Collecting Post-Petition Rent from Bankrupt Tenants

Now that most states have lifted their moratoria on commercial evictions, tenants strapped by COVID-19 losses are increasingly seeking refuge in bankruptcy courts. But while the automatic stay buys tenants some time to decide whether to reject their lease, tenants in bankruptcy still have to pay their rent within 60 days. At least, that’s how it works in normal times. But since the COVID-19 crisis began, bankruptcy courts have bent the rules to relieve tenants from their so-called post-petition rent obligations. Here’s a look at this troubling trend and how to avoid getting burned.

Scene Shifts to Bankruptcy Courts

When the pandemic first began, state and local governments around the country issued stay-at-home and shutdown orders to enforce social distancing. While it helped prevent the virus from spreading, keeping people at home also prevented retailers, restaurants, and other commercial tenants from generating the business revenues they needed to pay their landlords. Luckily for tenants, eviction moratoria and the shutdown of the judicial system stymied landlords from enforcing the lease.

As businesses and courts reopen, the battleground is shifting to the bankruptcy courts, where tenants have always enjoyed legal protections vis-à-vis their landlords and other creditors. The starting point is that when a tenant (debtor) files for chapter 11 bankruptcy, it gets 60 days to decide what to do with its lease. The tenant has three options:

The so-called “automatic stay” bars landlords and other creditors from suing the tenant until it makes its decision. The saving grace for landlords is that Section 365(d)(3) of the Bankruptcy Code requires the tenant/debtor “to timely perform all [lease] obligations” at the end of the 60-day period.

But the normal rules don’t apply during a pandemic. Thus, while we’re still in the early stages of the crisis, the initial cases suggest that bankruptcy courts will be reluctant to hold tenants affected by COVID-19 to their usual Section 365(d)(3) post-petition rent obligations.

The ‘Timely’ Rent Pause Button: The Modell Case

Since March, there have been several significant COVID-19 cases favoring retail or restaurant tenants. The first involves New York-based sporting goods chain Modell’s, which filed for chapter 11 bankruptcy on March 11. Original plan: Hold going-out-of-business sales to liquidate inventory and use the proceeds to pay off landlords and other creditors by mid-April. But days after filing, state and local shutdown orders forced Modell’s to stop store sales. The question was how this unprecedented situation would impact the bankruptcy case.

On March 27, the New Jersey court cited the company’s inability to carry out the proposed sales in “suspending” Modell’s bankruptcy for 34 days under Section 305(a) of the Bankruptcy Code, which allows the bankruptcy court to suspend a bankruptcy case in the best interest of the debtor and creditors. Notably, the court said Modell’s could abate rent beyond the Section 365(d)(3) 60-day limit. With stores still closed beyond the extension date, the court would go on to suspend the case twice more.

The Pier One Case

The Modell’s case quickly became a trend as other retail and restaurant tenants affected by state and local shutdown orders sought their own bankruptcy pauses. For example, a Virginia bankruptcy court paused Pier 1’s bankruptcy case ruling that the retailer was “authorized to temporarily defer making. . . rental payments to landlords who have not voluntarily consented to a rent deferral.” According to the court, “COVID-19 presents a temporary, unforeseen, and unforeseeable glitch” and that, given retailers’ strained circumstances, it would be unfair to require Pier 1 to allocate its already-scarce resources to landlords, as opposed to other creditors [In re Pier 1 Imports, Inc., No. 20-30805 (KRH), Docket No. 493 (Bankr. E.D. Va. Apr. 2, 2020)].

Other Tenant Bankruptcy Cases Put on Hold for COVID-19

Other cases where a bankruptcy court relied on Section 305(a) to hit the pause button for retail and restaurant tenants impaired by COVID-19 shutdown orders have occurred in:

• Texas, In re J. C. Penney Co. Inc., Case No. 20-20182 (DRJ) [Docket No. 721] (Bankr. S.D. Tex. June 11, 2020);
• Delaware, In re CraftWorks Parent, LLC, No. 20-10475 (BLS), Docket No. 217 (Bankr. D. Del. Mar. 30, 2020);
• Kansas, In re Bread & Butter Concepts, LLC, Case No. 19-22400 (DLS) [Docket No. 219] (Bankr. D. Kan. May 15, 2019).

From Rent Pause to Rent Relief: The Hitz Case

Tough as they were for landlords to swallow, those early cases were about when, not whether tenants had to pay their post-petition rent. A recent case out of Illinois raises the stakes, with the tenant claiming that COVID-19 didn’t simply extend but totally excused its post-petition rent obligations.

The seeds were sown when a restaurant group in chapter 11 failed to pay its post-petition rent, citing the force majeure clause of the lease. The landlord asked the bankruptcy court for permission to evict the tenant for violating its Section 365(d)(3) duty. And, thus the stage was set for the first litigation over what has become arguably the biggest question in all of commercial leasing at the present time: Does a force majeure clause excuse a tenant’s obligation to pay rent?

The clause at issue included the following language:

Landlord and Tenant shall each be excused from performing its obligations or undertakings provided in this Lease, in the event, but only so long as the performance of any of its obligations are prevented or delayed, retarded or hindered by . . . laws, governmental action or inaction, [or] orders of government . . . Lack of money shall not be grounds for Force Majeure.” [Emphasis added.]

The case turned on the interpretation of two key phrases:

“Orders of government.” The tenant noted that it had to shut down after the governor of Illinois issued an executive order suspending all on-premises consumption of food and beverage. As a result, it claimed the executive order was a force majeure event triggered by the “orders of government” language.

“Lack of money.” The landlord claimed the force majeure clause didn’t apply because the tenant’s failure to perform was due to the “lack of money.”

Finding itself in the position of having to apply state law to interpret the terms of a lease, the federal bankruptcy court sided with the tenant. The executive order “hindered” the tenant’s performance, the court acknowledged. But the scary part is how far the court had to go to torture the lease language to interpret in the tenant’s favor.

The reason the tenant couldn’t perform wasn’t “lack of money” but because the executive order limited its ability to operate. As a result, the “lack of money” limitation didn’t apply and the tenant could invoke the force majeure clause. The landlord, which must have been stunned by the court’s reasoning, contended that the tenant could have gotten the money to pay rent by applying for a Small Business Administration loan. But the court brushed that argument aside because nothing in lease said that the party affected by a government action had to apply for such a loan.

The Consolation Prize

The landlord didn’t walk away empty-handed. The court noted that the executive order applied only to on-premises consumption and still permitted curbside pickup and delivery services. Using the tenant’s own evidence demonstrating that the ban on on-premises consumption rendered 75 percent of the restaurant space unusable, the court found the remaining 25 percent could have been used for curbside pickup and delivery. As a result, it concluded that force majeure clause excused only 75 percent of its post-petition rent and the tenant still had to pay the 25 percent balance [In re Hitz Restaurant Group, No. BR 20 B 05012, 2020 WL 2924523 (Bankr. N.D. Ill. June 3, 2020)].

Impact on You

Tenant bankruptcies put landlords in a highly difficult position. But at least in the past, landlords could count on getting the post-petition rent after 60 days. That may no longer be the case, at least when dealing with tenants affected by COVID-19. It’s important for landlords to recognize that the general willingness to suspend the normal rules and protect commercial tenants has apparently seeped into the bankruptcy courts. The specific impact of this is that landlords can no longer rely on the usual Section 365(d)(3) post-petition rent safety net.

Two Ways to Protect Yourself

Here are two things you can do to protect yourself from this “new normal.”

1. Be prepared for post-petition rent delays. First, recognize that the normal timetables may not apply and that there’s a risk that bankruptcies may be paused. The potential for a pause is especially significant as COVID-19 cases resurge and new rounds of shutdown orders loom. Result: It may take much longer than 60 days to collect post-petition rent from tenants in chapter 11, and you should be prepared to factor these additional delays into your short- and medium-term financial plans.

2. Recognize the risk of right to receive post-petition rent at all. A delay isn’t even the worst thing that can happen to your post-petition rent. The Hitz case illustrates the willingness of bankruptcy courts to invoke the force majeure clause of the lease to excuse some or all of a tenant’s obligation to pay post-petition rent at all. Of course, this same risk pertains not only to bankruptcy but the other state and federal courts you may rely on to enforce your lease against a tenant that hasn’t paid rent due to COVID-19.