DLA Piper

USA May 24 2021

The COVID-19 pandemic created unprecedented disruptions across the global economy, perhaps most severely in the retail sector. Shelter-in-place orders, government-mandated closures and other restrictions drastically reduced or entirely wiped out revenue streams, resulting in an increased number of bankruptcy filings by retail debtors.

While bankruptcy generally provides a breathing spell from creditors, debtors usually must continue paying rent to landlords. To help address cash flow and liquidity issues caused by the pandemic, some debtors have sought to defer their commercial lease obligations, including rent, in addition to attempting to invoke force majeure clauses and/or the “frustration of purpose” doctrine. These efforts have achieved mixed success.

A. Section 365(d)(3) of the Bankruptcy Code1

Section 365(d)(3) of the Bankruptcy Code generally requires that debtors remain current on lease obligations during bankruptcy, subject to a limited exception that allows the court to defer obligations for 60 days after the petition date upon a showing of cause.2,3

Prior to the COVID-19 pandemic, section 365(d)(3) had been most thoroughly discussed in the context of stub rent, including whether a debtor could defer paying stub rent until confirmation of a plan.4 In a leading case, the Circuit City5 court ruled that stub rent is a post-petition obligation entitled to treatment as an administrative expense of the bankruptcy estate, but that it did not have to be paid at the beginning of the case under section 365(d)(3). Instead, debtors could pay stub rent upon plan confirmation, with other administrative expenses.

The court noted that while section 365(d)(3) requires a debtor to timely perform post-petition lease obligations, the obligation to pay stub rent arose before the bankruptcy filing, when the monthly rent came due. The court noted that the Bankruptcy Code provides no express remedy for failing to comply with section 365(d)(3), including nothing that would elevate a landlord’s claim to “super-priority” status requiring immediate payment before other administrative expenses.

B. Pier 1 Imports

One of the first cases to address lease obligations during the pandemic was In re Pier 1 Imports.6 Pier 1 Imports filed for Chapter 11 bankruptcy on February 17, 2020. The debtors initially anticipated only minor disruptions due to the virus’s impact on Chinese suppliers. The court wrote, “No constituency in these cases predicted that the world would effectively grind to a halt.”7 By the end of March, however, the company was forced to close nearly all its retail outlets due to stay-at-home orders and mandated closures of non-essential businesses.

Pier 1 filed a motion asking to pay only “critical expenses,” such as insurance, utilities, and security, for a “Limited Operations Period.” During that period, certain landlords would not receive rent, notwithstanding the terms of the leases or section 365(d)(3). Not surprisingly, numerous landlords objected.

The court granted Pier 1’s motion and allowed the debtors to defer paying rent. The court extensively discussed the unprecedented nature of the pandemic, described as “a temporary, unforeseen, and unforeseeable glitch in the administration of the Debtors’ Bankruptcy Cases.”8 Recognising the “extraordinary nature of the relief” it was granting, the court relied on the broad equitable powers granted by section 105(a) of the Bankruptcy Code.9 The court acknowledged the apparent inconsistency with section 365(d)(3), but found, in reliance on the former Circuit City decision, that section 365(d)(3) does not provide a separate remedy if a debtor cannot comply with its rent obligations. The court concluded that failing to pay rent does not result in a super-priority claim that must be paid immediately, but only an administrative expense.

Critically, the court noted the lack of a realistic alternative – Pier 1 could not generate sufficient revenue to pay rent because it was prohibited from opening its stores, and it could not liquidate inventory while the stores were closed. The court noted that landlords were the only objectors, though lenders, thousands of furloughed employees, and suppliers were also negatively affected.

At least one other court, in Bread & Butter Concepts, fully adopted the reasoning from Pier 1 and granted similar relief.10 In that case, the court similarly noted that only landlords had objected, and found that the “unprecedented circumstances require temporary relief to preserve the Debtors’ opportunity to benefit from the reorganisation afforded by Chapter 11.”11

C. CEC Entertainment

On the other end of the spectrum, in December 2020, the court in In re CEC Entertainment Inc. ruled that section 365(d)(3) prohibits rent deferrals.12 The debtors operated a nationwide chain of Chuck E. Cheese venues, and had filed for bankruptcy on June 24, 2020. In early August, the debtors filed a motion to abate rent payment for 141 locations that continued to be impacted by governmental orders or regulations.

The CEC debtors presented three arguments: (1) sections 365(d)(3) and 105(a) give the court equitable power to alter post-petition rent obligations (i.e. the Pier 1 argument); (2) government orders eliminating or reducing operations triggered force majeure clauses in the leases; and (3) debtors should be relieved from paying rent by the “frustration of purpose” doctrine. By the time of the court’s ruling, the debtors had reached agreement with all but 6 landlords.

The court denied the motion, holding that section 365(d)(3) unambiguously requires timely performance of all lease obligations during bankruptcy. The court found that it could not grant relief that directly violated a provision of the Bankruptcy Code. In rejecting the “broad equitable powers” arising under section 105(a) argument, the court noted that such powers are not unlimited. Rather, section 105(a) only authorizes “bankruptcy courts to fashion such orders as are necessary to further the substantive provisions of the Code.” Because the motion directly contradicted section 365(d)(3), the court could not approve lease deferrals. The court expressly disagreed with the holding in Pier 1, though noted that such disagreement was perhaps only “on the margins.” The court also rejected the debtors’ force majeure and frustration of purpose arguments under applicable state law and the terms of the relevant leases.

D. Conclusion

These cases are just two examples of how courts and restructuring professionals have sought to address the continuing impact of the pandemic on retail operations for companies in bankruptcy. Many cases involve consensual agreements between the affected parties that did not require the court to make a substantive decision. These issues will continue to develop as the long-term impact of the pandemic continues to be addressed through ongoing bankruptcy cases.

DLA Piper – Aaron Applebaum


Source: https://www.lexology.com/library/detail.aspx?g=ec726ef0-f986-470e-8d3e-d03e693b7b46&utm_source=Lexology+Daily+Newsfeed&utm_medium=HTML+email+-+Body+-+General+section&utm_campaign=Calbar+business+section+subscriber+daily+feed&utm_content=Lexology+Daily+Newsfeed+2021-05-26&utm_term=

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