that the impacts of COVID-19 will lead to more bankruptcies in the commercial space. Bankruptcy is difficult for all parties involved, but assessing your position in advance puts you in the best position for making quick, informed decisions when faced with these situations.