Restructuring

OVERVIEW

In a recent decision, In re Le Tote, Inc., No. 20-33332-KLP, 2020 Bankr. LEXIS 3044 (Bankr. E.D. Va. Oct. 30, 2020), the Bankruptcy Court for the Eastern District of Virginia held that a trust that holds a commercial mortgage backed securities (“CMBS”) loan to certain landlords, secured by those landlords’ leases with a chapter 11 debtor, could not compel the debtor to pay rent to its landlords when the trust held no rights under the relevant lease agreement. With more and more retail stores filing for bankruptcy because of the general decline in brick-and-mortar retail, which has been exacerbated by the impact of the COVID-19 pandemic, disagreements between landlords and their lenders have proliferated. While landlords may be concerned with the long term survival of their tenant’s business, lenders to those landlords may care more about receiving the payments due under their loans. Practitioners should be aware that, absent a specific provision in the lease agreement, or foreclosure on the leased properties by the lender, landlords generally hold the exclusive right to collect rent from tenants and exercise certain rights in the tenants’ chapter 11 cases.

BACKGROUND

In July 2015, the landlords of twenty-four properties being leased by retailer Lord & Taylor (the “Landlords”) executed a loan agreement (the “Loan”) with several lenders (the “Original Lenders”). The Landlords pledged the leases and rents due under the lease agreement for the properties (the “Master Lease”) as collateral for the Loan.

Lord & Taylor was not a party to the loan agreement or any of its supporting agreements. However, in conjunction with the Loan, Lord & Taylor executed a Subordination, Non-Disturbance and Attornment Agreement (“SNDA”) where it acknowledged its understanding that rents due for twenty-four of its stores were serving as collateral for the Loan. The SNDA provided that all rent due to the Landlords was to be paid to a lockbox to which the Original Lenders would have access.

In November 2015, the Original Lenders securitized the Loan and assigned their right, title, and interest in the Loan to an investment trust (the “Trust”), which was appointed to serve as trustee for holders of the CMBS.

In April 2020, after the breakout of COVID-19 and the closure of thousands of retail stores nationwide, Lord & Taylor stopped paying rent. A few months later, in August 2020, Lord & Taylor filed for chapter 11 protection. With the future of the Loans backing the CMBS put into question, the Trust filed a motion with the Bankruptcy Court seeking standing to enforce the Master Lease and compel debtor Lord & Taylor to pay rent. 

ANALYSIS

Interestingly, no one questioned whether the Trust had party in interest standing under section 1109(b) of the Bankruptcy Code. Accordingly, the issue was purely one of whether the Trust had any legal right to enforce the Landlords’ right to payment under the Master Lease. 

The Trust’s first argument was that the execution of the SNDA gave it the right to enforce the Master Lease. Specifically, the Trust claimed that creation of the lockbox, an account typically intended to protect lending parties from events of default, allowed it to compel the payment of rent. The court disagreed, however, that the creation of the lockbox allowed the Trust to step in the shoes of the Landlords. The Master Lease specifically stated that Lord & Taylor would not be required to fulfill “any obligation to make payments of debt service…” owed by the Landlords to their lenders. The court stated that the Trust was conflating its right to receive unpaid debt service payments from the Landlords under the Loan – amounts that Lord & Taylor cannot be held responsible for under the terms of the Master Lease – with the Landlords’ right to collect rent from Lord & Taylor. If the Trust wished to step in the shoes of the Landlords, then the first step would have been to foreclose on the collateral backing the Loan – a step it failed to take prior to filing the motion.

The Trust then argued that it could enforce rental payments due under the Master Lease because it was a third-party beneficiary of that agreement. The Master Lease provided that Lord & Taylor “shall not take any action [that] would constitute a violation, breach or default of any of the terms of the” Loan. The Trust claimed that this provision made it a third-party beneficiary of the Master Lease. On this point, the court looked to New York law (which governed the Loan), noting it allows third parties to enforce a contract in two situations: (1) “when the third party is the only one who could recover for the breach;” or (2) “when it is otherwise clear from the language of the contract that there is an intent to permit enforcement by the third party.” Dormitory Auth. of the State of N.Y. v. Samson Constr. Co., 30 N.Y.3d 704, 710 (2018) (internal citations omitted). Here, the court found neither requirement to be satisfied. First, the court found that only the Landlords were afforded remedies under the Master Lease in the event of a breach. Second, nowhere in the Master Lease was the Trust provided the right to collect rent. Rather, the Master Lease provided that “[Lord & Taylor] will pay [rent] to Landlord” in a manner that “Landlord from time to time may designate.” Accordingly, the court disagreed with the Trust’s contention that it was a third-party beneficiary of the Master Lease.

The Trust’s third argument was that its rights as a secured creditor under U.C.C. § 9-109(a) allowed it to enforce the Master Lease. Despite § 9-109(d)(11), which states that Article 9 does not apply to “an interest in or lien on real property,” the Trust argued that the Master Lease was not only a real property lease, but also a contract that contained general rights and intangibles. In support of this theory, the Trust cited § 9-109(a)(11)(D), which provides an exception for agreements involving mixed security interests that cover both real and personal property. The Trust then argued that it was seeking not to enforce rights in real property, but only the contractual rights afforded to it by the Master Lease. The court was unpersuaded by this argument, noting that the Trust cited no case law in support of its reading of Article 9. Instead, the court chose to follow the plain language of § 9-109(d)(11) which expressly excludes interests in real property from the provisions of Article 9.

Finally, the Trust attempted to argue that it held legal title to the rents owed by Lord & Taylor by virtue of the assignment of rights the Original Lenders received and assigned to it when it purchased the Loan. In disputing this, the court agreed with the holding in In re S. Side House, LLC, 474 B.R. 391 (Bankr. E.D.N.Y. 2012), where the Bankruptcy Court for the Eastern District of New York found that when an assignment of rents acts as additional security, the lender has a lien on the rents, but title to the rents remains with the borrower. Here, the assignment of rents contemplated under the Loan was intended to act as collateral for that Loan. Because the assignment was strictly for security purposes, the court found that the Trust did not have title in the rents.

The court’s decision was also impacted by important practical considerations. It noted that for a debtor to have a meaningful opportunity to reorganize under chapter 11, it must be able to approach creditors and have meaningful conversations regarding the future of its business. If a debtor is unsure which party has the final authority to commit to a resolution, then necessary conversations that could advance the debtor’s reorganization efforts may never take place. Here, the court noted that debtors would be “in an untenable position” if both landlords and their lenders had authority to take action.

CONCLUSION AND TAKE-AWAY

The court, therefore, concluded that while the Trust had the right to participate in Lord & Taylor’s bankruptcy as a “party in interest” pursuant to § 1109(b), it did not have the right to compel Lord & Taylor to pay rent. Until the Trust established itself as a controlling party under the Master Lease, only the Landlords had standing to enforce the agreement. It is important for lenders and holders of CMBS not to confuse the right to collect debt service payments from borrowers that are landlords with the generally exclusive right of landlords to collect rent from tenants that may be debtors. If a lender having a security interest in lease payments does wish to play landlord, then the first step would be to initiate a foreclosure action with respect to its collateral should it have the right to do so under the applicable loan agreement. This would allow the lender to step in the shoes of the landlord and determine itself how best to deal with tenants in default. However, even before signs of borrower distress, lenders could theoretically attempt to ensure their rights under the lease agreements between their landlord-borrowers and their tenants by drafting those documents to provide lenders with those clear rights. This would help provide a lender with options in a situation where borrowers fail to take action against delinquent tenants. The lesson is clear and simple – parties should draft documents clearly to make sure they have the rights they need in particular situations.