Bankruptcy Courts Authorize Debtors to Defer Post-Petition Rent Payments Amid COVID-19 Store Closures

Historically, the interests of landlords whose commercial real estate is occupied by debtors in Chapter 11 proceedings have been generally well protected. Indeed, Section 365(d)(3) of the Bankruptcy Code requires the debtor to timely perform all of its post-petition obligations under its nonresidential leases of real property — most important among those, rent. Although the Bankruptcy Code permits a bankruptcy court, upon a showing of cause, to extend payment obligations that arise within the first 60 days of the case, it provides that the time for performance cannot be extended past the 60th day. As a result, landlords generally could expect the rent to be paid and to be paid on time.

However, in light of the recent COVID-19 mandated store closures, those historical expectations are being tested. For example, brick-and-mortar retailers whose operations have been shut down due to government-mandated closure orders are finding themselves without the revenue to pay rent and without lenders willing to finance the payment of rent during any shutdowns as part of emergency funding. As a result, some of these retailers have successfully petitioned the bankruptcy courts for relief from the Bankruptcy Code’s mandatory post-petition rent payment provisions.

Modell’s Sporting Goods

Modell’s Sporting Goods had just started conducting its going-out-of-business (GOB) sales when the COVID-19 executive orders forced the closure of its stores and, hence, the cessation of its GOB sales. Without the revenue to fund its post-petition rent obligations, Modell’s filed a motion with the New Jersey Bankruptcy Court pursuant to Sections 105 and 305 of the Bankruptcy Code, seeking an order temporarily suspending its cases, including its obligations to pay post-petition rent. In a series of orders and over the objection of numerous landlords, the Modell’s court granted the relief requested, effectively suspending Modell’s obligations to pay post-petition rent at least through May 31. In so ruling, the court recognized that the suspension of Chapter 11 cases (and of a debtor’s obligations to pay post-petition rent) is an extraordinary remedy, but that “there is no question that these are extraordinary times.”

At the request of the landlords, the court mandated that the parties (i.e., Modell’s, its landlords and its secured creditors) participate in mediation to, among other things, resolve how to address the landlords’ claims going forward, including the provision of adequate protection for the landlords. In so holding, the court recognized that all parties need to “share the pain” and that (a) the ability to surcharge the prepetition lenders collateral under Section 506(c) of the Bankruptcy Code for the costs of preserving or disposing of that collateral had not been waived and (b) the landlords were free to seek additional (nonmonetary) relief if the circumstances require it.

Pier 1 Imports

Similarly, Pier 1 Imports filed a motion seeking authority to temporarily cease making post-petition rent payments during a “limited operations period” resulting from the COVID-19 shutdowns. The Bankruptcy Court for the Eastern District of Virginia granted the relief requested over the objections of landlords. The court found that Section 365(d)(3) of the Bankruptcy Code does not give the landlords a right to compel payment in accordance with the terms of the underlying leases. Rather, to the extent that Pier 1 is obligated to pay rent and fails to timely pay such rent, the Pier 1 landlords are entitled to an administrative expense claim that must be paid on the effective date of any plan of reorganization. The court noted that “[t]o compel payment by the Debtors now would be to elevate payment of rent to the [landlords] to superpriority status, i.e., a claim that would be paid before all other accrued but unpaid administrative expense claims.”

Additionally, the court found that, to the extent adequate protection is required, the continued payment by Pier 1 in the ordinary course of certain related nonrent payments under certain of the leases (e.g., triple net leases), such as insurance payments, security obligations and utility payments, as well as assurance of cure payments after the limited operations period, is sufficient adequate protection for Pier 1’s landlords. However, the court did not authorize any adequate protection payments to landlords that are directly responsible for insurance, taxes, utilities and maintenance under their respective leases.

Other Cases

The extent to which other debtors, in and out of retail cases, will seek and successfully obtain relief from their post-petition rent obligations remains to be seen. For example, a purchaser of assets out of the Forever 21 bankruptcy proceeding sought relief from the bankruptcy court that would allow it to delay surrendering property that is subject to rejected leases without paying post-petition rent accruing during that delay. The Bankruptcy Court for the District of Delaware concluded that its equitable powers did not permit it to circumvent the mandate of Section 365(d)(3) of the Bankruptcy Code. So long as the purchaser, standing in the shoes of Forever 21, remained in possession of the leased premises, it was required to pay post-petition rent.

Likewise, along with its Chapter 11 petitions, J. Crew filed a motion seeking an extension of the time in which it must pay its post-petition rent obligations arising during the first 60 days of its bankruptcy cases, while reserving the right to seek further extensions. Various objections to the motion have been lodged by landlords and the official creditors committee, distinguishing J. Crew from Modell’s and Pier 1. Generally, the objections contend, among other things, that unlike Modell’s and Pier 1, J. Crew (a) is operating some stores and other stores will be opening soon as restrictions get lifted throughout the country, and (b) is not liquidating but rather is pursuing a Chapter 11 confirmation plan with adequate post-petition financing. A hearing is currently scheduled for May 21.

Takeaway

Suffice it to say that these are extraordinary times, and the bankruptcy courts may be sympathetic to the financial challenges facing a debtor that, by government order, is unable, in whole or in part, to operate its business or otherwise generate sufficient revenue to pay its rent. In cases that are administratively solvent (i.e., there is sufficient value to pay all post-petition creditors), the issue is essentially one of timing. That is, the question is when will the rent be paid, not if the rent will be paid.

However, in cases where administrative insolvency is a real threat, the risk to landlords becomes apparent. We expect the issue of adequate protection for the landlords to be at the forefront of those cases. Precisely what form that adequate protection will take may depend on the facts and circumstances and could include (a) the ability to surcharge secured lenders’ collateral under Section 506(c) of the Bankruptcy Code; (b) the ability to compel assumption/rejection of the underlying leases; (c) the lifting of the automatic stay to permit termination and/or eviction; and (d) cash payments for taxes, utilities, insurance and maintenance.

Notwithstanding the foregoing, what the cases have yet to address to date is precisely what obligations must be paid. That is, do the debtors have defenses under applicable state law, such as force majeure, frustration of purpose, impossibility and the like? The debtors have generally reserved rights with respect to that question, which will very much depend on the facts and circumstances of each case and each lease.