When Kmart, then the second largest discount retailer in the country, filed for reorganization under Chapter 11 bankruptcy in January 2002, many shopping center owners were taken aback. What was going to happen to the more than 2,000 stores the company operated at the time?

It turned out, those landlords had good cause to worry — they ended up enduring years of uncertainty before regaining their space because the bankruptcy code then in effect gave retailers an unlimited period of time to assume or reject their leases.

That is no longer the case. Two years ago, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 established a 210-day deadline for retailers to decide whether to retain or reject their leases. Previously, it had been left up to the judge whether to grant debtors unlimited extensions after the initial deadline period of 60 days. The new legislation prevents cases from dragging on for years and the 2005 Act also requires the landlord's consent if the tenant wants to assign the lease to a third party.

But shopping center owners should not be complacent, warns Patrick Maxcy, partner in the bankruptcy group of the international law firm Sonnenschein Nath & Rothenthal LLP. Since the courts want to see debtors reorganize, they will continue to favor tenants' rights over landlords'.

“Landlords already had very favorable provisions in the bankruptcy code [before 2005], but they have been treated poorly by the court very often,” Maxcy notes.

Because landlords rarely sit on the board of unsecured creditors, those creditors with no collateral often advocate for the leases to be sold to a third party so that they can get paid. And because any bankruptcy provisions in the lease become void once a bankruptcy actually occurs (to save the debtor from instant ruin), there is little landlords can do about it. Therefore, it is crucial that landlords try to protect themselves in advance, during the lease negotiations, with clauses that are not bankruptcy-specific.

In case of a bankruptcy, the best scenario for landlords is if the tenant decides to keep the lease and pays its overdue accounts, preserving the fiscal health of the property, Maxcy says. Instead, what often happens is that bankrupt retailers reject their leases outright or use designation rights to sell them to third parties, preventing landlords from taking control of the space until the leases run out.

“In cases like that there is an uncertainty, an interruption to the cash flow and if it triggers co-tenancy provisions, you may see a domino effect with other tenants going to minimum rent,” explains Scott Loventhal, director of development with Garden Commercial Properties, a Short Hills, N.J.-based real estate owner with more than 25 million square feet of retail and commercial space in its portfolio.

That's how the story played out in Kmart's case. Shortly after its 2002 bankruptcy filing, Kmart closed 283 of its 2,114 stores and sold a portion of the leases to Home Depot and Lowe's, as well as signing a $43 million transaction with the joint venture of Klaff Realty, Shottenstein Stores Corp. and Kimco Realty Corp. By 2003, another 317 locations were shuttered, prompting Kmart to seek the services of Kimco to market the stores to third parties and then split the profits. By the time Kimco found new tenants to occupy the spaces, almost three years had passed.

This year has so far been kind to landlords. The first quarter of 2007 posted only 743 store closings, according to the Retail Quarterly report from Merrill Lynch, the lowest number of closings in six years. Last year, the figure was 2,082. Since the first quarter usually accounts for 30 percent to 60 percent of annual store closings, there is hope that 2007 will continue as uneventfully as it started.

But there are some large national tenants that have been experiencing problems lately, including furniture sellers Pier 1 Imports and Bombay Company, Inc. and electronics retailers RadioShack and Sharper Image.

And in early May, Tweeter, which sells electronics through 153 stores nationwide, also announced that it will be closing 49 locations and is considering filing for bankruptcy. At the moment, the company does not have enough capital to pay for the store closings, its executives told the press.

Lawyers advise landlords to stick together in bankruptcy cases involving large national chains. The court could ignore one owner in favor of the unsecured creditors, but it won't be able to dismiss the claims of several companies working as a group.

“In a bankruptcy, landlords are in a defensive position but they have a tendency not to bend together,” notes Maxcy. “They should really consider whether it would make sense to work [as a team].”

Eventually Kmart reorganized and as of March 2007, operates 1,416 stores as part of the Sears Holdings Corp. However, the bankruptcy serves as a lesson to landlords on the many issues facing them in case a tenant goes bust.

To-do list

It's recommended that property owners conduct a thorough investigation of the tenant before entering negotiations. Such investigations should include credit reports and an analysis of the business plan for the location in question, says Mark Drogalis, vice president, legal with Edens & Avant, a Columbia, S.C.-based shopping center operator that owns 16.4 million square feet of retail space.

Many landlords ask for a cash security deposit in the amount of two months' rent, but what will make a big difference in a bankruptcy case will be letters of credit from third-party financial institutions — which will remain in effect if the tenant is declared bankrupt, according to Glen Rosenberg, vice president and general counsel with Menin Development Companies, Inc., a Palm Beach Gardens, Fla.-based firm that owns and manages 2.4 million square feet of retail space.

A rarely employed technique, according to Jay Welford, partner in the bankruptcy department of Southfield, Mich.-based law firm Jaffe Raitt Heyer & Weiss, P.C., is having a bankruptcy lawyer look over all new leases. The lawyers, he says, can anticipate which provisions have a good chance of being upheld by the court and can assist in drafting the most enforceable legal document.

The move might seem extreme in the case of a financially healthy national tenant, but there were instances in the past, including Kmart, Winn-Dixie and Toys “R” Us, where retailers went bust without warning. Kmart's financial troubles would not have been evident even if an exhaustive due diligence had been performed, Drogalis notes.

Landlords also need to identify all fees as “rent” in the lease agreement, since courts tend to be literal in their interpretation of legal documents, says Maxcy. In case of a bankruptcy, this will maximize the amount of money the landlord will recoup if the tenant decides to reject its leases because the landlord's compensation is counted in rent.

In addition, landlords should be as precise as possible when defining the tenant's use and financial position in the event a lease is assigned to a third party. As a result of the 2005 legislation, the new tenant would have to adhere to the same use and be fiscally comparable to the original tenant at the time of the lease signing. Welford suggests including the tenant's net worth in the lease so there can be no misinterpretation in court.

Landlords should also routinely monitor tenants' performance during the term of their occupancy. If signs of trouble are present, the landlord can approach the retailer before a bankruptcy is announced to work out a mutually beneficial agreement.

For example, Inland Real Estate Corp. employs a tenant relations team to identify distressed retailers and alert the leasing team to potential problems. There were instances when the Oak Brook, Ill.-based REIT, which owns and manages 14 million square feet of real estate in the Midwest, approached struggling tenants and offered to relieve them of their obligations. In many cases, according to Charles Cimorelli, vice president and director of leasing with Inland, they gladly accept the offer.