Commentary: Bankruptcy can provide landlords a safe harbor from retail storm
Robert S. Marticello
A federal bankruptcy court approved the $5.2 billion sale of Sears' assets to ESL Investments, the hedge fund owned by Sears' chairman and former CEO Eddie Lampert. However, prior to Sears' bankruptcy filing, it had begun the process of shedding stores. With each passing month, reports surfaced that Sears was closing more and more unprofitable stores, and the retailer shuttered additional locations once the bankruptcy case was filed.
Sears may be the largest retailer to file for bankruptcy protection, but it is certainly not alone. A number of well-known brands, including Sports Authority, RadioShack, Toys “R” Us, Brookstone, Gymboree and Payless ShoeSource, have all commenced bankruptcy cases. Moreover, retailers' attempts to reorganize have largely failed, resulting in going-out-of-business liquidations and store closings by the hundreds.
While retail companies grab the headlines, landlords across the country have been left holding the bag. As landlords well know, bankruptcy allows lessees to reject, i.e., break, unexpired leases for unwanted locations, leaving the landlords with an unsecured claim in the bankruptcy case.
Vacancies created by the retail industry meltdown have been staggering, and commercial property owners are faced with the challenge of filling the space vacated by one anchor tenant when other retailers are reducing, not expanding, their store count.
For property owners, this period of transition can cause a cash crunch and debt to mount. Commercial properties are burdened by secured debt. The principal amount of the loan and the required debt service payments were likely based on the rental income a property is expected to generate when occupied. Even a temporary drop in rental income can make it difficult to service existing secured debt, which can trigger the threat of foreclosure.
Bankruptcy is a tool that can help commercial property owners weather this storm.
First, bankruptcy provides a welcome breathing spell by immediately halting collection actions by creditors, from lawsuits to demand letters. During this respite, a company can develop a game plan and survey its options. Companies can look for new sources of cash to refinance existing debt and consider whether to reorganize its operations or sell its real estate. Bankruptcy can provide time to raise additional capital to make necessary improvements. Many landlords are re-developing their properties in order to change with consumer tastes. Landlords have turned to entertainment-based tenants, such as, restaurants, virtual reality experiences, theaters, gyms and the like.
Second, bankruptcy can reduce secured debt and modify the interest rate. Under the bankruptcy code, a secured claim is measured by the collateral that secures it. That is, the amount of a loan that is treated as "secured" in a bankruptcy case is based on the value of the collateral. For example, if and to the extent a loan is secured by commercial property that has declined in value due to a drop in rental income or otherwise, then the amount of the loan will be reduced to equal the new, reduced property value. The amount of the loan over and above the value of the collateral is treated as an unsecured debt. In addition, only creditors owed secured debt are entitled to interest after the commencement of a bankruptcy case and the interest must be at a market rate. Thus, to the extent a company's debt is accruing interest at an above-market rate, it can be reduced.
Third, bankruptcy allows a company to develop a plan for the repayment of its creditors. This allows a company to stretch payments out over time and tailor the amount and timing of payments to the company's expected cash flow. Proposed payments can take into consideration the time necessary to complete renovations or redevelopment. Secured creditors must be paid in full, albeit based on the value of the collateral and with interest at a market rate. Typically, a company must pay only a percentage of its unsecured debt. Both secured and unsecured creditors can be paid within a reasonable amount of time. While certain requirements must be satisfied in order to obtain court approval of a plan, generally speaking, a company need not obtain the approval or consent of all its creditors.
Retail bankruptcies cause a chain reaction and no party may be impacted more than the landlords whose properties are vacated. But it is important to bear in mind that it is not only retail tenants who can utilize the bankruptcy code to their benefit. Bankruptcy can provide useful tools to commercial property owners in financial need. In particular, bankruptcy can provide property owners with time, the ability to adjust their liabilities to the economic realities created by the loss of key tenants, and an opportunity to re-position for the future.
Robert S. Marticello is a founding partner at the insolvency and bankruptcy law firm Smiley Wang-Ekvall, LLP in Costa Mesa, Calif. (The opinions expressed are those of the author and do not necessarily reflect the views of the firm or its clients. This article is for general information purposes and is not intended to be and should not be taken as legal advice.)