Debtor Beware Fourth Circuit Enforces Restrictive Use Clause to Block DebtorTenants Assignment of Shopping Center Lease

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Sep 2004

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Landlords hate it when
their tenants file bankruptcy because suddenly, they are at risk of losing
control over their property—literally—if the debtor/tenant
elects to assume and assign the lease to a stranger. For the landlord of a
shopping center, the possibility of a debtor/tenant's assignment of
the lease is especially problematic because, in order to attract other
tenants and ensure the desired tenant mix (so as to enhance profitability),
shopping center leases generally contain restrictive-use clauses. Lease
negotiations with national retailers now often center around the
retailer's form of shopping center lease (rather than the
landlord's form), and the retailer's form might state that if
the national retailer's exclusivity within the shopping center is
breached by another tenant in the center, or if another tenant begins to
operate a business at the shopping center that constitutes a
"prohibited use," the "injured" national
retailer/tenant has remedies against the shopping center landlord.
Consequently, shopping center landlords who are parties to leases that
contain such provisions are legitimately concerned about the possibility
that a debtor/tenant can assign the lease to a third party, upset the
tenant mix within the shopping center and trigger a violation of various
use and/or exclusivity clauses contained in the leases between the landlord
and the other tenants within the shopping center.

In an effort to protect themselves, shopping center
landlords (indeed, most commercial landlords) often insert lease clauses
that prohibit the tenant from assigning the lease; however, Bankruptcy Code
§365(f)(1)<a href="#1" name="1a">1</a> renders such clauses ineffective if the debtor/tenant
files bankruptcy and wants to assign the lease. Commercial leases also tend
to contain lengthy anti-bankruptcy provisions that render the
debtor/tenant's bankruptcy filing an automatic termination or default
under the lease; however, those provisions are inoperative due to the
Bankruptcy Code's prohibition on so-called "ipso facto" clauses. See 11 U.S.C. §365(e)(1).<a href="#2" name="2a">2</a>

But what about restrictive-use clauses that are so
characteristic of shopping center leases? Can the shopping center landlord
use the restrictive-use clauses to defeat a debtor/tenant's attempt
to assume and assign a shopping center lease? The answer—at least in
the Fourth Circuit—appears to be "yes."

On April 22, 2004, the Fourth Circuit Court of Appeals
issued its opinion in In re Trak Auto Corp., 367 F.3d 237 (4th Cir. 2004). Trak Auto Corp. was a
retailer of automotive parts and accessories and once operated 196 stores
throughout nine states and the District of Columbia. After filing chapter
11 on July 5, 2001, Trak Auto sought to assume and assign its lease in the
West Town Center, a shopping center located in Chicago. Trak Auto's
lease in the West Town Center limited the debtor/tenant's use of the
leased premises to the "sale at retail of automobile parts and
accessories and such other items as are customarily sold by tenant at its
other Trak Auto Stores." 367 F.3d at 240.

After filing chapter 11, Trak Auto hired a real
estate firm to market its West Town Center lease and to solicit bids. No
auto parts retailer bid on the Trak Auto's West Town Center lease.
The high bidder was a clothing store, which offered $80,000 to "buy
out" Trak Auto's lease so that it could open a discount
clothing store in the West Town Center. Thus, Trak Auto filed a motion for
authority to assume the West Town Center lease and assign it to the high
bidder—the discount clothing store.

The landlord of West Town Center objected to Trak
Auto's motion and argued that the proposed assignment would violate
the restrictive-use provision in Trak Auto's West Town Center lease,
which limited the use of the leased premises to the retail sale of
automotive parts and accessories and other items customarily sold at Trak
Auto stores. The bankruptcy court held an evidentiary hearing and made
several interesting findings of fact, as follows:

<ol>

<li>The West Town Shopping Center was in
Chicago—an urban area where only 59 percent of the population owns
cars.

</li><li>The shopping center was surrounded by competing
shopping areas.

</li><li>There were 25 tenants in the West Town Center,
including clothing stores, food vendors, a Kmart, a laundromat, a travel
agency, a bank, a small loan agency, an adult entertainment outlet and a
public library branch.

</li><li>Although Trak Auto was the only auto-parts retailer
within the West Town Shopping Center, there were seven auto-parts retailers
within a three-mile radius.
</li></ol>

These findings of fact were accepted by the Fourth
Circuit Court of Appeals; however, the bankruptcy court and the Fourth
Circuit Court reached vastly different legal conclusions.

The bankruptcy court concluded that because no
auto-parts retailer bid on the debtor's West Town lease, "the
market in the area is saturated and cannot bear [the] restriction limiting
the use to sale of auto parts and accessories." 367 F.3d at 244.
Thus, the bankruptcy court reasoned that the market had the practical
effect of transforming the use restriction into an anti-assignment clause,
which is unenforceable under Code §365(f)(1). The bankruptcy court
also found that the landlord did not present sufficient evidence to
demonstrate that the assignment of the lease to a clothing retailer would
upset the tenant mix. 364 F.3d at 240. Consequently, the bankruptcy court
authorized the debtor to assume the lease and assign it to the clothing
store. The landlord appealed to the district court, which affirmed.

When the landlord appealed to the Fourth Circuit
Court of Appeals, the circuit court framed the issue differently than had
the lower courts. Basically, the Fourth Circuit Court of Appeals stated
that the issue was how to deal with the conflict between Code
§365(b)(3)(C),<a href="#3" name="3a">3</a> which "specifically requires a
debtor/tenant at a shopping center to assign its store lease subject to any
provision restricting the use of the premises," 367 F.3d at 241,
while Code §365(f)(1) generally allows a debtor to assign its lease
notwithstanding a provision in the lease that restricts the assignment. In
other words, the Fourth Circuit Court of Appeals honed in on an inherent
conflict within two subsections of §365.

The Fourth Circuit began its analysis with an
in-depth review of the legislative history of §365 and found evidence
that Congress intended to protect shopping center landlords because:

<blockquote>A shopping center is often a carefully planned
enterprise, and though it consists of numerous [sic] individual tenants,
the center is planned as a single unit, often subject to a master lease or
financing agreement. Under these agreements, the tenant mix in a shopping
center may be as important to the lessor as the actual promised rental
payments, because certain mixes will attract higher patronage of the stores
in the center.
</blockquote>

367 F.3d 242, citing H.R. Rep. No. 95-595 at 348 (1977), U.S. Code Cong. &
Admin. News 1977 at 5963, 6305. The Fourth Circuit observed that the
original version of §365(b)(3) provided that the debtor/tenant could
not assign a shopping center lease unless there was adequate assurance that
"assignment of the lease would not breach substantially any provision, such as a
radius, location, use or exclusivity provision, in any other lease,
financing agreement or master agreement relating to said shopping
center." 367 F.3d at 243. However, shopping center landlords found
this protection to be inadequate because the debtor/tenant could avoid the
effect of these provisions by convincing the bankruptcy court that the
assignment would not cause a substantial breach of a use, radius, location or exclusivity provision.
Also, the reference in the 1978 version of the Bankruptcy Code to
"any other lease" was construed by debtors (and some bankruptcy
courts) to mean that the landlord of the shopping center was only eligible
for protection if it could prove that some
other lease related to the shopping center
would be breached. Consequently, the shopping center landlords lobbied
Congress to amend §365(b)(3) to provide shopping center landlords with
additional protection in order to preserve the tenant mix. In 1984,
Congress amended §365(b)(3)(C) to delete the word
"substantially" and to fix the confusing statutory reference to
"any other lease." Thus, §365(b)(3)(C) now requires the
debtor/tenant of a shopping center lease to provide adequate assurance:

<blockquote>
(C) that assumption or assignment of such lease is
subject to all provisions thereof, including (but not limited to)
provisions such as radius, location, use or exclusivity provision, and will
not breach any such provision contained in any other lease, financing
agreement or master agreement relating to such shopping center...

</blockquote>

Armed with this clear understanding of the legislative
history of Bankruptcy Code §365(b)(3)(c), the Fourth Circuit Court of
Appeals then squarely faced the conflict between
§365(f)(1)—which contains a general invalidation of
anti-assignment clauses—and §365(b)(3)(C), which the Fourth
Circuit considered to be a "more specific provision that requires the
assignee of a shopping center lease to honor a clause restricting use of
the premises." Citing the general rule of statutory construction that
a more specific statutory provision will control a general one, 367 F.3d at
243, the Fourth Circuit held that §365(b)(3)(C) effectively
"trumps" §365(f)(1). Consequently, at least in the Fourth
Circuit, the use restrictions contained in a shopping center lease will be
enforced, and a debtor/tenant will be unable to assume and assign that
shopping center lease to a non-conforming tenant.

The ruling in Trak Auto is especially interesting because there is nothing in
§365 that makes §365(b)(3)(C) expressly superior to
§365(f)(1). Certainly, Congress knows how to make one statute superior
to another. For example, §365(d)(3) is made expressly superior to
§503(b)(1) because §365(d)(3) states that it applies "notwithstanding §503(b)(1) of this title." After its in-depth analysis of the legislative
history behind §365(b)(3)(C), it is surprising that the Fourth Circuit
did not consider the meaning or effect of Congress's failure to make
§365(b)(3)(C) expressly superior to §365(f)(1), but instead
simply resorted to rules of statutory construction to resolve the inherent
conflict between the two provisions. Perhaps it was obvious to the Fourth
Circuit that §365(b)(3)(C) must trump §365(f)(1), but other courts might have
declined the invitation to use statutory construction for fear of
judicially rewriting the Code, and thus might have ruled that this conflict
between §§365(b)(3)(C) and 365(f)(1) is for Congress to resolve
via an amendment to the Code.

Obviously, Trak Auto is very good news for shopping center landlords who want to
enforce the restrictive-use clauses in their shopping center leases so that
they can regain control over the leased premises or block the assignment of
the shopping center lease to a tenant that would violate use and/or
exclusivity provisions. Conversely, Trak Auto is bad news for shopping center tenants who may become
debtors and find it more difficult than ever before to find viable
assignees who satisfy the restrictive use clauses in their shopping center
leases. Indeed, the paucity of satisfactory assignees (many of whom may be
the debtor's competitors, who don't want to see the
debtor/tenant survive the bankruptcy anyway) is likely to drive down the
price that the debtor/tenant can get for the assignment of its shopping
center leases. Consequently, if the other circuits follow the Fourth
Circuit's opinion in Trak Auto, then shopping center tenants who file bankruptcy could lose
the ability to reap the financial gain from assumption and assignment of
their shopping center leases. This could be a significant loss to the
debtor/tenant's bankruptcy estate, especially if the debtor/tenant
enjoys below-market rental rates on its shopping center leases, or if the
leases are valuable due to location or other factors. In the aftermath of Trak Auto, debtor/tenants will
probably still bring motions to assume and assign the leases, and it will
be up to the shopping center landlord to insist that the use restriction be
honored. Once the shopping center landlord objects to the assignment and
demands compliance with the restrictive use provisions, the debtor/tenant
will have an "uphill slide" in jurisdictions that follow Trak Auto, and the shopping
center landlords will get their desired result—control over the
leased premises—once again. For the shopping center landlord, this
outcome represents a long-desired trip to the "head of the
line."

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Bankruptcy
Code §365(f)(1) states:

<blockquote>
(f)(1) Except as provided in subsection (c) of this
section, notwithstanding a provision in an executory contract or unexpired
lease of the debtor, or in applicable law, that prohibits, restricts or
conditions the assignment of such contract or lease, the trustee may assign
such contract or lease under paragraph (2) of this subsection; except that
the trustee may not assign an unexpired lease of nonresidential real
property under which the debtor is an affected air carrier that is the
lessee of an aircraft terminal or aircraft gate if there has occurred a
termination event. <a href="#1a">Return to article</a>
</blockquote>

<a name="2">2</a> Bankruptcy
Code §365(e)(1) states:

(e)(1) Notwithstanding a provision in an executory
contract or unexpired lease, or in applicable law, an executory contract or
unexpired lease of the debtor may not be terminated or modified, and any
right or obligation under such contract or lease may not be terminated or
modified, at any time after the commencement of the case solely because of
a provision in such contract or lease that is conditioned on—

<blockquote>
(A) the insolvency or financial condition of the
debtor at any time before the closing of the case; 
(B) the commencement of a case under this title; or 
(C) the appointment of or taking possession by a
trustee in a case under this title or a custodian before such commencement. <a href="#2a">Return to article</a>
</blockquote>
</blockquote>

<a name="3">3</a> Bankruptcy
Code §365(b) states, in pertinent part:

(b)(1) If there has been a default in an executory
contract or unexpired lease of the debtor, the trustee may not assume such
contract or lease unless, at the time of assumption of such contract or
lease, the trustee—

<blockquote>
(A) cures, or provides adequate assurance that the
trustee will promptly cure, such default; 
(B) compensates, or provides adequate assurance that
the trustee will promptly compensate, a party other than the debtor to such
contract or lease, for any actual pecuniary loss to such party resulting
from such default; and 
(C) provides adequate assurance of future
performance under such contract or lease...
</blockquote>
(2) Paragraph (1) of this subsection does not apply
to a default that is a breach of a provision relating to—

<blockquote>
(A) the insolvency or financial condition of the
debtor at any time before the closing of the case; 
(B) the commencement of a case under this title;

(C) the appointment of or taking possession by a
trustee in a case under this title or a custodian before such commencement;
or 
(D) the satisfaction of any penalty rate or
provision relating to a default arising from any failure by the debtor to
perform nonmonetary obligations under the executory contract or unexpired
lease.
</blockquote>
(3) For the purposes of paragraph (1) of this
subsection and paragraph (2)(B) of subsection (f), adequate assurance of
future performance of a lease of real property in a shopping center
includes adequate assurance—

<blockquote>
(A) of the source of rent and other consideration
due under such lease, and in the case of an assignment, that the financial
condition and operating performance of the proposed assignee and its
guarantors, if any, shall be similar to the financial condition and
operating performance of the debtor and its guarantors, if any, as of the
time the debtor became the lessee under the lease;

(B) that any percentage rent due under such lease
will not decline substantially;

(C) that assumption or assignment of such lease is
subject to all the provisions thereof, including (but not limited to)
provisions such as a radius, location, use or exclusivity provision, and
will not breach any such provision contained in any other lease, financing
agreement or master agreement relating to such shopping center; and

(D) that assumption or assignment of such lease will
not disrupt any tenant mix or balance in such shopping center. <a href="#3a">Return to article</a>

Journal Authors

Lisa Sommers Gretchko

Journal Date

Wednesday, September 1, 2004 - 12:00

Bankruptcy Rule

2004