Rent Deferments Challenge Landlords’ Statutory Protections in Chapter 11

Beginning in late March with In re Modell’s Sporting Goods, Inc., No. 20-14179 (Bankr. D.N.J.), some bankruptcy courts in retail Chapter 11 cases have been allowing debtors to suspend post-petition rent payments to their landlords, in contravention of the long-accepted practice, based on Bankruptcy Code Section 365(d)(3), that such payments must continue to be made as they come due in the ordinary course of business.

In all cases where a debtor is a tenant under an unexpired commercial lease, Section 365(d)(3) requires a Chapter 11 debtor to “timely perform all [post-petition] obligations of the debtor” under any unexpired lease of nonresidential real property. The statute requires payment of “obligations … until such lease is assumed or rejected.” Section 365(d)(3) further provides that “The court may extend, for cause, the time for performance of any such obligation that arises within 60 days after the date of the order for relief, but the time for performance shall not be extended beyond such 60-day period.” Absent, however, is what happens when a debtor violates Section 365(d)(3). Until recently, the appropriate remedy for a debtor’s violation of Section 365(d)(3) was to cause the lease to be rejected in a timely manner. In re DBSI Inc., 407 B.R. 159, 164 (Bankr. D. Del. 2009).

However, as set forth below, at least one court has determined that Section 365(d)(3) does not provide a remedy to effect payment if a debtor fails to perform its obligations under Section 365(d)(3)—a landlord simply has an administrative expense claim under §365(d)(3), not a claim entitled to “superpriority” or immediate payment.

On March 7, 2020, Gov. Andrew Cuomo declared a Disaster Emergency in New York as a result of the COVID-19 pandemic. Beginning on March 20, Cuomo issued various “stay at home” Executive Orders which severely restricted non-essential business activities, including most retail.

As a result, on March 27, 2020, pursuant to Bankruptcy Code Sections 105(a) and 305(a), Judge Vincent Papalia “suspended” Modell’s Chapter 11 case pending in the District of New Jersey for 34 days. Modell’s, No. 20-14179, Dkt. 166. Modell’s argued it was unable to conduct proposed going-out-of-business sales because the premises were forced to close under the “stay at home” orders, and as such, the entire case needed to be suspended to preserve estate assets. Modell’s, No. 20-14179, Dkt. 115. During the suspension, Judge Papalia also permitted Modell’s to abate rent for over 60 days beyond the petition date, notwithstanding the express 60-day limitation in Section 365(d)(3).

Thereafter, bankruptcy courts in Delaware (In re CraftWorks Parent, LLC., No. 20-10475, Dkt. 217) and the Eastern District of Virginia (In re Pier 1 Imports, Inc., No. 20-30805, Dkts. 493, 629 & 637) granted similar relief, including the suspension of rent payments beyond Section 365(d)(3)’s 60-day deadline. In Pier 1, Judge Kevin Huennekens issued a detailed opinion, see No. 20-30805, Dkt. 637 (Bankr. E.D. Va. May 10, 2020), providing a roadmap for subsequent cases. Heunnekens “did not find that the Debtors do not have to pay rent,” interpreting Section 365(d)(3) to mean that a debtor has “an obligation to pay rent in accordance with the terms of the underlying leases.” However, Section 365(d)(3) does not contain “a remedy to effect payment.” (Citing his decision in In re Circuit City Stores Inc., 447 B.R. 475, 511 (Bankr. E.D. Va. 2009)). Circuit City held that a landlord has an administrative expense claim if rent is not paid, but not a claim entitled to superpriority. Id. Such administrative claims must be paid in cash on the effective date of the plan under Section 1129(a)(9)(A). If he compelled payment earlier, Huennekens said he would be improperly elevating post-petition rent to superpriority status. If a landlord is entitled to adequate protection under Sections 361 and 363 during the rent abatement period, then current payments for insurance, utilities, and security, coupled with assurance of cure payments at a later date, would be “sufficient to protect the Lessors against any perceived diminution in value.” Underlying his decision, Judge Huennekens found that the debtors “cannot operate as a going concern and produce the revenue necessary to pay rent because they have been ordered to close their business.”

In another Delaware case, In re 24 Hour Fitness Worldwide, Inc., et al., No. 20-11558, numerous landlord objections to the debtors’ post-petition financing motion were overcome with “Rent Protections” in the Aug. 3, 2020 order approving that motion, Dkt. 652. The order differentiates between “Closed Clubs” and “Open Clubs.” Consenting landlords will receive 30 percent of the rent reserved for closed clubs and 100 percent of the rent for the period that a club is open after July 1, 2020. Thus, landlords obtained at least partial relief, even for the premises shuttered by COVID.

In the Southern District of Texas, (In re CEC Entertainment, Inc., et al., No. 20-33163), the court granted the debtors’ motion for 60-day rent deferral over a numerous “well-taken” landlord objections. Judge Marvin Isgur found that deferral was necessary to give the debtors flexibility to respond to changing regulations and to make lease rejection decisions. Shortly thereafter, the debtors asked the court to abate rent payments for 141 closed or limited operation stores “until such restriction or order has been lifted and to reflect the extent and duration of such forced governmental closures or limitations.”

The debtors asserted that abatement was necessary to protect their contractual and common law rights under certain commercial leases and to ensure their ability to successfully reorganize in Chapter 11.

On Sept. 8, 2020, Judge Isgur heard testimony and oral argument in connection with certain landlord objections to the debtors’ rent abatement motion and asked for further briefing on the following point: if the force majeure clause in a lease does not support granting rent relief, but state policy does, which controls, the lease or state policy? The CEC debtors recently proposed to make interim payments to landlords according to the following terms:

• Closed restaurants: 20% of rent;
• Take-out only restaurants: 30% of rent;
• Dine in / Limited Occupancy restaurants: 40% of rent.

Given the $3 trillion commercial mortgage market, see www.wsj.com/articles/businesses-cant-pay-rent-thats-a-threat-to-the-3-trillion-commercial-mortgage-market-11585051201, these issues are critically important to landlords and their lenders, particularly in cases where a debtor is ultimately unable to make up the amounts due, which may happen if a case becomes administratively insolvent. In that event, landlords may find themselves in the position of involuntary, unsecured, and interest-free lenders to administratively insolvent estates.

If the new precedent persists beyond the pandemic, it threatens to undermine the Bankruptcy Code’s statutory protections designed to protect commercial landlords from becoming involuntary lenders. Nothing in the foregoing court decisions appear to limit a debtor’s entitlement to rent deferments to “black swan” events like the current global pandemic. Thus, it is reasonable to ask if this could become accepted relief in every successive financial crisis? If so, it represents a serious departure from pre-COVID practice—and Congressional intent to afford commercial landlords greater protections in Chapter 11. See H.R. CONF. REP. 98-882 (1984), as reprinted in 1984 U.S.C.C.A.N. 576, 598-99.

Congressional intent, however, may be shifting—at least temporarily—away from landlord protections. The Judicial Conference of the United States’ Budget Committee proposed legislation on April 28, 2020 to give bankruptcy courts authority to extend and toll statutory deadlines and time periods during the pandemic, which would include additional flexibility to extend Section 365(d)(3)’s 60-day period. //www.uscourts.gov/sites/default/files/judiciary_covid-19_supplemental_request_to_house_and_senate_judiciary_and_approps_committees.4.28.2020_0.pdf. The most likely scenario is that the proposed legislation could be included in the next COVID stimulus bill (if there is one). Landlords—and commercial mortgage lenders—should keep a close eye for new developments.

Despite these challenges, landlords still have options to protect their interests –particularly prior to a Chapter 11 filing, when leverage is greater. While communications with a landlord’s mortgage lender are a judgment call, generally landlords would be wise to keep lenders apprised of their property operations, including tenant rent relief and defaults. We find many landlords are actively engaged in negotiating lease amendments to provide short-term rent relief.

Such amendments provide an opportunity to make the lease as “bankruptcy friendly” as possible in anticipation of a tenant’s filing and also to correct any “loose ends” in the lease documents. Of course, any pre-petition modification of a lease due to a tenant’s inability to pay must reflect reasonably equivalent value and be carefully drafted with the Bankruptcy Code’s avoidance provisions in mind. These steps will better position the landlord if the tenant ends up in a bankruptcy proceeding.

In sum, even though payment of post-petition rent under a nonresidential lease (prior to rejection) has historically been an absolute requirement—subject only to the 60-day grace period in Section 365(d)(3)—bankruptcy courts, as courts of equity and pursuant to Section 105(a), have the ability during these extraordinary times to take a more flexible approach.

This clearly is an evolving trend that should continue for at least the duration of the pandemic and perhaps beyond, as bankruptcy judges and practitioners seek out creative and unique responses to difficult issues. Landlords, commercial mortgage lenders, and other affected parties are well-advised to engage constructively with tenants and utilize whatever tools are available to avoid the possibility of court-ordered rent deferral/abatement in Chapter 11.

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Reprinted with permission from the September 21, 2020 issue of the New York Law Journal. © 2020 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved. For information, contact 877-257-3382 or reprints@alm.com or visit www.almreprints.com.