Shifting bankruptcy laws

Unlike previous slowdowns, when a company could emerge from bankruptcy court as a healthier and leaner version of its old self, the example of more than two dozen high-profile retailers over the past year shows that, more often than not, the path to a bankruptcy filing is a swift and jarring road to liquidation.

When Richmond, Va.-based Circuit City Stores filed a petition in U.S. Bankruptcy Court under Chapter 11 of the Bankruptcy Code last November, executives first shut 155 stores. They kept the doors open at 567 superstores, but those efforts weren't enough. On Jan. 5, the company asked the court's permission to put the chain up for sale.

After two potential investors expressed interest and negotiations started, landlords across the country hoped that the tenant chain might survive under a new owner. But no deal occurred by the Jan. 16 court deadline, and Circuit City took steps to liquidate its assets. Acting president James Marcum expressed his disappointment, saying, “The company had been in continuous negotiations.”

Changes to the federal bankruptcy law in 2005 made it tougher to emerge from Chapter 11, says Shapiro of Greenberg Traurig. The changes reduced the time for retailers to decide which leases to reject.

“They have a very powerful right to walk away from leases with minimal damages,” Shapiro says. Another development is the new clout of junior lien holders such as hedge funds. Some of the liens stem from mezzanine loans, he adds. “In a lot of these cases you end up finding that the junior lien holders have the fulcrum position in the bankruptcy case, and they are pushing for quick sales of these companies.”

Falling dominoes hurt landlords

When stores close and chains stop growing, projects started before the recession may be unable to attract renters, while existing centers can't keep key tenants.

When a big retailer shuts an unprofitable store, the lease agreements of remaining tenants frequently give them the right to pull out of the shopping center without penalty. Called co-tenancy clauses, they can be devastating for landlords and may even push an owner into bankruptcy, says real estate attorney Irwin Fayne, a partner at Holland & Knight in Fort Lauderdale, Fla.

Landlords may persuade the tenant to stay by reducing rent or offering more space. But if one co-tenant pulls out, others may follow, says Fayne. “You could wind up with a house of cards. As one card falls, a few more fall, and eventually there's a collapse.”

For bargain hunters, distressed landlords spell opportunity. “I think this is one of the greatest times to be buying underperforming shopping centers of the last decade or two,” says Brad Hutensky, general partner of Hutensky Capital Partners, based in Hartford, Conn. Hutensky raised $100 million to snap up distressed properties over the next two years, and expects an internal rate of return of 20% to 30%.

Shapiro believes the problems in retail herald a worrisome new phase for other commercial real estate sectors. “I think that later this year you'll start to see more commercial office towers, industrial properties and the like move into a much more troubled state.”

Denise Kalette is senior associate editor.