Smooth Sailing for Designation Rights Sales

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Feb 2003

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For a column focused on current, debate-provoking issues on chapter 11s, what subject could be more
appropriate than the sale of designation rights under real estate leases? The Journal's 2001 feature article on
this topic<a href="#2" name="2a">2</a> engendered spirited debate,<a href="#3" name="3a">3</a> and the bankruptcy court for the Southern District of New York in
the Ames Department Store case has just released a thorough opinion approving the theoretical
underpinnings for this increasingly common practice.<a href="#4" name="4a">4</a> From the perspective of a neutral observer of this
phase of the Ames case and past advocate for both purchasers and opponents of designation rights, the
debate over designation rights is likely to continue, but will focus more on implementation than on theory.
The practice has become well-established as an effective mechanism for generating large sums of cash for
liquidating or downsizing retailers, but it is far from uniform in its application. This article will review the
latest opinion in Ames Department Stores and will identify aspects of the practice that remain to be decided.

<h3>The Ames Department Stores Cases</h3>

Ames announced in August 2002 that it would close its remaining discount stores and liquidate. At the
time of the announcement, it had anchor stores throughout the Northeast, the Mid-Atlantic states and into
the Midwest, with most stores located in community and strip shopping centers. In contrast to national
big-box retailers like Kmart, Montgomery Ward or Hechinger, Ames's lease disposition process did not
result in the sale of designation rights to distressed real estate buyers or national shopping center owners.
Instead, the right to market the largest group of Ames leases was sold in November 2002 to Shaw's
Supermarkets. Shortly after the approval of the Shaw's transaction, Ames agreed to sell designation rights
to 18 other locations to Shaw's regional competitor, The Stop & Shop Supermarket Co. The Stop & Shop
sale was proposed as one to be completed without further competitive bidding in view of the substantial
$20 million price offered by Stop & Shop, plus its commitment to assume more than $350,000 in
monthly carrying costs on the stores until ultimate disposition.

The proposed Stop & Shop transaction met with multiple objections by lessors who were
counterparties to the leases in question, including objections to the legal underpinnings for the sale of
designation rights in bankruptcy cases. The transaction was approved in a December 2002 memorandum
decision by Bankruptcy Judge Robert E. Gerber, who ruled that "the sale of designation rights is fully
permissible in bankruptcy cases, and...there is nothing in either bankruptcy or non-bankruptcy law that
prohibits this plainly salutary means for making available for the benefit of creditors the underlying
economic value in a debtor's leases."<a href="#5" name="5a">5</a>

<blockquote><blockquote>
<hr>
<big><center>
Designation rights transactions have transformed the
lease-assignment process in retail cases over the last several years,
and there seems to be no question that they will continue to be an
important tool for realizing value for creditors.
</center></big>
<hr>
</blockquote></blockquote>

The court adopted the definition of designation rights as "the right to direct the debtors to assume and
assign unexpired leases...to third parties qualifying under the Bankruptcy Code, after such non-end users
locate ultimate purchasers of the unexpired leases."<a href="#6" name="6a">6</a> The court further explained that the subsequent
assumption and/or assignment of a lease under this arrangement is effected by the debtor and is subject to
compliance with the lessor protections of §365 of the Code, including those applicable to shopping center
leases.

In support of the sale, Ames submitted several orders approving designation rights sales in bankruptcy
cases from 1996 through 2002, including Best Products, Bradlees, Caldor, Grand Union, Hechinger,
Jumbo-sports, Kmart, Montgomery Ward I and II, Service Merchandise and Sun TV. The court
acknowledged these orders as having some persuasive value<a href="#7" name="7a">7</a> and followed the rulings in the Ernst Home
Centers case<a href="#8" name="8a">8</a> approving the sale of designation rights.

The court's approach to the landlords' challenge to Ames's proposed sale of designation rights was to
analyze the nature of rights being sold and then consider whether rights were impermissibly vested in a
party without fiduciary duties to creditors. Its conclusion was that the bundle of rights held by Ames
constituted saleable property in the economic sense and that there was nothing in the Code that negated that
conclusion.

The court began by considering whether the designation rights qualified as property of the estate under
§541 of the Code. Under the Second Circuit's ruling in the Prudential Lines case<a href="#9" name="9a">9</a> that Congress wished to
bring anything of value into debtors' estates under §541, the Ames court found that the bonus value in the
leases was plainly property of the estate under §541(a)(1). The court observed further that it was doubtful
that the result would be different in any other circuit.<a href="#10" name="10a">10</a> Section 541(a)(6), covering proceeds of property of
the estate, provided additional support for the court's conclusion, a position previously espoused by the
courts in Ernst Home Centers. Finally, invoking §541(a)(7) of the Code covering any interest in property
that the estate acquires after the commencement of the case, the court found that the debtor's power under
§365(f) to assign leases over landlords' objections was a mechanism that allowed it to realize on the
underlying economic value in its leases and to secure the value as proceeds of the leases.

The objecting landlords argued that the Third Circuit's ruling in the Cybergenics case<a href="#11" name="11a">11</a> removed
Ames's rights from the ambit of §541(a)(1) because a debtor's ability to realize the value of its leases
depended solely on its statutory powers to assume and assign leases under §365 of the Code, and that power
did not belong to the debtor as of the filing of the petition. In short, they contended that the sale of
designation rights was simply a sale of a federal power to a non-fiduciary, a result not permitted under
Cybergenics.<a href="#12" name="12a">12</a> The Ames court rejected the Cybergenics argument for three reasons. First, under the
proposed arrangement, Ames retained the sole right to seek later assignment of any of the leases to
end-users, albeit subject to direction by Stop & Shop. Second, the most important part of what Ames was
selling was not its rights under the Code, but the underlying value in the leases, an asset that existed before
the chapter 11 cases were filed, even though the value of the leases would only be realized post-petition.
Third, the court distinguished Cybergenics as involving distinctions between the rights of debtors and
creditors, not distinctions between a debtor's property interests prior to the case and its enhanced powers to
realize on that property interest as a debtor-in-possession (DIP) under §365 of the Code. Cybergenics, the
court noted, expressly disclaimed any attempt to rule on the relative rights of debtors and DIPs. Moreover,
the sale of designation rights was not solely an assignment of the power to compel lessors to accept
assignments of leases under §365(f), but was only a means for realizing the underlying economic value in
the leases.

The final objection dispatched by the court in Ames was that the debtor was improperly seeking to
transfer the fundamental powers of a DIP to a non-fiduciary. The court rejected this contention because
Ames retained the right to seek to assume, reject or assign leases, and because it had exercised its business
judgment by negotiating for an immediate sale and possible future assignment of the leases. In sum, the
court found that the designation rights transaction was simply an example of the nearly infinite ways to
structure a transaction that makes business sense for creditors and the estate and involves a proper exercise
of business judgment.

<h3>Open Issues</h3>

A number of issues still can be expected to arise in connection with designation rights transactions. The
Ames court noted<a href="#13" name="13a">13</a> that disputes over "going dark" or use provisions can and should be dealt with at the
time of the assignment of individual leases after approval of the designation rights sale. However, the
length of the designation period and any rights of the debtor and the purchaser to extend the period after
expiration are issues on which landlords have legitimate interests. A balance needs to be struck between the
debtor's desire to maximize value by extending the period during which the designation rights purchaser can
take advantage of the Code to overcome certain lease provisions and the landlord's interest in maximizing
the value of its shopping center or surrounding property.

The transparency of the lease assignment process may be markedly different under some designation
rights arrangements than would be the case if the debtor marketed the leases under §365. Courts should
carefully review provisions that permit limited notice and eliminate public filing requirements for future
assumptions, assignments or rejections negotiated by the designation rights purchaser.

The nature of the arrangement between the debtor and the designation-rights purchaser for payment of
carrying costs during the designation period can have a significant impact on the rights of landlords and
other property-related creditors. The debtor and the designation rights purchaser may attempt to define
carrying costs in a manner that effectively limits the rights of property-related creditors or excludes certain
obligations. The debtor may seek to shield itself from requests for payment of administrative expenses
related to the property by pointing to the designation rights purchaser's obligation to bear those costs.
However, the purchaser's agreement to indemnify the estate should not negate the possibility of creditors
seeking payment from the debtor in the first instance. Additionally, property-related creditors should seek to
obtain a direct right to enforce the carrying costs provisions against the designation rights purchaser in the
bankruptcy court. Unless the court approves such a direct right of action, the rights of administrative
creditors will be more difficult to enforce than if the debtor had remained in possession and bound by
§§365(d)(3) and 503(b). It may also be the case that the debtor will have few funds available to pay
administrative creditors until it receives the final profit-sharing payment under the designation rights
transaction. This need for clarity in terms of payment and remedies takes on even greater significance with
designation rights for fee-owned properties where the designation-rights purchaser should be expressly
obligated to pay taxes and property-related expenses to provide adequate protection for mortgagees or for the
estate should the property ultimately be put back to the debtor.

Designation rights transactions have transformed the lease assignment process in retail cases over the
last several years, and there seems to be no question that they will continue to be an important tool for
realizing value for creditors. As this technique gains even greater acceptance and application, care should be
taken to protect the rights of creditors and landlords who are held at bay while the real estate professionals
complete their work.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Board-certified in business bankruptcy by the American Board of Certification. <a href="#1a">Return to article</a>

<a name="2">2</a> Taylor, William F. and Tiemstra, James A., "Designation Rights" Sales: Triumph of Expedience over the
Code?" Am. Bankr. Inst. J., September 2001 at 1. <a href="#2a">Return to article</a>

<a name="3">3</a> Letters to the Editor, Am. Bankr. Inst. J., December/January 2002 at 8. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Ames Department Stores Inc., 2002 WL 31911070 (Bankr. S.D.N.Y. Dec. 31, 2002)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> Id. at *1. <a href="#5a">Return to article</a>

<a name="6">6</a> Id. at *1 n2. <a href="#6a">Return to article</a>

<a name="7">7</a> Id. at *3, n7. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Ernst Home Ctr. Inc., 209 B.R. 974 (Bankr. W.D. Wash. 1997)</a>, appeal dismissed, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… Brickyard
Assoc. Ltd. v. Ernst Home Ctr. Inc. (In re Ernst Home Ctr. Inc.), 221 B.R. 243 (B.A.P. 9th Cir. 1998)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9… Comm. of Unsecured Creditors of Prudential Lines Inc. v. PSS S.S., 928 F.2d 565, 573 (2d Cir.
1991)</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… WL 31911070</a> at *6. <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… Comm. of Unsecured Creditors of Cybergenics Corp. v. Chinery (In re Cybergenics Corp.),
226 F.3d 237 (3d Cir. 2000)</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> The objecting landlords withdrew any arguments based on <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… Comm. of Unsecured Creditors of
Cybergenics Corp. v. Chinery (In re Cybergenics Corp.), 304 F.3d 316</a> (3d Cir.), reh'g. en banc granted
and opinion vacated, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… F.3d 785 (3d Cir. Nov. 18, 2002)</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… WL 31911070 at *10 n34</a>. <a href="#13a">Return to article</a>

Journal Authors

Daniel J. Carragher

Journal Date

Saturday, February 1, 2003 - 12:00

Bankruptcy Rule

2003