In the Spotlight: Retail Tenant Bankruptcies

Part of this scenario may seem out of place. Generally speaking, the automatic stay (Section 362 of the Bankruptcy Code) prevents creditors from taking certain actions against the debtor, so how is it that the contractors are allowed to record mechanics' liens after the debtor files its bankruptcy petition? Most courts find that mechanics' liens recorded post-petition to perfect the lien claimants' rights against and interests in the real property for pre-petition work fall within an exception to the automatic stay. See Sections 362(b)(3) and 546(b) of the Bankruptcy Code.

Moreover, once recorded (i.e., perfected) against the real property, the mechanics' liens are afforded the same priority as they enjoy in accordance with state law. If the debtor/tenant elects to assume the lease, the mechanics' liens must be “cured” (i.e., paid or otherwise satisfied or released). See Section 365(b) of the Bankruptcy Code. However, if the debtor/tenant rejects the lease, there is no cure obligation, and the debtor/tenant “walks away” from the construction project. Until recently, that meant the landlord would be left to settle with the lien claimants directly, and relegated to the class of unsecured creditors to seek reimbursement for the settlements payments, often recovering from the debtor/tenant only a fraction of what was paid to settle the mechanics' liens.

The Mervyn's Holdings Case

'In July 2008, Mervyn's LLC and various affiliates (collectively, the Debtors) filed Chapter 11 in Delaware. Prior to the bankruptcy (in January 2008), Mervyn's entered into a nonresidential real property lease with a landlord (the Lease), and agreed (among other things) to construct, open, and operate a Mervyn's department store in Southern California. Among its many provisions, the Lease also required the Debtors to indemnify the landlord for a multitude of claims, including mechanics' liens.

Construction of the store was never completed, and multiple mechanics' liens were recorded against the real property after the Debtors' bankruptcy filings because the Debtors failed to pay the general contractor (and others) for works of improvement. The general contractor also sued the landlord to foreclose the mechanics' liens. The Debtors ultimately rejected the Lease, but the landlord expended several million dollars to settle the mechanics' lien claims and the attendant litigation. The landlord subsequently moved in the bankruptcy case to obtain administrative priority treatment of its indemnity claims under Section 365(d)(3) of the Bankruptcy Code (“The trustee shall timely perform all the obligations of the debtor, except those specified in section 365(b)(2), 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 this title.”) and thus recover 100% of the mechanics' lien settlement payments from the Debtors.

Finding that the Debtors' indemnity obligations arose post-petition and prior to the rejection of the Lease, the Bankruptcy Court sided with the landlord, and required the Debtors to fully reimburse the landlord. WM Inland Adjacent, LLC v. Mervyn's, LLC (In re Mervyn's Holdings, LLC), Adv. No. 09-50920 (KG), 2013 WL 85169 (Bankr. D. Del. Jan. 8, 2013).

In seeking administrative priority for its claims arising from the Debtors' indemnity obligations, the landlord relied upon the Third Circuit's opinion in Centerpoint Properties v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 268 F.3d 205 (3rd Cir. 2001). Montgomery Ward held that Section 365(d)(3) of the Bankruptcy Code requires a debtor under a nonresidential real property lease to timely perform all obligations arising after an order for relief is entered but before the lease is rejected, even where the landlord's liability arose before the order for relief.

In Montgomery Ward, the debtor was required to pay real property taxes invoiced by the landlord post-petition even though they related to pre-petition periods because the debtor's obligation to pay the taxes arose post-petition. In Mervyn's Holdings, rather than real property taxes, the Debtors became obligated to indemnify the landlord when several mechanics' liens were recorded and the landlord was sued by the mechanics' lien claimants, all of which occurred after the Debtors filed their voluntary petitions and before the Lease was rejected.

The Montgomery Ward court noted that it is ultimately the terms of the lease that determine the Debtors' obligations and when they arose. Montgomery Ward, 268 F.3d at 209-210. In Mervyn's Holdings, the Lease contained expansive indemnity language:

Tenant shall indemnify, defend and save Landlord and any agent, beneficiary, contractor, manager, member, director, employee, lessor, mortgagee, officer, parent, partner, shareholder and trustee of Landlord (collectively the “Landlord Indemnified Parties, and each a “Landlord Indemnified Party”) harmless from and against any and all liabilities, suits, obligations, fines, damages, penalties, claims, costs, charges and expenses, including, without limitation, reasonable engineers, architects' and attorneys' fees, court costs and disbursements (“Losses”), which may be imposed upon or incurred by or asserted against Landlord or any Landlord Indemnified Party by reason of any of the following occurring prior to, during or after (but if after, then attributable to a period of time falling prior to or within) the Term:

'

(ii) any act or failure to act on the part of Tenant or any of its officers, agents, employees or licensees;

'

(v) any lien or claim which may be alleged to have arisen against or on the Premises from work being performed by Tenant (or anyone acting by, through, under or on behalf of Tenant), or any lien or claim which may be alleged to have arisen out work performed under this Lease by Tenant (or anyone acting by, through, under or on behalf of Tenant) and created or permitted to be created by Tenant against any assets of Landlord under any law for work being performed by Tenant (or anyone acting by, through, under or on behalf of Tenant), or any liability which may be asserted against Landlord with respect thereto;

(vi) any failure on the part of Tenant to keep, observe and perform any of the terms, covenants, agreements, provisions, conditions or limitations contained in any subleases affecting the Premises on Tenant's part to be kept, observed or performed;

'

(viii) any Default by Tenant.

The landlord relied upon Montgomery Ward and argued that the Debtors' indemnity obligations under the Lease were triggered either in September 2008 (when the mechanics' liens were recorded) or October 2008 (when the landlord was sued by the general contractor), and thus they arose post-petition and pre-rejection. As such, the landlord argued it was entitled to recover dollar-for-dollar what it paid to settle all of the claims arising from the mechanics' liens.

'In response, the Debtors argued (among other things) that the landlord's claims were mere general unsecured claims because the indemnity obligations arose when the Lease was executed (pre-petition). In support of that argument, the Debtors relied upon several cases involving executory contracts with indemnification obligations. Alternatively, the Debtors argued that the indemnity obligations related only to the pre-petition construction work. Thus, if the landlord had any claims at all, the Debtors argued they could only be general unsecured claims, and only payable on a pro-rata basis with all other unsecured creditors.

'The Mervyn's Holdings court found the cases relied upon by the Debtors unpersuasive because none involved a lease of nonresidential real property in a shopping center. More importantly though, the Mervyn's Holdings court held that while the conduct giving rise to the indemnity obligation occurred pre-petition, the Debtors' obligation to indemnify the landlord arose when the mechanics' liens were recorded and the general contractor sued the landlord to foreclose the mechanics' liens.

'In response to the Debtors' suggestion that the landlord had no claim against the Debtors until the landlord settled the claims with the general contractor, the Mervyn's Holdings court relied upon Montgomery Ward and pointed out the difference between a claim and an obligation: “In the context of section 365(d)(3), the relevant time is when an 'obligation' arises, which is different from when a 'claim' arises. The Court of Appeals for the Third Circuit distinguished a 'claim,' which is an 'unmatured right to payment,' from an 'obligation,' which is 'something one is legally required to perform under the terms of the lease.'” WM Inland Adjacent, LLC v. Mervyn's, LLC (In re Mervyn's Holdings, LLC), Adv. No. 09-50920 (KG), 2013 WL 85169, at *6 (Bankr. D. Del. Jan. 8, 2013).

Lessons for Landlords

For landlords, the Mervyn's Holdings court has not found (and most likely will not find) acceptance in proration jurisdictions. However, given the right indemnity language in its nonresidential real property lease, and a debtor filing its bankruptcy case in a billing date jurisdiction, the Mervyn's Holdings case provides a landlord with a powerful tool to minimize its losses associated with mechanics' liens, and maximize its recovery on a debtor's indemnification obligation.

Brian D. Huben is a partner in the Los Angeles office of Katten Muchin Rosenman LLP. His practice focuses on the representation of shopping center owners, developers, and managers as creditors in retail tenant bankruptcies, and in litigation in state and federal courts.

The Scenario: Shopping center landlords know it all too well. A prospective tenant expresses interest in leasing space at a shopping center. The landlord considers the prospective tenant a good addition to the tenant mix and balance at the shopping center. Negotiations follow. The tenant wants to build out its prototypical store. A letter of intent is signed. More negotiations take place. Multiple drafts of the lease are circulated. Perhaps, to close the deal, the landlord decides to give the tenant a construction allowance to offset the tenant's costs of building out the space at the shopping center. The lease is executed. Designs and plans are exchanged and approved. The tenant hires and executes a construction agreement with a general contractor. Permits are pulled. Construction begins. Draws are paid to the general contractor.

'And then ' the tenant files for bankruptcy. The work stops, the payments stop, and recordation of the mechanics' liens starts. In many states, even though the landlord has no contractual relationship with the general contractor (or, for that matter, the subcontractors, materialmen, or suppliers), the contractors who worked on construction of the tenant's store nonetheless have a right to record a lien against the landlord's fee simple interest in the property to secure payment for labor or materials supplied as part of the construction, or work of improvement. In this scenario, what remedies are available to a landlord?

The Mechanics' Liens

Part of this scenario may seem out of place. Generally speaking, the automatic stay (Section 362 of the Bankruptcy Code) prevents creditors from taking certain actions against the debtor, so how is it that the contractors are allowed to record mechanics' liens after the debtor files its bankruptcy petition? Most courts find that mechanics' liens recorded post-petition to perfect the lien claimants' rights against and interests in the real property for pre-petition work fall within an exception to the automatic stay. See Sections 362(b)(3) and 546(b) of the Bankruptcy Code.

Moreover, once recorded (i.e., perfected) against the real property, the mechanics' liens are afforded the same priority as they enjoy in accordance with state law. If the debtor/tenant elects to assume the lease, the mechanics' liens must be “cured” (i.e., paid or otherwise satisfied or released). See Section 365(b) of the Bankruptcy Code. However, if the debtor/tenant rejects the lease, there is no cure obligation, and the debtor/tenant “walks away” from the construction project. Until recently, that meant the landlord would be left to settle with the lien claimants directly, and relegated to the class of unsecured creditors to seek reimbursement for the settlements payments, often recovering from the debtor/tenant only a fraction of what was paid to settle the mechanics' liens.

The Mervyn's Holdings Case

'In July 2008, Mervyn's LLC and various affiliates (collectively, the Debtors) filed Chapter 11 in Delaware. Prior to the bankruptcy (in January 2008), Mervyn's entered into a nonresidential real property lease with a landlord (the Lease), and agreed (among other things) to construct, open, and operate a Mervyn's department store in Southern California. Among its many provisions, the Lease also required the Debtors to indemnify the landlord for a multitude of claims, including mechanics' liens.

Construction of the store was never completed, and multiple mechanics' liens were recorded against the real property after the Debtors' bankruptcy filings because the Debtors failed to pay the general contractor (and others) for works of improvement. The general contractor also sued the landlord to foreclose the mechanics' liens. The Debtors ultimately rejected the Lease, but the landlord expended several million dollars to settle the mechanics' lien claims and the attendant litigation. The landlord subsequently moved in the bankruptcy case to obtain administrative priority treatment of its indemnity claims under Section 365(d)(3) of the Bankruptcy Code (“The trustee shall timely perform all the obligations of the debtor, except those specified in section 365(b)(2), 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 this title.”) and thus recover 100% of the mechanics' lien settlement payments from the Debtors.

Finding that the Debtors' indemnity obligations arose post-petition and prior to the rejection of the Lease, the Bankruptcy Court sided with the landlord, and required the Debtors to fully reimburse the landlord. WM Inland Adjacent, LLC v. Mervyn's, LLC (In re Mervyn's Holdings, LLC), Adv. No. 09-50920 (KG), 2013 WL 85169 (Bankr. D. Del. Jan. 8, 2013).

In seeking administrative priority for its claims arising from the Debtors' indemnity obligations, the landlord relied upon the Third Circuit's opinion in Centerpoint Properties v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 268 F.3d 205 (3rd Cir. 2001). Montgomery Ward held that Section 365(d)(3) of the Bankruptcy Code requires a debtor under a nonresidential real property lease to timely perform all obligations arising after an order for relief is entered but before the lease is rejected, even where the landlord's liability arose before the order for relief.

In Montgomery Ward, the debtor was required to pay real property taxes invoiced by the landlord post-petition even though they related to pre-petition periods because the debtor's obligation to pay the taxes arose post-petition. In Mervyn's Holdings, rather than real property taxes, the Debtors became obligated to indemnify the landlord when several mechanics' liens were recorded and the landlord was sued by the mechanics' lien claimants, all of which occurred after the Debtors filed their voluntary petitions and before the Lease was rejected.

The Montgomery Ward court noted that it is ultimately the terms of the lease that determine the Debtors' obligations and when they arose. Montgomery Ward, 268 F.3d at 209-210. In Mervyn's Holdings, the Lease contained expansive indemnity language:

Tenant shall indemnify, defend and save Landlord and any agent, beneficiary, contractor, manager, member, director, employee, lessor, mortgagee, officer, parent, partner, shareholder and trustee of Landlord (collectively the “Landlord Indemnified Parties, and each a “Landlord Indemnified Party”) harmless from and against any and all liabilities, suits, obligations, fines, damages, penalties, claims, costs, charges and expenses, including, without limitation, reasonable engineers, architects' and attorneys' fees, court costs and disbursements (“Losses”), which may be imposed upon or incurred by or asserted against Landlord or any Landlord Indemnified Party by reason of any of the following occurring prior to, during or after (but if after, then attributable to a period of time falling prior to or within) the Term:

'

(ii) any act or failure to act on the part of Tenant or any of its officers, agents, employees or licensees;

'

(v) any lien or claim which may be alleged to have arisen against or on the Premises from work being performed by Tenant (or anyone acting by, through, under or on behalf of Tenant), or any lien or claim which may be alleged to have arisen out work performed under this Lease by Tenant (or anyone acting by, through, under or on behalf of Tenant) and created or permitted to be created by Tenant against any assets of Landlord under any law for work being performed by Tenant (or anyone acting by, through, under or on behalf of Tenant), or any liability which may be asserted against Landlord with respect thereto;

(vi) any failure on the part of Tenant to keep, observe and perform any of the terms, covenants, agreements, provisions, conditions or limitations contained in any subleases affecting the Premises on Tenant's part to be kept, observed or performed;

'

(viii) any Default by Tenant.

The landlord relied upon Montgomery Ward and argued that the Debtors' indemnity obligations under the Lease were triggered either in September 2008 (when the mechanics' liens were recorded) or October 2008 (when the landlord was sued by the general contractor), and thus they arose post-petition and pre-rejection. As such, the landlord argued it was entitled to recover dollar-for-dollar what it paid to settle all of the claims arising from the mechanics' liens.

'In response, the Debtors argued (among other things) that the landlord's claims were mere general unsecured claims because the indemnity obligations arose when the Lease was executed (pre-petition). In support of that argument, the Debtors relied upon several cases involving executory contracts with indemnification obligations. Alternatively, the Debtors argued that the indemnity obligations related only to the pre-petition construction work. Thus, if the landlord had any claims at all, the Debtors argued they could only be general unsecured claims, and only payable on a pro-rata basis with all other unsecured creditors.

'The Mervyn's Holdings court found the cases relied upon by the Debtors unpersuasive because none involved a lease of nonresidential real property in a shopping center. More importantly though, the Mervyn's Holdings court held that while the conduct giving rise to the indemnity obligation occurred pre-petition, the Debtors' obligation to indemnify the landlord arose when the mechanics' liens were recorded and the general contractor sued the landlord to foreclose the mechanics' liens.

'In response to the Debtors' suggestion that the landlord had no claim against the Debtors until the landlord settled the claims with the general contractor, the Mervyn's Holdings court relied upon Montgomery Ward and pointed out the difference between a claim and an obligation: “In the context of section 365(d)(3), the relevant time is when an 'obligation' arises, which is different from when a 'claim' arises. The Court of Appeals for the Third Circuit distinguished a 'claim,' which is an 'unmatured right to payment,' from an 'obligation,' which is 'something one is legally required to perform under the terms of the lease.'” WM Inland Adjacent, LLC v. Mervyn's, LLC (In re Mervyn's Holdings, LLC), Adv. No. 09-50920 (KG), 2013 WL 85169, at *6 (Bankr. D. Del. Jan. 8, 2013).

Lessons for Landlords

For landlords, the Mervyn's Holdings court has not found (and most likely will not find) acceptance in proration jurisdictions. However, given the right indemnity language in its nonresidential real property lease, and a debtor filing its bankruptcy case in a billing date jurisdiction, the Mervyn's Holdings case provides a landlord with a powerful tool to minimize its losses associated with mechanics' liens, and maximize its recovery on a debtor's indemnification obligation.

Brian D. Huben is a partner in the Los Angeles office of Katten Muchin Rosenman LLP. His practice focuses on the representation of shopping center owners, developers, and managers as creditors in retail tenant bankruptcies, and in litigation in state and federal courts.