E-Commerce vs. Brick and Mortar: Buying and Selling Shopping Centers in DistressReal Estate Update Article
Declining sales by large brick-and-mortar stores are a harbinger of the challenges facing shopping center owners. The continued popularity of e-commerce shopping creates additional pressure on the retail business model. As retailers continue to close locations, landlords will be compelled to seek alternatives to fill a significant amount of vacant space. However, finding replacement tenants is becoming more difficult. Subdividing a space to attract multiple tenants is one strategy, but it may cause a reduction in foot traffic for the remaining stores. Recently, some owners have converted their premises for residential use, adjusting the business model to a residential/commercial mix (which presents unique challenges, including picking an experienced partner in the residential space).
Unfortunately, some owners may need to seek financial relief for their property, which can take place in or out of court. The capital structure for the property may dictate which route to pursue, or the key players might have a preference as to how the ownership and debt structure should be modified. Class B and C malls can be especially pressured, and if workouts are not feasible, a reorganization under Chapter 11 of the United States Bankruptcy Code (the “Bankruptcy Code”) may provide relief.
There are two ways to implement a Chapter 11 proceeding: the easy way and the hard way. Going into the case with a pre-baked, pre-solicited plan of reorganization (the “Plan”) is always the preferred option. Modifying the debt structure (as to amounts, repayment terms, and interest) and possibly the ownership structure can be accomplished within the confines of the Plan. Transfers of real estate or ownership interests under the Plan can also generate savings by way of the transfer tax exemption under the Bankruptcy Code (this method was used for the iconic “Lipstick” building in New York City).
The majority of bankruptcy cases are made more cumbersome by third-party judgments or significant disputes between owners and lenders. However, all is not lost, as the Chapter 11 process can provide a methodology for right-sizing the property in a relatively short period of time. Section 363 of the Bankruptcy Code allows the debtor to sell its property outside of a Plan. Ordinarily, the court will establish the procedures for the sale, which usually include execution of a non-disclosure agreement, completion of due diligence, submission of bids under an approved form of sale agreement (which is subject to change by the bidders and acceptance by the owner and lenders), and an auction if there are multiple bidders. The entire process can, depending upon numerous factors, be completed in 30 to 60 days, if all goes well. The preference is to initiate the sale process with a “stalking horse bid,” which will be subject to higher and better offers by other bidders. Since a stalking horse bid is used to generate greater value for the debtor, if a higher bid prevails, the stalking horse bidder is generally entitled to a “break-up” fee (usually equal to a percentage of the sale price). However, these sales can be complicated by a mortgage lender’s rights under Section 363(k) of the Bankruptcy Code. That section allows such a lender to credit bid its “allowed claim” at the auction, so that it can either become the owner of the property and avoid the foreclosure process, or put pressure on other bidders at the auction to increase their bids. Yet many commentators and even some judges have expressed concern that this option may “chill” the bidding process, depending upon the amount of the allowed claim when compared to the value of the real estate.
It is also important to note that the owner’s ability to jettison under-market leases may be limited. Section 365(h) of the Bankruptcy Code provides that if a landlord rejects a lease of non-residential real property, then the tenant may either 1) treat the lease as terminated and vacate the premises, or 2) remain in the premises for the balance of the term, including any renewals, and continue to pay rent. If the tenant elects to stay and pay, the landlord may stop providing services, but the tenant may offset against its rent the damages it incurs as a result of the landlord’s nonperformance. The question as to whether a Section 363 sale of the property, free and clear of liens and claims, trumps a tenant’s holdover rights (under Section 365(h)) after its lease has been rejected is very much in flux, depending upon the jurisdiction, so extreme caution should be exercised if the buyer expects the tenant to vacate the space upon closing.
The Chapter 11 Plan process does not need to be treated separately from a Section 363 sale process. If time and other factors permit, the sale under the Plan can be very beneficial. The Bankruptcy Code (Section 1123) allows for a Plan to provide for the sale of property free of liens. If the sale is accomplished “under” the Plan, then the parties can get the benefit of the transfer tax exemption. Those savings can be significant, depending on the transfer tax rate and the value of the property, but there is a cost to conducting the sale under the Plan (both in legal fees and costs to keep the case alive). In addition, a Plan can only be confirmed if certain classes of creditors are paid in full and, if the kitty is empty after payment of the creditors’ claims, then the plan route may not be available, leaving the sale process as the only viable option.
The authors were recently involved in a case where the stars aligned, In re: Fountains of the Boynton Associates, Ltd. (Southern District of Florida), concerning a shopping center located in Boynton Beach. The sale was accomplished under a confirmed Plan, which allowed a pre-confirmation auction process. There were over seven qualified bidders and the lender had an agreed-upon cap to its ability to credit bid, so all of the bidders knew going into the auction the range for the lender’s bidding.
In the final analysis, more bankruptcy filings by owners of shopping centers can be expected as the e-commerce onslaught continues, and the use of the Chapter 11 process may prove to be one of the most effective means of overcoming the challenges confronted by owners.
© 2017 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.