Designation Rights Sales Triumph of Expedience Over the Code

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Sep 2001

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Last year was a tough one for Montgomery Ward. Sales were down and the Christmas
season was "make or break" for the company. Timing, being everything, was not on
its side. The economy, after years of growth, was slowing. Consumers, concerned
about the economy, scaled back their Christmas shopping.

The result was a lackluster holiday sales season and the death knell for retailers like
Montgomery Ward that were clinging to life. In the end, Montgomery Ward was forced
to file for chapter 11 protection in December 2000 and liquidate its holdings.
In re Montgomery Ward, D. Del., C.A. No. 00-4667 (2000).

Although Montgomery Ward had inventory and customer lists that were valuable, its
greatest assets were real estate holdings, both owned and leased. However, the
process of liquidating hundreds of real estate interests would be time-consuming and
costly. Montgomery Ward needed to find a way to sell its properties efficiently so
as to maximize the proceeds for the benefit of its creditors. To accomplish this,
Montgomery Ward proposed that it assign its interest in the properties to a so-called
"designated rights bidder"—in other words, a liquidator.

Bankruptcy Judge Raymond Lyons characterized the debtors' motion this way: "[M]y
understanding of the deal is that the properties of the debtor...[are] broken up
into two categories—fee-owned properties and leasehold interests—and [the liquidator] will
be acquiring the right to compel the debtor to sell fee-hold interests to a designated
purchaser and the right to compel the debtor to move to assume and assign leasehold
interest to assignees designated by [it.]" In exchange, the liquidator would pay
Montgomery Ward an up-front fee and share profits from the ultimate disposition of the
property. Montgomery Ward was free of the burden of selling off all the properties
itself, and it received a large up-front payment and the prospect of additional
payments upon sale. Allowing market forces to operate freely, the liquidator,
Montgomery Ward and the creditors would all benefit.

Montgomery Ward filed its "designated rights motion" in February 2001. Printed
and bound like an issue of Newsweek, the motion ran 58 pages. Buried in the
arguments supporting the motion were provisions to assist the "designated rights purchaser"
in the efforts to maximize the disposal of the properties. Any terms in the leases,
which in Montgomery Ward's estimation infringed on the ability to sell the lease, were
deemed "anti-assignment" clauses that the court should invalidate. "Going-dark"
provisions were at the forefront.

The speed by which Montgomery Ward sought this relief was extraordinary even by
Delaware standards—approximately two weeks from the filing of the motion to a hearing
on the merits. Landlords hastily filed opposition papers, objecting on the basis that
the relief affected the landlords' "due process rights" and that the court should allow
more time for the landlords to respond. By moving so quickly, left unaddressed was
the fundamental question of whether such "designation rights sales" are even permitted
under the Bankruptcy Code. In the end, the matter was approved without a formal
opinion from the court.

Montgomery Ward sought authorization for the sale of "designation rights" under the
provisions of §363(b)(1). However, nowhere in the motion was there a discussion
of whether the so-called designation rights were property of the estate that could be
transferred. Rather, the proposed sale of designation rights contemplated allowing the
designated rights purchaser to exercise unique bankruptcy powers under §365 for its
own benefit.

<blockquote><blockquote>
<hr>
<big><center>
Montgomery Ward's motion simply did not take into
consideration the heightened risk of expense and damage
to the estate should the designated rights purchaser
default.
</center></big>
<hr>
</blockquote></blockquote>

The Third Circuit had previously determined that certain types of rights available
to trustees and debtors-in-possession are not "assets" that could be sold to a third
party even with bankruptcy court approval. In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cybergenics Corp., 226
F.2d 237 (3rd Cir. 2000)</a>, the court held that state law fraudulent
conveyance claims that the debtor was authorized to pursue, pursuant to its strong-arm
powers in its capacity as a chapter 11 debtor-in-possession (DIP), were not an
asset that belonged to the debtor personally, and therefore could not be sold to a
third party as part of a court-approved sale of assets. The court came to the
"inescapable conclusion" that the fraudulent transfer claims, which state law provided
to Cybergenics' creditors, were never assets of Cybergenics. That conclusion was not
altered by the fact that a DIP is empowered to pursue those fraudulent transfer
claims for the benefit of all creditors. The avoidance power itself "was likewise not
an asset of Cybergenics, just as this authority would not have been a personal asset
of a trustee, had one been appointed." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 245</a>. The court held that because
the provisions of §365 permitting assumption and assignment of leases were unique
bankruptcy powers to be exercised for the benefit of all creditors, those powers do
not exist and therefore cannot be assigned outside of the context of a bankruptcy
case.

To be sure, there are cases interpreting provisions of the Code that allow for
the appointment of a representative of the estate to pursue avoidance powers, for
instance, on behalf of the estate. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§1123(b)(3)(B)</a>. But even the cases interpreting those provisions speak in
terms of "representatives" of the estate, not sales of assets. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… the Matter
of Texas Gen. Petroleum Corp., 52 F.3d 1330 (5th Cir. 1995)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Sweetwater, 884 F.2d 1323 (10th Cir. 1989)</a>; and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Churchfield Mgmt. & Inv. Corp., 122 B.R. 76 (Bankr. N.D. Ill.
1990)</a>. The Ninth Circuit had permitted the transfer of avoidance powers outside
of the context of a chapter 11 reorganization plan, but only "when a creditor [was]
pursuing interests common to all creditors." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re P.R.T.C. Inc., 177
F.3d 774, 781 (9th Cir. 1999)</a>. In the Montgomery Ward matter, the
designated rights purchaser was pursuing assumption and assignment of leasehold interests
for its own pecuniary benefit and gain. Indeed, it was not even suggested that the
designated rights purchaser was a creditor of the estate.

The only published opinion upon which Montgomery Ward relied for authority to permit
the sale of designation rights was <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Ernst Home Center Inc., 209 B.R.
974 (Bankr. W.D. Wash. 1997)</a>. However, the Ernst case arose under the
Ninth Circuit's more expansive view of the transfer of bankruptcy rights (see, e.g.,
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…., supra</a>). It also suffered from the same analytical deficiencies criticized
by the Third Circuit. In Ernst, the bankruptcy court characterized what was sold to
the liquidator as "bonus value." This euphemism was used to disguise what was truly
being sold to the designated rights purchaser as property of the estate. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, supra,

209 B.R. at 985</a>. Moreover, the court failed to discuss what portion of the
"bonus value" was not going to be recaptured for the benefit of creditors of the
estate, but solely for the benefit of the designated rights purchaser. Unfortunately,
rather than analyze the appropriateness of selling unique bankruptcy powers for a discount
to the detriment of creditors of the bankruptcy estate, the court seemed motivated by
the expediency and size of the down payment. ("The opportunity should not be rejected,
even if it will produce in the end only a small distribution to unsecured creditors."
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 980</a>.) This is most likely the reason why much of the court's analysis
seemed strained, such as its conclusion that the transaction was a sale of property of
the estate because it included a sale of three fee interests. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 985-86</a>.

Even if the Ernst case were the law governing the sale of designation rights in
the Montgomery Ward case, the court expressly excluded from its holding those landlords
that had continuous operation covenants in their leases. The court stated that it would
give "those landlords the opportunity to show that the terms of their leases would,
under state law, give them the right to remove Ernst from possession, notwithstanding
Ernst's continued payment of all monetary amounts due under the lease." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at
982</a>. It is assumed that many of the affected landlords in the Montgomery Ward
matter had such provisions. Because the designated rights purchaser was not a creditor
of Montgomery Ward's bankruptcy estate, it had no particular motivation to act on
behalf of any creditor of the bankruptcy estate, but was principally motivated to
maximize its profit. As a result, several aspects of the transaction were adverse
to creditors: first, the designation rights were being sold at a deep discount or
the designated rights purchaser would have had nothing to do with it; second, some
substantial portion of the proceeds from the assignment of leases under §365 of the
Bankruptcy Code would not be available for distribution to creditors; and third,
landlords whose leases were ultimately rejected would have no claim for damages against
the non-debtor party (designated rights purchaser) who caused the damage, but merely
an unsecured claim in the bankruptcy estate. Giving a landlord such a doubly
discounted source of recovery for damage directly caused by a non-debtor party clearly
distorted the balance of the equities created by §365. Furthermore, the failure
to return all profits to the estate from the assumption and assignment of leases could
not possibly have been in the best interests of creditors.

Montgomery Ward's motion simply did not take into consideration the heightened risk of
expense and damage to the estate should the designated rights purchaser default. The
value was surrendered merely for the expediency of having a third party cover holding
costs and the potential for much higher costs of administration caused by individual
objections each time an "end user" assignee was proposed. These are the very reasons
why the Third Circuit determined that bankruptcy rights cannot be sold as though they
were any other type of asset that exists in the absence of a bankruptcy case.

In the end, the court was not required to produce a written decision on these
points because the interested parties resolved their issues with the debtor, leaving the
court without a reason to delve more deeply into whether such sales violate the Code.
With more debtors turning to similar sales, perhaps we will see another court take
this issue on directly and thus decide whether the expedience of this practice trumps
the very Code upon which it is based.

Journal Authors

James A. Tiemstra

William F. Taylor

Journal Date

Saturday, September 1, 2001 - 12:00

Bankruptcy Rule

2001