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Force Majeure Clause Triggered by Pandemic Shutdown Order Partially Relieves Chapter 11 Debtor from Timely Paying Postpetition Rent

With their doors closed by mandatory government shutdown orders in effect until most states started gradually reopening in May and June, many businesses have found it difficult or impossible to satisfy their lease obligations during the COVID-19 crisis. Businesses pushed into bankruptcy have increasingly looked to the courts for rent relief, even though the Bankruptcy Code expressly protect landlords' interests by requiring debtors to timely pay postpetition rent. However, in response to the extraordinary circumstances created by the pandemic, some courts are finding ways to provide at least partial relief to debtors in a way that attempts to protect landlord interests.

One example was the ruling handed down by an Illinois bankruptcy court in In re Hitz Restaurant Group, 2020 WL 2924523 (Bankr. N.D. Ill. June 3, 2020). In a matter of apparent first impression, the court addressed the impact of the pandemic on a "force majeure" clause in a contract, which clause generally relieves the parties from performing their obligations when certain circumstances beyond their control arise that render performance impracticable, illegal, inadvisable, or impossible. The bankruptcy court held that, because a government shutdown decree forced a restaurant to suspend on-premises dining, the force majeure clause in the restaurant's lease partially relieved the debtor from paying postpetition rent. However, because the debtor still generated income from takeout and delivery services during the shutdown period, the court concluded that the debtor was obligated to pay a portion (25%) of its obligations under the lease.

Payment of Non-Residential Real Property Lease Obligations in Bankruptcy Pending Assumption or Rejection

Under section 365(a) of the Bankruptcy Code, a trustee or chapter 11 debtor-in-possession ("DIP") may, with court approval, assume or reject any of the debtor's executory contracts or unexpired leases. Pending assumption or rejection, section 365(d)(3) of the Bankruptcy Code obligates the trustee or DIP to "timely perform all the obligations of the debtor … arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of [the Bankruptcy Code]."

Added to the Bankruptcy Code in 1984, section 365(d)(3) was intended to ameliorate the immediate financial burden borne by commercial landlords pending the trustee's decision to assume or reject a lease. Prior to that time, landlords were routinely compelled to seek payment of rent and other amounts due under a lease by asking the bankruptcy court for an order designating those amounts as administrative expenses. The process was cumbersome and time-consuming. Moreover, landlords' efforts to get paid were hampered by the standards applied in determining what qualifies as a priority expense of administering a bankruptcy estate. See generally Collier on Bankruptcy ("Collier") ¶ 365.04[1] (16th ed. 2020).

Section 503(b)(1) of the Bankruptcy Code provides that allowed administrative expenses include "the actual, necessary costs and expenses of preserving the estate." Rent payable under an unexpired commercial lease during a bankruptcy case falls into this category. See JN Med. Corp. v. Auro Vaccines, LLC, 597 B.R. 879, 898 (D. Neb. 2019). Even so, section 503(b)(1) has uniformly been interpreted to require that, in addition to being actual and necessary, an expense must benefit the bankruptcy estate to qualify for administrative priority. See Collier at ¶ 503.06. Prior to the enactment of section 365(d)(3), "benefit to the estate" in this context was determined on a case-by-case basis by calculating the value to the debtor of its "use and occupancy" of the premises, rather than looking to the rent stated in the lease. See, e.g., In re Bob Grissett Golf Shoppes, Inc., 50 B.R. 598, 607 (Bankr. E.D. Va. 1985), on reconsideration, 76 B.R. 89 (Bankr. E.D. Va. 1987). Moreover, even if a landlord's claim for postpetition rent was conferred with administrative expense priority, the Bankruptcy Code did not specify when the claim had to be paid.

Section 365(d)(3) was designed to remedy this problem. It requires a trustee or DIP to remain current on lease obligations pending assumption or rejection of a lease. Nevertheless, courts have struggled with the precise meaning of the provision. For example, courts disagree over whether the phrase "all the obligations of the debtor … arising from and after the order for relief" means: (i) all obligations that become due and payable upon or after the filing of a petition for bankruptcy; or (ii) obligations that "accrue" after filing the bankruptcy petition. The former approach is commonly referred to as the "performance" or "billing date" rule. Under the latter approach, which is sometimes referred to as the "proration" or "pro rata" approach, the portion of real estate taxes and other non-rent expenses that accrue prior to a bankruptcy filing but are payable postpetition need not be paid currently as administrative expenses pending a decision to assume or reject the lease. See generally Collier at ¶ 365.04[1].

Section 365(d)(3) has also been controversial in cases where the timing of a bankruptcy filing creates "stub rent." Stub rent is the rent that accrues during the period following the bankruptcy petition date until the next rent-payment date. For example, if a lease calls for the payment of rent on the first of each month, and the petition date falls on the 10th day of the month, assuming that rent was not paid prior to the petition date, the stub-rent period would be from the 10th day of the month through the end of the month. Because section 365(d)(3) requires current payment of obligations "arising from and after the order for relief," it could be argued that stub rent need not be paid under section 365(d)(3) because the payment was due prior to the petition date. Some courts have rejected this approach, ruling that section 365(d)(3) requires a debtor to pay stub rent on a prorated basis as part of its duty to "timely perform" its obligations arising under its unexpired leases. Other courts disagree, holding that stub rent need not be paid under section 365(d)(3). See generally Collier at ¶ 365.04[1][c].

Courts also disagree whether section 365(d)(3), rather than section 503(b)(1), is an appropriate basis for conferring administrative priority on (as distinguished from requiring performance of) a postpetition lease obligation. For example, in In re Goody's Family Clothing Inc., 610 F.3d 812 (3d Cir. 2010), the U.S. Court of Appeals for the Third Circuit ruled that section 365(d)(3) does not supplant or preempt section 503(b)(1). The court concluded that the DIP's use of the leased premises postpetition to produce income provided an "actual and necessary" benefit to the estate and that commercial landlords were thus entitled to stub rent as an administrative expense. Other courts have held that section 365(d)(3) provides authority to confer administrative status on a claim independent of section 503(b)(1). See, e.g., In re The Leather Factory Inc., 475 B.R. 710 (Bankr. C.D. Cal. 2012).

Hitz Restaurant

Hitz Restaurant Group ("Hitz") operates Giglio's State Street Tavern, an Italian restaurant and bar in Chicago. It leases the premises from The South Loop Shops, LLC ("South Loop"), which retained Kass Management Services, Inc. as its leasing agent (together with South Loop, the "landlord"). The lease provides that rent, common area maintenance fees, real estate taxes, and late fees (collectively, "rent") in the aggregate amount of approximately $16,000 are due on the first day of each month. A force majeure clause in the lease provides that:

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, orders of government …. Lack of money shall not be grounds for Force Majeure.

Hitz had not paid the full amount of the rent since before July 2019. The landlord served a notice of termination of the lease in December 2019 and sued to evict Hitz from the premises in January 2020. Hitz forestalled eviction by filing for chapter 11 protection in the Northern District of Illinois on February 24, 2020.

On March 16, 2020, an executive order issued by Illinois's governor went into effect to address the pandemic. It provided in part as follows:

Beginning March 16, 2020 at 9 p.m. through March 30, 2020 [later extended to April 30 and then May 29], all businesses in the State of Illinois that offer food or beverages for on-premises consumption—including restaurants, bars, grocery stores, and food halls—must suspend service for and may not permit on-premises consumption. Such businesses are permitted and encouraged to serve food and beverages so that they may be consumed off-premises, as currently permitted by law, through means such as in-house delivery, third-party delivery, drive-through, and curbside pick-up. In addition, customers may enter the premises to purchase food or beverages for carry-out[.] However, establishments offering food or beverages for carry-out, including food trucks, must ensure that they have an environment where patrons maintain adequate social distancing.

After Hitz failed to pay postpetition rent on the first of March and April, the landlord filed a motion on April 27, 2020, for relief from the automatic stay to evict Hitz from the premises unless Hitz immediately complied with section 365(d)(3) by paying past-due and future postpetition rent.

Hitz argued that its obligation to pay postpetition rent was excused by the force majeure clause triggered by the governor's executive order. The landlord countered that the clause did not apply because: (i) it was never triggered, as the order did not shut down the banking and postal systems, and Hitz was physically capable of writing and mailing rent checks; (ii) Hitz's failure to perform arose merely due to a "lack of money," which is expressly excluded from the scope of the clause; and (iii) Hitz could have paid the rent by obtaining a small business loan under the Paycheck Protection Program.

The Bankruptcy Court's Ruling

The bankruptcy court ruled that the force majeure clause was triggered by the governor's executive order but that Hitz was not totally relieved of its obligation under section 365(d)(3) to pay postpetition rent. In particular, the court explained, the order did not totally suspend all restaurant and bar operations but was limited to on-premises consumption. Like other restaurants, Hitz was still permitted to offer takeout, curbside pickup, and delivery service. For this reason, the court concluded that Hitz's obligation to pay postpetition rent under section 365(d)(3) should be reduced in proportion to the reduction of its ability to provide restaurant and bar services. Pending an evidentiary hearing on this issue, the court concluded preliminarily that, because approximately 75% of the leased restaurant space was rendered unusable by the executive order, Hitz's obligation to pay rent during the period that the order was in force should be correspondingly reduced.

The bankruptcy court rejected each of the landlord's arguments. Initially, it noted that contracts are enforced according to the terms under Illinois law, which provides that a force majeure clause will excuse performance only if the triggering event was in fact the proximate cause of nonperformance. The court characterized the landlord's contention that Hitz was physically capable of sending rent checks as a "specious argument … that lacks any foundation in the actual language of the force majeure clause of the lease." According to the court, the governor's executive order was the proximate cause of Hitz's failure to pay rent, rather than "lack of money." Finally, the court wrote that "[n]othing in the [force majeure clause or court decisions] requires the party adversely affected by governmental actions or orders to borrow money to counteract their effects."

The bankruptcy court accordingly directed Hitz to pay 25% of its obligations under the lease for the months of April, May, and June 2020 no later than June 16, failing which the stay would be lifted because of Hitz's failure to adequately protect the landlord's interest in the leasehold.

Outlook

In cases where an unexpired commercial real property lease contains a force majeure clause and the clause specifies "governmental action" as a triggering event, bankruptcy courts inclined to follow the approach adopted by the court in Hitz Restaurant may grant debtors some measure of relief (at least temporarily) during the pandemic from the obligation to make timely postpetition rent payments. It remains to be seen whether other courts will follow this approach, which may be essential to some debtors' prospects for reorganization.

Even in cases not involving a force majeure clause, bankruptcy courts have been willing to suspend, defer, or delay commercial rent payments due to COVID-19—generally exercising their broad equitable powers under section 105(a) of the Bankruptcy Code or in accordance with section 305(a), which allows the court to suspend all proceedings in a case. See, e.g., In re J.C. Penney Co. Inc., No. 20-20182 (DRJ) (Bankr. S.D. Tex. June 11, 2020); In re Craftworks Parent LLC, No. 20-10475 (BLS) (Bankr. D. Del. May 21, 2020); In re Bread & Butter Concepts, LLC, No. 19-22400 (DLS) (Bankr. D. Kan. May 15, 2020); In re Pier 1 Imports, Inc., 2020 WL 2374539 (Bankr. E.D. Va. May 10, 2020); In re Modell's Sporting Goods, Inc., No. 20-14179 (VFP) (Bankr. D. N.J. Mar. 27, 2020). Until the pandemic abates, more rulings like this are likely.

Finally, as in Hitz, landlords may argue that their interest in leased premises occupied by a debtor during a bankruptcy case is entitled to some form of "adequate protection" under section 361 of the Bankruptcy Code, which typically takes the form of periodic cash payments, additional or replacement liens, or an administrative expense claim designed to compensate for any diminution in value of a creditor's interest in property. In this case, a debtor-tenant would bear the burden of demonstrating that something other than immediate cash payments of rent satisfies this requirement. See, e.g., Pier 1, 2020 WL 2374539, **6-7 (to the extent that adequate protection was required in connection with the court's issuance of an order temporarily suspending the payment of commercial rent during the "limited operations period" when their stores were closed due to stay-at-home orders, the debtors' continued payment of related non-rent expenses and assurance of cure payments in the future was sufficient to protect the lessors against any perceived diminution in value).

A version of this article is being published in Lexis Practice Advisor. It has been reprinted here with permission.

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