Landlord can leverage position in bankruptcy of a retail tenant
For the vast majority of independent retailers selling small ticket consumer goods, the holiday sales season is the period each year when the business hits break-even, turns a profit, or continues to sustain losses and becomes insolvent.
Holiday boom or bust
When a disappointing holiday sales season is followed by returns, and the post-holiday consumer sales hangover, the resultant financial distress can quickly turn into a filing for bankruptcy protection. A landlord who has ever been a creditor in the bankruptcy reorganization of a retail debtor with even just one lease location has firsthand knowledge of just how frustrating, disruptive and costly these proceedings can become.
Seasoned shopping center landlords are well versed in the cyclical nature of the retail industry and its financial effect on the success or failure of independent retailers, but it may well be too late for a landlord to alter a relationship relative to the tenant after the ink on the lease dries.
Once a creditor in bankruptcy, a shopping center landlord is powerless to change the terms of the lease and the respective rights of the parties without approval of the bankruptcy court.
A shopping center landlord that leverages its position during lease negotiations to prepare for the possibility of a future bankruptcy filing is in a considerably better position and more likely to maximize its value proposition as a creditor.
A shopping center landlord can follow four quick tips during lease negotiations that may take center stage when one of its retail tenants seek bankruptcy protection:
- Standard form of lease. The starting point for all lease negotiations should be the shopping center landlord’s standard form of lease.
A skilled real estate attorney will draft the standard of form lease with provisions designed to protect the landlord’s rights and offer favorable remedies under the law of the state where the real property is located in the event of a tenant default. These provisions can provide the landlord with the ability to act immediately when a tenant’s financial crisis hits and a bankruptcy filing appears inevitable.
Shopping center landlords should consult with an attorney before negotiating away rights and remedies that are available under standard form leases.
- Contractual lien. Most commercial leases grant the landlord both contractual and statutory landlord’s liens. If, for whatever reason, the form of lease does not include a contractual lien provision, then the appropriate language should be added.
A statutory landlord’s lien is not enforceable in bankruptcy, but a properly perfected contractual lien under the applicable state’s Uniform Commercial Code will give the landlord a security interest in the tenant’s property.
Although it may be difficult for a landlord to obtain a first lien on the tenant’s property because there is usually bank financing in place, a landlord with a junior lien may be able to use the lien as leverage to gain an advantage in any subsequent bankruptcy or to receive a greater distribution on a secured claim.
- Security deposit. Requesting a security deposit during lease negotiations rather than after the tenant is in financial crisis is a more strategic approach. Cash, after all, is more likely to be available.
In a subsequent bankruptcy proceeding, the security deposit will be applied against the maximum statutory claim the landlord can assert under bankruptcy law. In other words, it will reduce the dollar value of the landlord’s claim. However, it is ordinarily better to have the money than to have the claim, given that claims are typically paid at substantially less than dollar for dollar, if even at all.
- Letters of credit. Letters of credit are another tool to maximize a landlord’s recovery. Even if the tenant has filed for bankruptcy protection, as a general rule, the landlord may draw on the letter of credit if it is entitled to draw on it under its terms.
A letter of credit and its proceeds are not property of the debtor’s estate but rather the property of the issuing bank paid on account of an independent obligation to the beneficiary of the letter of credit under bankruptcy law.
The retail industry is inherently cyclical and the difference between the solvent tenant and the insolvent tenant may ultimately depend upon sales during the holiday season. The unpredictability of the retail industry and the holiday sales season requires landlords to take steps during tenant lease negotiations to prepare for even the possibility of bankruptcy.
Will next year be a holiday boom or holiday bust for the retail tenant? Without the aid of a crystal ball, the use of these tips at the very outset of the landlord-tenant relationship may prove to be critical to successfully leveraging the landlord’s position as a creditor should a bankruptcy occur.
This article originally appeared in the Houston Business Journal, January 20, 2005.