LEGISLATIVE UPDATE Designation RightsA New Post-BAPCPA World

Journal Issue

Feb 2006

Column Name

Legislative Update

Citation

ABI Journal, Vol. XXV, No. 1, p. 10, February 2006

Bankruptcy Code

365

Topic Tags

Executory Contracts/Leases

Legislation

Practice and Procedure

Journal HTML Content

Though this question may have been debatable several years ago,1 a debtor’s
ability to sell to a third party the estate’s right to market, assume
and assign an unexpired lease of nonresidential real property—what has
come to be called “designation rights”—is now a permanent
fixture in large chapter 11 cases of retailers and other multi-location debtors.
With the passage of the Bankruptcy Abuse Prevention and Consumer Protection
Action of 2005 (BAPCPA), however, there are new timing and substantive limitations
on a debtor’s ability to assume and assign a nonresidential real property
lease. This article addresses these new “rules of engagement” for
disputes between multi-location/big box retail debtors and landlords.
 The Foundation for Designation Rights
 Designation Rights are essentially “the right to direct the debtors
to assume and assign...unexpired leases...to third parties qualifying under
the Bankruptcy Code,” after the intermediary purchasers holding that right
of direction locate the ultimate third-party purchaser/assignee of the unexpired
lease. In re Ames Depart-ment Stores Inc., 287 B.R. 112, 114 at n.2 (Bankr.
S.D.N.Y. 2002). The actors are thus generally (1) the buyer of the designation
rights, who will locate (2) a successor tenant-designee to take assignment of
the lease, which will occur when the buyer locates this successor and thereafter
directs (3) the debtor to make a motion to assume under §365 or, more commonly,
a process is pre-approved by the bankruptcy court for the delivery of “notice
of designation” to the landlord, the receipt of which triggers a shortened
time period for the landlord to object to the assumption-and-assignment and
request a hearing before the bankruptcy court.

The permissibility of the sale of designation rights is essentially settled
law. Although the highest court to address the issue is a Bankruptcy Appellate
Panel (BAP), the sale of designation rights has been repeatedly approved in
at least 15 instances (see Ames, 287 B.R. at 117) and in all reported
decisions that have addressed the issue. See In re Ernst Home Ctr. Inc.,
209 B.R. 974 (Bankr. W.D. Wash. 1997), appeal dismissed, BC Brickyard Assoc.
Ltd. v. Ernst Home Ctr. Inc. (In re Ernst Home Ctr. Inc.), 221 B.R.
243, 248-56 (BAP 9th Cir. 1998) (Russell, J. concurring).
 The bases for the sale of designation rights, in short, come from the ability
of the debtor to sell rights of value that are estate property. Under §363(b)
of the Code, the debtor, “after notice and a hearing, may use, sell or
lease, other than in the ordinary course of business, property of the estate.”
Innumerable cases have found that unexpired leasehold interests are property
of the estate. See, e.g., 48th St. Steakhouse Inc. v. Rockefeller
Group Inc. (In re 48th St. Steakhouse Inc.), 835 F.2d 427, 430 (2d
Cir. 1987) (“the courts are in agreement that unexpired leasehold interests...
constitute property of the bankrupt estate”), cert. denied, 485 U.S. 1035
(1988). It thus derives also from §541 jurisprudence concerning the extent
of “property of the estate.” Congress, in enacting §541, wished
to “bring anything of value that the debtors have into the estate.”
Official Comm. of Unsecured Creditors of Prudential Lines Inc. v. PSS S.S.
Co., 928 F.2d 565, 573 (2d Cir. 1991). Thus “property of the estate”
is broad, and includes even strictly contingent interests. See Mid-Island
Hosp. Inc. v. Empire Blue Cross and Blue Shield (In re Mid-Island Hosp.
Inc.), 276 F.3d 123, 128 (2d Cir.), cert. denied, 123 S.Ct. 104 (2002).

Designation rights are now a permanent part of the chapter 11 landscape. Congress,
however, has changed the procedural ground rules by targeted provisions in BAPCPA.
 BAPCPA Amendments Affecting Designation Rights
 1. New Assumption Time Limits. Section 365(d)(4), as amended by BAPCPA, provides
120 days for assumption of nonresidential real property leases, which may be
extended only for an additional 90 days. Any subsequent extension must be on
the consent of the lessor. §365(d)(4)(B)(ii).
 This timing limitation dramatically alters the ability for debtors to complete
a designation rights sales process without landlord input. In the past, in large
retail cases the bankruptcy courts granted (a) virtually an unlimited number
of extensions in which to assume or reject nonresidential real property leases,
and (b) periods of well over a year in which the property involved could remain
dark while an assignee was found, negotiated with and permitted to make any
necessary alterations/build out to the premises. Though debtors’ counsel
may believe the limitations on assumption are a congressional overreaction,
it is certainly retail debtors’ very success at obtaining essentially
open-ended extensions that brought renewed Congressional scrutiny.2
As the legislative history indicates, the amendment to §365(d)(4) “is
designed to remove the bankruptcy judge’s discretion to grant extensions
of the time for the retail debtor to decide whether to assume or reject a lease
after a maximum possible period of 210 days... Beyond that maximum period, the
judge has no authority to grant further time unless the lessor has agreed in
writing to the extension.” H.R. Rep. No. 109-31, pt. 1, at 86-87, reprinted
in 2005 U.S. Code Cong. & Admin. News 152-153.
 This constrained timing will have the practical effect of requiring debtors
to consult with and involve landlords in virtually all designation rights sale
initiatives, and also with respect to any complicated assumption and assignment.
This is because, given the time required to complete consummation of a designation
rights process (including marketing leases to potential assignees and performing
any major build out of a “big box” space), or even in a conventional
lease assignment and build-out undertaking, seven months will likely prove to
be a difficult and even impossible time frame for any multi-location or “big
box” premises-holding debtor. Thus, even ignoring the effect of the specific
provisions of BAPCPA that require strict enforcement of lease terms upon assumption
(discussed later in this article), it would appear that the era of retail debtors’
use of unilateral omnibus motions to assume and assign leases (with or without
a designation rights feature), seeking to “steamroller” undesirable
lease provisions and landlord opposition, is a thing of the past.
 Given this smaller window of time, (a) prudent debtors will make a more considered
focus pre-petition on real estate issues, and (b) some debtors will make mistaken
and/or premature assumption of leases.3 The best-prepared
debtors will make early, hard decisions, pre-petition, as to which failing/underperforming
locations are to be closed or turned around, rather than (as in the past) being
able to ride through the bankruptcy process hoping for a better holiday selling
season or a “white knight” designation-rights purchaser.

2. New Limitations on Invalidation of “Anti-Assignment” Provisions.
Many of the essential concerns for retail landlords are (1) lengthy periods
of nonoperation (particularly with shopping centers), (2) protection of landlord
rights to control premises alteration (including subdividing and signage), (3)
obviously collection of rent, as well as damages for rent reductions and lease
termination by other tenants (usually, again, in the shopping center context),
during the period of the debtor’s/designation rights purchaser’s
marketing of the lease, and (4) preserving landlord rights to object to the
identity (type or nature of business) and/or financial wherewithal of the successor
tenant who is proposed, and of future tenancies. In pre-BAPCPA cases, debtors
generally asked for, and very frequently received, bankruptcy court rulings
under §365(f) of the Code providing that none of the provisions in the
lease (or local law) that restrict nonoperation (“going dark”),
signage, use/tenant mix, premises alteration/subdividing, and future assignments
and subletting, were enforceable.4 Some debtors have
even obtained rather astonishing rulings “striking” provisions from
the lease. See, e.g., Rickel Home Centers, 240 B.R. at
832 (clause restricting premises use as home improvement store permanently stricken
from lease to permit office supply store use). From Congress’ strong reaction
embodied in BAPCPA, the perception was that some bankruptcy courts were rewriting
retail leases.
 From this sprung rather convoluted revised language in §365(b)(1)(A).
The first new clauses are effectively a legislative overruling of cases exemplified
by In re Claremont Acquisition Corp. Inc., 113 F.3d 1029, 1034-35 (9th
Cir. 1997), and In re Lee West Enter. Inc., 179 B.R. 204 (C.D. Calif.
1995), which held that historical defaults that are impossible to be cured (e.g.,
having “gone dark” pre-petition) at the time of assumption are a
bar to assumption. By the new language, BAPCPA provides that such historical
defaults need not be cured (recognizing that, even in bankruptcy, no one possesses
a time machine), but that the default cannot continue after assumption. Thus,
new §365(b) provides that any “failure to operate in accordance with
a nonresidential real property lease...shall be cured by performance at and
after the time of assumption in accordance with such leases, and pecuniary losses
from such default shall be compensated in accordance with the provisions of
this paragraph....” §365(b)(1)(A) (emphasis supplied); see,
also, H.R. Rep. No. 109-31, pt. 1, at 83, reprinted in 2005 U.S. Code
Cong. & Admin. News 149-50. Some debtors’ counsel may suggest that
the phrase “at and after” leaves maneuvering room for the timing
of assumption (e.g., to allow for a lengthy dark period), but the context
of the provision and legislative history appear to say strongly otherwise.

As part of BAPCPA, Congress also added a specific cross-reference to §365(b)
(as amended) within §365(f). This is clearly a legislative override of
the cases that sanctioned debtors’ aggressive invocation of §365(f)
to excise lease provisions that are only indirect impediments to the assignment
of leases (such as use provisions), and that are not outright anti-assignment
clauses prohibited by §365(f).5
 Conclusion
 BAPCPA has swung the pendulum of negotiating power in lease assumption and
assignment proceedings within a chapter 11 dramatically back toward lessors.
Where the selling of under-market leases and the subsequent premises build-out
is going to take longer than 210 days, the landlord’s permission will
have to be obtained. Where the proposed tenant is of a different nature, or
requires material signage alterations or subdividing, or needs other relief
from the lease for the assignment to work, landlord consent will be required.
Some debtors’ counsel have suggested that this is the end of multi-million
dollar designation rights deals that benefit unsecured creditors; landlords’
counsel contend that this merely gets them a seat on the chapter 11 train as
opposed to being tied to the tracks, and that the economic burdens are now more
fairly balanced (e.g., the economic cost of dark stores will not be borne
entirely by the lessor). It remains to be seen how much of the value in an under-market
lease will be bargained back to the landlord as part of settlements. That may
occur, but it is clearly Congress’ paramount intent to alleviate the full
onus on landlords, particularly in shopping centers, of open-ended lease assumption
“limbo” and what (in some instances) was effectively the re-writing
of leases in chapter 11.
<h3>Footnotes</h3>
1 See Taylor and Tiemstra, “‘Designation Rights’ Sales:
Triumph of Expedience over the Code?,” ABI Journal Sept. 2001.

2 Indeed, vacancies have been an issue for well over 20 years and were a specific
focus of prior amendments to §365. Shopping center landlords have asserted
for the past several decades that the limbo of endless extensions of the time
to assume or reject leases were destroying their businesses because (among other
things) it allowed smaller tenants to invoke rent reductions (from anchors going
dark) and the lessened traffic even caused smaller tenants to fold. At the time
of the consideration of the Code amendments enacted in 1984, members of Congress
pointed to the effect of the lack of any real deadline for assumption or rejection
in chapter 11 cases: The first problem which this bill would remedy is the long-term
vacancy or partial operation of space by a bankrupt tenant. [[T]enant space
has been vacated for extended periods of time before the bankruptcy court forced
the trustee to decide whether to assume or reject the lease. During this time,
the other tenants of the shopping center are hurt because of reduced customer
traffic in the shopping center.... The bill would lessen the problems caused
by extended vacancies and partial operation of tenant space by requiring that
the trustee decide whether to assume or reject a nonresidential real property
lease within 60 days after the order for relief in a case under any chapter.
The time period could be extended by the court for cause, such as in exceptional
cases involving a large number of leases.... If the lease is not assumed or
rejected within this 60-day period, or any additional period granted by the
court, the lease is deemed rejected and the trustee must immediately surrender
the property to the lessor. 
130 Cong. Rec. S8894-95, 98th Cong., 2nd Sess. (daily ed. June 29, 1984) (remarks
of Senator Hatch), reprinted in 1984 U.S. Code Cong. & Admin. News 576,
599.
3 Congress anticipated this by providing a limitation on administrative expense
priority for a nonresidential real property lease that is assumed and then subsequently
rejected. The priority amount is all monetary obligations due under the lease
(excluding penalties and obligations arising from or relating to a failure to
operate) for the two-year period following the rejection date or actual turnover
of the premises, whichever is later. Section 503(b)(7); H.R. Rep. No. 109-31,
pt. 1, 96, reprinted in 2005 U.S. Code Cong. & Admin. News 160-61. The remaining
sums are treated as a §502(b)(6) claim. Id.
 4 See, e.g., In re Rickel Home Centers Inc., 240 B.R.
826 (D. Del., 1998) (use clause permanently stricken from lease to permit office
supply store use; restriction on subdividing or altering the premises constituted
de facto anti-assignment clauses); In re Bradlees Stores, Case No. 00-16035
(Bankr. S.D.N.Y.) (order made unenforceable any lease provision that prohibits,
restricts or conditions alterations, additions and improvements (except for
structural alterations, limited to certain scheduled objecting landlords); premises
permitted to be dark for a year); In re Montgomery Ward LLC, et al., Case
No. 00-4667 (Bankr. D. Del.) (essentially same). In most of these cases, relief
was granted even before an assignee was identified, based on the debtors’
claim that marketing the leases would be difficult if any of these restrictions
were in place.

5 The legislative history is emphatic here: 
Section 404(b) amends §365(f)(1) to assure that §365(f) does not override
any part of §365(b). Thus, §404(b) makes a trustee’s authority
to assign an executory contract or unexpired lease subject not only to §365(c),
but also to §365(b), which is given full effect. Therefore, for example,
assumption or assignment of a lease of real property in a shopping center must
be subject to the provisions of the lease, such as use clauses. 
H.R. Rep. No. 109-31, pt. 1, at 87, reprinted in 2005 U.S. Code Cong. &
Admin. News 153.

Journal Authors

Robert N. H. Christmas

Journal Date

Wednesday, February 1, 2006 - 12:00

Bankruptcy Rule

2006

none