The 11 U.S.C. § 365(b)(3)(A) Adequate Assurance Standard: An Overlooked Tool for Shopping Center Landlords?

When a retail debtor seeks to sell its assets in a chapter 11 proceeding pursuant to § 363 of the Bankruptcy Code, one of the key issues that often arises is whether the debtor will be permitted, as part of such sale, to assume and assign its store leases to the proposed buyer pursuant to § 365 of the Bankruptcy Code.

Of particular relevance are the protections for shopping center[1] landlords set forth in § 365(b)(3) of the Bankruptcy Code, which provides that when there has been a default in a shopping center lease that a debtor seeks to assume, adequate assurance of future performance must be provided to landlords, including adequate assurance

(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.

11 U.S.C. § 365(b)(3) (emphasis added).

In light of the ongoing struggles of the traditional retail sector, which are likely to be exacerbated in light of the severe strain on the economy caused by COVID-19 restrictions, § 365(b)(3) may prove to be a powerful tool for shopping center landlords in retail bankruptcies who are opposing assignments of leases and seeking to retake control of their properties.

Such was the case in a recent opinion by the Federal District Court for the Southern District of New York, which examined § 365(b)(3)(A) in In re Sears Holdings Corp., et al.[2] In Sears, Sears Holding Corp. had an unexpired lease for a store location in Mall of America that contained many tenant-friendly provisions, including the near-unilateral right to assign the lease to any assignee with a net worth or shareholder equity of at least $50,000,000. Through the bankruptcy, Sears sold substantially all of its assets through a § 363 sale and thereafter attempted to assign approximately 660 leases to the buyer, including the Mall of America lease.

The bankruptcy court approved the assignment over the Mall of America landlord’s objection, finding that although there was no “similarity of financial condition and operating performance” between Sears and the proposed assignee, as required by § 365(b)(3)(A), the lease could nevertheless be assigned because the lease itself only required that the net worth or shareholder equity of the assignee be at least $50,000,000, which the court determined was “highly likely.”

On appeal, the district court reversed the bankruptcy court, noting that the few courts that have examined § 365(b)(3)(A) have concluded that it requires proportionally comparable financial health between the assignee and/or its guarantors and the debtor as of the lease’s inception.[3] Additionally, the district court gave no weight to the “pre-approved” assignment language in the lease, concluding that the lease’s equity standard could not be substituted for a “congressionally-mandated standard for providing adequate financial assurance of future lease performance.”

Aside from the Sears opinion, there is limited case law specifically interpreting § 365(b)(3)(A) of the Bankruptcy Code, and no clear standard for satisfying its requirements. Nevertheless, based on the case law that is available, the analysis appears to turn on the facts and circumstances of each case, with courts examining and comparing balance sheets, Form 10-Ks and 10-Qs, annual reports, cash-flow statements and other financial records, the experience of the owner or operator of the assignee, and the financial condition of guarantors.[4]

As demonstrated by the Sears opinion, § 365(b)(3) of the Bankruptcy Code could present significant potential obstacles for retail debtors in the current economic climate. Shopping center leases often run for a term of decades, and a retail operator’s financial condition may suffer a dramatic decline during such time, as in the case of Sears. While a buyer of assets may, at the time of the bankruptcy proceedings, have sufficient financial resources to acquire a retail operator’s assets, which are valued as of the time of the sale and sold at bankruptcy discount prices, such buyer might not have the same financial resources the debtor had years or decades prior to the chapter 11 proceedings. This may be particularly true when a lease dates back to significantly better days for a retail operator. Thus, satisfaction of this statutory requirement could prove difficult for any debtor that is far into the term of its long-term lease, especially those with limited historical financial information.

Moreover, for an ailing retailer like Sears that is seeking to avoid the fate of liquidation, it is often a newly formed financial buyer, with little prior operating history, that provides a final lifeline. In such instances, when a landlord opposes the assignment, courts may require substantial proof of financial wherewithal and operating experience, which inherently will be more difficult with a new entity.

In adopting 11 U.S.C. § 365(b)(3)(A), “Congress provided a rigorous standard that an assignee of a bankrupt’s shopping center lease must meet in order to give the landlord adequate assurance that the new tenant will not shortly end up in bankruptcy.”[5] In doing so, however, it may have created a significant obstacle to consummating “going concern” sales in the current retail environment, which keep stores in operation, retain jobs for employees and produce greater outcomes for stakeholders. The alternative outcome is frequently liquidation of inventory and store locations going dark.

While the issues regarding assumption and assignment of leases in the retail context are frequently resolved by agreement among the relevant parties, the Sears case confirms that when there is a dispute, debtors will not be able to skate past the § 365(b)(3)(A) requirements over the objection of an informed landlord.