In 2002, Hon. Robert E. Gerber of the U.S. Bankruptcy Court for the Southern District of New York published In re Ames Dep’t Stores Inc.,[1] a case that has often been cited as being an innovative approach to addressing issues arising in debtor estates with numerous locations subject to unexpired real property leases. Those issues concern an estate’s interest in what could amount to hundreds or thousands of unexpired leases and the estate’s attempt to capture value from those leases in the face of its § 365(d)(3) obligation to timely perform under the lease, as well as manage any pre-rejection liability such as administrative expenses. The severity of these concerns will depend on the nature of the debtor’s business, the lease provisions, and general circumstances with respect to the property. Naturally, these concerns are magnified when the debtor is no longer operating or lacks the resources that are necessary to operate for any significant period after it files its petition.
The solution is to authorize the sale of the “designation rights” of those unexpired leases. The general idea is that the debtor has the authority to choose which of its unexpired leases it desires to keep and assign, or reject. Depending on the circumstances, some of those leases might be below market value, or the particular location might be desirable. Since its inception, which, to be fair, was not born in the Southern District,[2] the approach has been used by retailers, mega-chains, franchises and even automobile manufacturers.[3] In all likelihood, the practice will continue, since it has the potential to bring significant value into an estate.
A well-known English proverb holds true that “necessity is the mother of invention.” As time passes, economic markets rise and fall. Restructuring professionals become more adept at manipulating the tools in their toolkits, and bankruptcy judges find themselves asked to “accommodate evolving ways to maximize value for creditors.”[4] However, in Ames, Judge Gerber placed parameters on the court’s ability to accommodate these evolving transactions. Those parameters included the “usual requirements for a debtor’s exercise of business judgment and notice and opportunity for parties in interest to be heard.”[5] He also referenced controversies arising under or within § 365, such as the time in which the debtor has to assume or reject, and use provisions — all of which must be resolved in connection with a sale of designation rights.[6] “Decisions of that character are in essence section 365 determinations, as to which any lessor concerns can be heard, at whatever time [that] they are ripe; the need to adjust any such provisions in approval orders to the facts of the case and facts involving any particular lessor(s) does not, however, go to whether sales of designation rights are permissible.”[7] One would naturally assume, then, that any transaction involving the sale of designation rights must not run afoul of § 365.
This article explores an example of a rather unorthodox transaction involving the sale of designation rights of an unexpired real property lease. In Munire Furniture Co. Inc.,[8] the traditional components were all involved: a debtor with an unexpired real property lease, a willing purchaser of the designation rights, and a substantial purchase price.[9] However, there was something about the transaction that did not resemble the status quo.
Going back briefly to the Ames decision, that transaction involved a debtor who ceased operations in the stores that previously had not closed.[10] Ames only operated post-petition for the purpose of conducting “going-out-of-business” sales at certain locations.[11] Similar to Ames, which had been a large chain of discount retail stores, the purchaser of the designation rights was Stop & Shop, a large chain of supermarkets.[12] The sale agreement in Ames defined what was being sold as the “sole, exclusive, and continuing right to select, identify and designate ... which [leases] shall be assumed and assigned ... and to whom.”[13] The Ames sale agreement provided that Stop & Shop would cause the debtor to assume and then assign certain leases to Stop & Shop, and detailed the procedure that the buyer and seller would follow in order to designate a lease.[14] It provided for the respective division of administrative, cure and other costs or expenses.[15] It should come as no surprise that the Ames sale agreement also provided that “the sale of [the] Designation Rights ... shall not effect a conveyance of the [leases] to [Stop & Shop].”[16]
The sale agreement controlling the transfer of designation rights in In re Three A’s Holdings, LLC,[17] better known as “Tower Records,” was nearly identical concerning the rights transferred to the purchaser, and substantially similar in procedure and division of administrative and other costs or expenses.[18] Both of the Ames and Tower Records sale agreements, as well as the respective sale orders, reserved the rights of counterparties to the leases with respect to § 365 and any subsequent motion to assume and assign to effectuate the conveyance of the lease.
This framework, or one substantially similar, was used in each of the cases analyzed for purposes of this article,[19] except for one: Munire. Munire was a furniture manufacturer and distributor whose primary business operated out of one location. It continued to operate in bankruptcy, but by most accounts did not have long to do so. The sale agreement in Munire bundled the sale of virtually all of its assets to one purchaser.[20] However, the transaction did not include the assignment of the lease for the premises on which the going-concern to be sold operated (for clarity), and instead included merely the designation rights to the property. The transaction was characterized as one that would result in Munire’s continued existence after the sale.[21] All operating expenses would be incurred by Munire and would be reimbursed by the purchaser.[22] The order authorizing the sale provided that Munire and the purchaser would be required to “fully comply” with the lease provisions until the later of the rejection of the lease, or the occupants vacated the premises.[23]
Notwithstanding representations that Munire would continue to operate as of the closing, the debtor would no longer carry any insurance; instead, the purchaser would be required to carry the appropriate insurance coverage pursuant to the lease.[24] A close inspection of the final documents painted a slightly different picture as to which entity would be operating.[25] A detailed review of the sale order, Munire sale agreement and the transition services agreement (TSA) make it clear that upon closing, the purchaser was “transferred” or “conveyed,” and the debtor took all of the necessary steps to “reduce to purchaser’s possession,” the purchased assets.[26] The purchased assets included every tangible and intangible asset, interest, right, license and permit used in the operation of the going concern located on the premises controlled by the lease.[27] The only excluded assets were minimal and in no way associated with the continued operation of the purchased going concern.[28]
As of the closing, the transfer “vest[ed the] purchaser with all right, title and interest of the debtor in the purchased assets.”[29] Pursuant to the sale order, the purchaser was authorized to “operate under any license, permit, registration and any other governmental authorization or approval of [Munire] with respect to the purchased assets, which included all of the licenses, permits and governmental authorizations.[30] The relinquishing of such interests calls into question whether Munire was legally permitted to operate the business after the closing. The sale order authorized the purchaser to operate with respect to the purchased property and any assumed agreement, but that did not include rights to the real property lease, other than the interest in directing the debtor to designate that lease. As such, the purchaser had not been authorized to operate on the premises controlled by the lease.
Pursuant to the TSA, the only transition services to be provided by the debtor were certain “support services … reasonably requested by [the purchaser], in connection with [the purchaser’s] ownership, operation, and management of the [going concern].”[31] Also pursuant to the TSA, the only service owed to the debtor was the purchaser’s reasonable efforts to provide access to certain books and records for purposes of the wind down in bankruptcy “with such access being controlled in all respects by [the purchaser].”[32]
Widely recognized bankruptcy law holds that interests in property are “created and defined” by state law.[33] The right to access the property is a fundamental interest controlled by the lease.[34] Pursuant to § 365, a transfer of that fundamental interest can only be done by assumption and assignment, or rejection of the lease and a new subsequent lease, so it seems a strain to contemplate that anything in the sale order, the Munire sale agreement or TSA can be read to have modified the right to access the premises.
Pursuant to New Jersey law, where Munire had been situated, a lease is any agreement that gives rise to a landlord/tenant relationship.[35] Moreover, a lease must be supported by valuable consideration to be enforceable, and the central requirement of consideration is a bargained-for exchange of promises.[36] However, a promise to pay rent in the absence of a lease or landlord/tenant relationship and a transfer of possession is unenforceable, and such a mere promise alone cannot constitute consideration.[37] Therefore, the purchaser’s obligation to comply with the lease, specifically its “promise” to pay rent, which had not been bargained for, could not serve as consideration to support the existence of a “lease” authorizing the purchaser to access the premises. Since there was no state-defined right to access the premises and the lease had not been assigned pursuant to § 365, the purchaser had no right to access the premises in order to operate the going concern that it had just purchased.
Some more artful transaction might sufficiently retain the debtor’s interest in the real property controlled by an unexpired lease, or the going concern residing thereon, to ensure that the parties do not technically run afoul of § 365. However, the concern is whether any such endeavor is merely an attempt to game the system. Landlords were afforded significant protections under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, not the least of which was the reduction of time for the debtor to assume or reject leases of non-residential real property from infinity (“for cause shown”) to (at most) 210 days without the landlord’s consent. While the landlord’s right to know how the lease will be treated by the debtor within the time prescribed by § 363(d)(4) might be protected, if courts continue to authorize a “de facto” assignment without assumption, cure or adequate assurance, what occurs is an actual hijacking of the landlord’s property. Without a true lease, what recourse does a landlord have in the event of catastrophic destruction to his/her property? Recourse against the debtor is likely found in the Bankruptcy Code, but what recourse is there against the purchaser? Is the lessor now forced to litigate in state court? Who wouldn’t want to have the opportunity to test drive the debtor’s property? Who should have that opportunity when it is not contemplated by the Code?
The scenario also raises significant concerns for the debtor’s estate. As always, depending on the circumstances, this could open the estate up to liability. Where an estate might already be limping along, liability arising from the pseudo-tenant’s failure to properly maintain the premises, if severe enough, could render the estate administratively insolvent. Furthermore, depending on how the deal is papered, what is stopping the landlord from moving to eject the purchaser who holds only designation rights to the lease? If there is no estate-interest left in or on the land, save for the debtor’s obligation to assume and assign, would that even amount to a stay violation? A demand for relief to eject the unauthorized tenant could stop short of lease termination. This, in effect, preserves all that the purchaser truly bargained for, but it certainly is not what the purchaser might have expected.
[1] 287 B.R. 112, 115 (Bankr. S.D.N.Y. 2002). While this article only concerns real property leases, the law of the case is applicable to various types of unexpired leases.
[2] See In re Ernst Home Ctr. Inc., 209 B.R. 974, 977 (Bankr. W.D. Wash. 1997).
[3] In re Chrysler LLC, 405 B.R. 84 (Bankr. S.D.N.Y.), aff’d, 576 F.3d 108 (2d Cir. 2009); In re Three A’s Holdings LLC, 364 B.R. 550 (Bankr. D. Del. 2007); In re Bradlees Stores Inc., No. 00-16033, 2001 WL 34809984 (Bankr. S.D.N.Y. March 28, 2001).
[4] 287 B.R. at 126.
[5] Id.
[6] Id.
[7] Id.
[8] Case No. 14-29229 (CMG) (Bankr. D.N.J.).
[9] Order Authorizing Sale (Doc. No. 171) (the “Munire Sale Order”).
[10] 287 B.R. at 115.
[11] Id. at 114.
[12] Id.
[13] Ames Sale Agreement (Doc. No. 1479-2), Section 2.2.
[14] Ames Sale Agreement (Doc. No. 1479-2).
[15] Id.
[16] Ames Sale Agreement (Doc. No. 1479-2), Section 2.2.
[17] 364 B.R. 550, 553 (Bankr. D. Del. 2007).
[18] See generally Tower Records Sale Agreement (Doc. No. 443-1).
[19] In re Chrysler LLC, 405 B.R. 84; In re Three A’s Holdings LLC, 364 B.R. 550; In re Bradlees Stores Inc., 2001 WL 34809984; In re Serv. Merch. Co. Inc., No. 99-02649-GP-11, 2002 WL 32168891 (Bankr. M.D. Tenn. Sept. 9, 2002); 155 Route 10 Assocs. Inc., Case No. 12-24414 (Bankr. D.N.J.); In the Matter of Christ Hosp., Case No. 12-12906 (Bankr. D.N.J.); In re Ashley Stewart Holdings Inc., Case No. 14-14383 (Bankr. D.N.J.).
[20] Munire Sale Agreement (Doc. No. 171).
[21] See Transcript of Sale Hearing, Nov. 19, 2014 (“Munire Transcript”), p. 24 (2:5, 19:21); p. 35 (15:21).
[22] Id.
[23] Munir Sale Order (Doc. No. 171) (subject to certain exceptions).
[24] See Sale Order (Doc. No. 171) (attaching final Munire Sale Agreement and TSA); Consent Order (Doc. No. 204).
[25] Id.
[26] See Sale Order (Doc. No. 171), Ordered ¶ 4; Munire Sale Agreement, Article 2.1.
[27] See Sale Order (Doc. No. 171), Ordered ¶ 5(iv) and (v); Munire Sale Agreement, Article 2.1.
[28] See Sale Order (Doc. No. 171), Ordered ¶ 5(iii); Munire Sale Agreement, Article 2.2.
[29] See Sale Order (Doc. No. 171), Ordered ¶ 10(A).
[30] See Sale Order (Doc. No. 171), Ordered ¶ 16; Munire Sale Agreement, 8.11.
[31] TSA, Exhibit A, Art.1.
[32] TSA, Exhibit A, Art. 2.
[33] Butner v. United States, 440 U.S. 48, 55, 59 L. Ed. 2d 136, 99 S. Ct. 914 (1979); O’Dowd v. Trueger (In re O’Dowd), 233 F.3d 197, 202 (3d Cir. N.J. 2000).
[34] Town of Kearny v. Discount City of Old Bridge Inc., 205 N.J. 386 (2011) (leases are contracts between landlord and tenant that set forth rights and obligations between them in connection with landlord’s temporary grant of possession of property); Maglies v. Estate of Guy, 193 N.J. 108, 143, 936 A.2d 414 (2007).
[35] Campi v. Seven Haven Realty Co., 294 N.J. Super. 37, 41-42 (1996); Delmat Corp. v. Kahn, 147 N.J. Super. 293, 297, 371 A.2d 296 (App. Div. 1977).
[36] Borbely v. Nationwide Mut. Ins. Co., 547 F. Supp. 959, 980 (D.N.J. 1981); Campi v. Seven Haven Realty Co., 294 N.J. Super. 37, 43 (1996); Continental Bank of Pa. v. Barclay Riding Acad., 93 N.J. 153, 170, 459 A.2d 1163 (1983).
[37] Campi v. Seven Haven Realty Co., 294 N.J. Super. 37, 44 (1996).