With the caveat that this post may become moot minutes after it’s posted, the first question that came to my mind following Sears’ recent chapter 11 filing—which was coupled with news that the company would shutter 142 stores (a number that may double by a November 1 DIP financing deadline for a second round of “store rationalizations”)—was whether there would be a forthcoming effort to generate some cash by auctioning off some of those leases. In its first-day motion to approve going out of business (GOB) sales procedures, Sears indicated it would retain the right to market and possibly monetize its GOB leases at some point down the road. But the company’s DIP financing seems to mandate “rejection” of additional GOB leases in a “Secondary Store Rationalization.”
The master list of stores slated for closing will probably be a mixed bag of undesirable/impossible to re-lease spaces in B and C malls and, perhaps surprisingly, some quantum of valuable locations in malls with significant upgrade potential and much higher rents. According to CNN Business, many of Sears’ long-term leases burden landlords with rents that are sometimes a third of what the current market will bear in redevelopment scenarios, especially in hotter suburban markets. Sears-heavy landlord Seritage Growth Properties, for example, has a history of re-letting former Sears properties for 3.5 to 4.5 times the rent Sears was paying.
So how can a retail tenant in a bankruptcy possibly control, let alone monetize, a defaulted lease for a premises that it clearly no longer intends to occupy or rent? What say, if any, does a landlord have in this situation? And why would a new tenant pay a premium of any kind for a dark Sears store?
For the uninitiated, the answers to these very reasonable questions have perplexing or arguably outrageous answers, all of which are rooted in the special protections afforded retail lessees under section 365 of the Bankruptcy Code.
Section 365 contains a laundry list of complex and nuanced rules for dealing with a debtor-tenant’s commercial real estate leases—including the “rejection,” “assumption,” and third-party “assignment” of leases. With respect to third-party assignment, the crux of these rules is the debtor-tenant’s right to assign the lease to a new tenant over the landlord’s objection (and without regard to whether the lease prohibits assignment), provided various technical requirements are met. These assignment rules are even more nuanced if the debtor is a tenant in a “shopping center”; i.e., the retail tenant cannot simply assume a lease, or assign it to a new tenant, over the landlord’s objection, without demonstrating that the new tenant meets various radius, tenant mix, use and other retail/mall-specific covenants that are in the debtor’s existing lease (this is a very broadstroke summary).
When the 365 assignment right is combined with an inventory of below-market leases, as it may (may) be in the Sears case, you have the perfect storm necessary for a lease auction: there will presumably be a market for long-term leases with below-market rents that landlords can’t increase, and some segment of that market will be willing to pay an upfront fee/premium for the privilege.
We last saw this type of retail lease auction in the Toys R Us earlier this year. In that case, auction procedures permitted landlords with back rent claims to credit bid their back rent balances; i.e., a landlord with months of back rent would have an advantage at auction.
Will Sears head down this road? There is a significant question as to whether Sears truly has any auction-worthy GOB properties, even if it closes every remaining store: some analysts think all Sears stores slated to close will be worthless. Indeed, vendor reclamation claims are on the rise, and a total GOB shutdown may be the only endgame.