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Seventh Circuit’s Warning to Landlords: Getting Out of Your Lease With a Distressed Company May Expose You to Bankruptcy Risk

March 16, 2016

The avoidance powers contained in chapter 5 of the Bankruptcy Code permit the recovery of certain prepetition “transfers” made by the debtor – either as a preference under section 547 or as a fraudulent transfer under either section 548 or state common law, made applicable under section 544 of the Bankruptcy Code.  Typically, the “transfer” is self-evident – pledging of collateral, a payment or distribution, or conveyance of an asset – and the analysis focuses on other aspects of the statutory elements, such as the timing of the transfer, solvency of the debtor, reasonably equivalent value, and the various defenses available to a transferee.  In Great Lakes Quick Lube, though, the focus was on whether the debtor actually had made a transfer that was subject to the avoidance powers.  In holding that the debtor had transferred a property interest when it voluntarily terminated its real property leases, the Seventh Circuit reminds us of the breadth of the notion of a “transfer” under the Bankruptcy Code. 

 

The controversy in Great Lakes Quick Lube centered around the debtor’s prepetition termination of two leases for profitable stores.  The creditors’ committee argued that the stores and the underlying leases were valuable and sought to avoid the terminations either as a preferential transfer to an existing creditor (i.e., the landlord) or as fraudulent transfers.  Although the Seventh Circuit recounts some of the value dispute, the bankruptcy court never ruled on that issue because it determined that the lease terminations did not constitute “transfers” that were subject to avoidance.

 

In reversing the bankruptcy court, Judge Posner, writing for the Seventh Circuit, noted that section 101(54)(D) of the Bankruptcy Code defines “transfer” broadly to include “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with – (i) property; or (ii) an interest in property.”  Because a leasehold clearly creates an interest in property, the debtor effected a transfer when it agreed that the landlord could take back its leases.  The landlord attempted to argue that construing transfer to include termination of a lease conflicted with section 365(c)(3) of the Bankruptcy Code, which prohibits assumption or assignment of a nonresidential real property lease that has terminated prepetition.  The court held that, because the committee was seeking only the recovery of the value of what was transferred, no conflict existed.  (This conclusion seemed to be a bit of legal shorthand and was an attempt not to disturb the new lease into which the landlord had entered.  Perhaps the more legally appropriate reasoning would have been to hold that the termination could have been avoided – thus, not triggering section 365(c)(3) – but that the new lessee qualified as a subsequent transferee that took for value and in good faith under section 550(b) of the Bankruptcy Code.)

 

Notably, the lease terminations in Great Lakes Quick Lube were voluntary terminations by agreement of the debtor and its landlord.  A more difficult question is whether a “transfer” occurs when the landlord or a contract counterparty terminates a lease or contract by virtue of the debtor’s default under the contract.  Presumably, even though the definition of “transfer” includes an involuntary transfer, the argument in that situation would be that the debtor’s rights under the contract or lease were limited to the rights existing from and after a default.

 

Given the bankruptcy court’s error in finding that no transfers had occurred, the Seventh Circuit did not have to consider the issue of what constitutes “reasonably equivalent value” in the context of a voluntary lease termination.  Judge Posner did, however, express skepticism at some of the reasons stated by the debtor for terminating the leases, including that the landlord had become “inflexible” when the debtor had fallen behind on its lease payments, and the debtor feared being sued by the landlord:

 

It seems unlikely that Great Lakes terminated leases on two profitable stores just because the landlord was being difficult and making threats.  But if Great Lakes knew it was going down the tubes it would have had no compelling reason to cling to the leases since if it did they would become assets of the estate in bankruptcy and thus property of Great Lakes’ creditors; and either way the leases would have no value to Great Lakes. Conceivably, therefore, even slight irritation with [the landlord’s principal] might have led Great Lakes to terminate them.

 

This is an unusual interpretation of a debtor’s motivations leading into bankruptcy (and suggests, with no foundation, that the debtor deliberately was trying to take assets away from its creditors).  Moreover, the court also noted that the landlord’s affiliates had agreed to terminate leases at three unprofitable stores, and those terminations were not the subject of any challenges.  How should a court determine value in the context of a lease or contract termination?  For example, if the lease or contract prohibited assignment, should the court take into consideration that the debtor could not have transferred its rights under the lease or contract?  Should the court take into account that the debtor could have filed for bankruptcy protection and taken advantage of the prohibition against assignment in section 365(f)?  Does it matter if the debtor could not afford to continue to honor the terms of a contract or lease and likely would have defaulted absent the agreement with its landlord or contract counterparty?  Should the court value each termination on a lease by lease basis, or should it look at the overall package of consideration the debtor received (which may have included releases from its obligations on the leases for the unprofitable stores)?

 

The decision provides no direct guidance on how landlords and contract counterparties dealing with distressed entities may protect themselves against the second-guessing that accompanies avoidance actions.  Forcing the potential debtor to the brink in terms of waiting for a default to occur and then terminating on the basis of the default seems like a solution that defers economic reality without benefiting either party.  (Moreover, it raises the issue of collusive defaults.).  As with many situations, documenting the rationale for the termination and the consideration provided may help, but is no panacea.

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