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Even though the statutory requirement for payment of all post-petition lease obligations is clear and unambiguous, the question arises: How is it that landlords in chapter 11 bankruptcy cases � and particularly, in the large retail cases that occupy the bankruptcy courts every year � find themselves trapped in involuntary servitude to debtors who continue to use a leased location, generate income from that use, and then stiff the landlord for significant amounts of rent? Despite the protections afforded by Congress, commercial landlords often become, at best, involuntary lenders and, at worst, charitable donors of free commercial space. All too often, post-petition rent obligations are not paid in full. Prior to the adoption of 11 U.S.C. 365(d)(3) in 1984, commercial landlords had to seek payment of post-petition rent as an administrative expense claim. This meant that landlords were only entitled to the reasonable value of the debtor’s actual use and occupancy of the property. In addition, even if such an administrative expense claim was allowed, it might not be paid until the end of the case. This could mean a delay in payment of months, if not years. And if the case was administratively insolvent, it would mean no payment at all. Section 365 of the code requires a bankruptcy trustee or debtor-in-possession to fulfill all of the obligations that arise under a nonresidential lease of real property between the day the bankruptcy petition is filed and the day the lease is assumed or rejected. On its face, this is a formidable coat of statutory armor designed to protect commercial landlords. In reality, the statutory armor provided by Congress is not as effective as the clear language of the code would lead the uninitiated to believe. Numerous chinks in the armor can be exploited by the debtor and by other parties in a bankruptcy case to the disadvantage of commercial landlords. The prudent landlord is proactive in attempting to plug these judicially created chinks, through which landlords routinely bleed millions of dollars onto the bankruptcy battlefield every year. Despite being clothed with statutory armor, a commercial landlord must heed the first rule of engagement: Know thine enemy. Timing Is Everything One of the first points of vulnerability for a commercial landlord is the timing of the filing of a chapter 11 case. The code requires that debtors pay post-petition rent. But what is post-petition rent? Suppose the lease provides that rent is due on the first day of the month and the debtor files on the 10th day of the month. How much of the rent is a prepetition claim and how much is a post-petition obligation that must be paid by the debtor? Initially, courts considering this seemingly simple question after the 1984 amendments applied the so-called “accrual method” to prorate lease obligations during the month in which the bankruptcy filing occurred. Using our example, rent for the first 10 days of the month would be a prepetition claim and rent for the remainder of the month will be a post-petition rental obligation that must be paid under �365(d)(3). More recently, some courts taking a closer look at the statutory language have determined that an argument that has been made by landlords for years has validity. Simply stated, the argument is that when Congress said the debtor “shall timely perform all obligations of the debtor arising under the lease,” it actually meant that the debtor is required to fulfill lease obligations as they arise and when they arise. For example, the Third U.S. Circuit Court of Appeals held in In re Montgomery Ward Holding Corp., 268 F.3d 205 (2001), that this “billing date approach” should be used in determining what constitutes a post-petition rental obligation. Under this approach, if an obligation arises under the terms of a lease after the bankruptcy is filed, it constitutes a post-petition obligation, regardless of the fact that the obligation may have “accrued” prepetition. In the Montgomery Ward case, the court addressed the issue of real estate taxes, the payment of which first became due under the lease after the bankruptcy was filed, but which accrued during the prior tax year. The court held that if the lease first required payment of the tax obligations after the bankruptcy was filed, it is a post-petition lease obligation that must be paid under �365(d)(3). Turning a shield into a sword, debtors have now used the Montgomery Ward decision to their advantage. You can bet the family farm that a major retail bankruptcy case will not be filed on the first of the month. Rather, debtors now wait until the second or third day of the month to file. Why? Some retail cases involve hundreds or even thousands of locations, most of which have leases with rent due on the first of the month. Debtors can capitalize on the substantial savings created by deferring hundreds of thousands of dollars in rent by filing after the rent becomes due under its monthly leases. If a lease provides that rent is due on the first of the month and the debtor files on the third of the month, payment of rent will not be required under �365(d)(3) until the first day of the following month. The rent from the filing date through the end of the month is an administrative claim in the bankruptcy case. However, administrative claims do not have to be paid on a “pay as you go” basis, but can be held until the conclusion of a case. Thus, a debtor can enhance its cash flow at the expense of its landlords simply by filing at a point in the month after rent is due under most of its leases. Thus, in a large retail case, a debtor can defer significant post-petition rental obligations for several months, or even years, until the confirmation of a plan of reorganization. If the case converts to a chapter 7 liquidation, landlords may be left holding a chapter 11 administrative claim, which will only be paid after chapter 7 administrative expenses are paid. Judicial Scale Tipper Despite the unambiguous language of the code and the clear interpretation of that language by the Third Circuit in Montgomery Ward, some bankruptcy judges seem to have no hesitancy about pulling out the sword of Solomon and wielding it against commercial landlords. Unfortunately, these judges fail to remember that in the biblical story, Solomon never cuts the child in two, since the natural mother agrees to give up her child in order to save its life. In contrast, some judges swing away, slicing through the landlords’ statutory protections while the debtor continues to use their property without full payment of the rent. The court acts to tip the scales of equity in favor of the debtor, despite the fact that Congress has already weighed the equities and frozen the balance between debtor and landlord through statutory language. There is rarely legal justification provided for such judicial scale tipping. Rather, some courts realize that landlords will be guided by the economic realities of the case. Particularly in cases where liquidation sales are being conducted and partial rent is being paid by professional liquidators, it simply makes economic sense for landlords to take what they can get, rather than file emergency appeals and seek stays in an attempt to halt the incredible inertia of a case in which hundreds of stores and millions of dollars in inventory are being liquidated on an expedited basis. In these cases, landlords know they are being shortchanged and that the court is ignoring the law. Yet, they are forced to go along based on a realistic cost-benefit analysis. Courts recognize this and use the economic disincentives against stays and appeals to benefit the debtor. This is a disturbing trend, which is said to be based on “equitable considerations,” but which ignores the maxim that equity must follow the law. In their quest to do equity for the benefit of the debtor, some bankruptcy judges simply ignore the statutory requirements in favor of the practical realities of the case. So, even though Congress says you should get paid doesn’t mean you actually get paid. The Grabbing Lender One might think that a landlord in a complex retail chapter 11 case need not be too concerned about the terms of post-petition financing provided by debtor-in-possession (DIP) lenders, since a post-petition lending package means that money will be coming into the case. The assumption might be that since the code requires that landlords be paid post-petition rent, an infusion of money must benefit the landlords. Working on such an assumption would be ill-advised. First, it is often the case that budgets related to the use of cash collateral or post-petition lending simply do not include any provision for the payment of post-petition rent. The reason for this is that �365(d)(3) is a statutory mandate without an automatic enforcement mechanism: It is incumbent upon a landlord to make an affirmative request to the bankruptcy court by motion to compel a debtor to pay post-petition rent. In short, if the landlord does not ask, the debtor often does not pay. National and regional shopping center owners are sophisticated enough to retain experienced counsel early in the case. However, many smaller or single location landlords do not seek experienced counsel soon enough and they suddenly find themselves in a situation where post-petition rent has not been paid for months, their lease has been rejected, and they are left to file an administrative claim and hope for a payment at the end of the case. The claim may or may not be paid, since some cases become administratively insolvent, which simply means that there is not enough money in the estate to pay all administrative creditors in full. In addition, post-petition lenders have recently expanded the scope of their collateral to include an assignment of commercial leases from the debtor. In some cases, lenders have actually included in post-petition lending orders provisions that allow them to take control of leased retail locations and liquidate them as part of their collateral. Since the foreclosing lender is not required to pay rent under the code, this can put a landlord in a situation where it has a foreclosing lender � who is under no obligation to pay rent � waving a bankruptcy court DIP financing order and claiming that it has the right to control the leased property for some period of time while it is liquidated. It is difficult to see how a bankruptcy court can assume the jurisdiction to create a forced tenancy for the benefit of a post-petition lender. Nevertheless, this actually happened in a recent New Jersey retail chapter 11 case, and post-petition lenders are beginning to routinely ask for an assignment of leases. Landlords should carefully examine post-petition loan agreements and proposed DIP financing orders. The ‘GOB’ Juggernaut The usual reason for a retail bankruptcy filing is the need to reorganize through consolidating operations and disposing of unprofitable stores. This process often takes the form of a going-out-of-business (GOB) sale that is often run by a professional liquidation firm. Commercial landlords should be aware that most bankruptcy courts will not honor provisions in a commercial lease that limit the conduct of GOB sales on the premises. Courts will routinely override lease provisions that prevent signs, banners, advertising or other types of marketing associated with GOB sales. Landlords must take special care to monitor the procedures approved by the court with respect to GOB sales and the marketing of the leases themselves to third-party purchasers. Absent proactive participation in the case, a landlord may wake up to find a neon “Bankruptcy Sale” banner on the pylon sign outside of its strip mall. A lease in a shopping center or a “big box” location with a remaining lease term has an inherent value that can be marketed to third parties to create cash for the bankruptcy estate. In order to assume and assign a lease, all arrearages under the lease must be cured. However, debtors in large retail cases will routinely use a “negative notice provision” in a court-approved sale order to establish the cure amount due under a lease. For example, the debtor will send a notice to a landlord declaring that the cure amount to be paid by the third party purchasing the lease is $100, while the landlord believes that the outstanding arrearages are $1,000. Under the negative notice provisions, which are routinely approved by bankruptcy courts, unless the landlord objects in very short order it will be stuck with the $100 cure amount. If a landlord is not proactive, it may also be stuck with a new tenant who is not financially responsible and who creates tenant mix, tenant balance or restrictive covenant problems with other retail tenants in a shopping center. The code requires adequate assurance of future performance on the part of an assuming party and also requires that tenant balance and mix issues be considered in a shopping center environment. However, a court will consider none of these issues independently unless a landlord is proactive in the case and objects to the assumption and assignment of a lease. In addition, landlords may not even be dealing directly with the debtor, since courts allow the sale of so-called “designation rights.” This is a sale by a debtor, to a third-party liquidator, of the debtor’s statutory right to allow a third-party purchaser to take an assignment of retail leases. The sale of such rights is for a lump-sum payment of cash. The debtor gets a pile of cash to fund its bankruptcy case, while the liquidator holds the leased properties for some period of time, sometimes allowing stores to “go dark” while it markets the unexpired leases. Bankruptcy courts routinely override lease provisions that prevent a store from “going dark,” at least for some period of time, to assist the debtor or the liquidator in these marketing efforts. The Store Trasher Assuming no one wants to buy a retail lease and the GOB sale at the location is concluded, the lease for that location will be rejected. A number of concerns arise within this context. First, landlords must be extremely diligent to file a claim for rejection damages in a timely manner. Routinely, debtors will obtain a rejection procedures order from the bankruptcy court that requires rejection claims to be filed within a short period of time, usually 30 days. The debtor will often attempt to obtain an order allowing rejection retroactive to the date a notice is given. If this happens, the landlord could be held in limbo between the date a rejection notice is given and the date the property is actually surrounded, without the payment of rent. In addition, a debtor or a professional liquidator may leave the leased location in an unacceptable condition; unwanted inventory, furniture and fixtures may be left behind. The landlord is stuck with the job of cleaning up the location to prepare for a new tenant. Not only does this create an expense for the landlord � which may be pursued as an administrative claim under certain circumstances � but it also creates potential liability for the landlord. Equipment lessors and secured lenders may assert a claim to some of the furniture, fixtures or equipment left behind by a debtor or a liquidator. Landlords should make sure that provisions are included in the rejection procedures order entered by the bankruptcy court that allow them to dispose of personal property abandoned at the location and that will protect them against the claims of third parties. The filing of a large retail case can be correctly analogized to blitzkrieg. The debtor knows when and where it intends to file. The landlords find out after the first salvo is fired. The debtor has already made plans to dump off non-productive stores and has already obtained a professional liquidator who will coordinate the GOB sale and lease sale. All too often, unprepared landlords find themselves standing exposed before a rushing assault of cash collateral orders, post-petition financing orders, orders permitting GOB sales, sales of designation rights, the assumption and assignment of leases, and the rejection of unprofitable locations. Landlords should not enter this battle unprepared; they certainly should not assume that the 50-page order that the debtor seeks to have entered on three days notice does not apply to them. The best defense is a good offense. It is imperative for commercial landlords to be proactive in a bankruptcy case and to move aggressively to insist that the protections afforded by Congress are enforced by the bankruptcy court. Although some courts will fail to do so, landlords should attempt to aggressively protect their interests. Waldt is of counsel in the litigation department and is a member of the bankruptcy, reorganization and capital recovery group, the franchise and distribution group, and the transactional finance group at Ballard Spahr Andrews & Ingersoll of Voorhees.

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