A chapter 11 debtor relinquished 2 leases prior to filing bankruptcy. The unsecured creditors’ committee sought to avoid the lease termination transaction as a preference or a constructive fraudulent transfer. The bankruptcy court ruled against the committee and the district court affirmed, so the committee appealed to the 7th Circuit.
The debtor owned a series of stores that provided oil changes and other automotive maintenance services. Prior to bankruptcy it had more than 100 store leases: Typically it bought a store and then did a sale-leaseback transaction with investors. Shortly before filing bankruptcy, the debtor negotiated with one of its landlords to terminate 2 leases for profitable locations (as well as 3 leases for unprofitable locations held by the landlord’s affiliates).
The creditors’ committee contended that the surrender of the 2 profitable locations constituted both a preference under section 547 of the Bankruptcy Code and a fraudulent transfer under section 548(a)(1)(B). A preference includes a transfer made by debtor while it was insolvent within 90 days before bankruptcy that allows a creditor to receive more than it would in a chapter 7 liquidation. The constructive fraudulent transfer alleged by the committee includes a transfer made by an insolvent debtor within 2 years prior to bankruptcy where the debtor did not receive reasonably equivalent value.
The parties disagreed about whether the landlord received more value than it would have in a chapter 7 liquidation and whether the debtor received reasonably equivalent value. However, the bankruptcy court did not reach those issues because it concluded that the lease terminations did not constitute transfers.
The debtor contended that it terminated the 2 profitable leases “for a variety of reasons including a strained relationship” with the landlord. According to the debtor, the landlord “was demanding and inflexible, especially in insisting on prompt payment of [the debtor’s] rental obligations despite its parlous [sic] financial state.” (Fancy that.) It was also afraid of being evicted and being sued because it was behind in paying its lease obligations.
The 7th Circuit expressed skepticism that the debtor terminated profitable leases because the landlord was difficult and making threats. “But if [the debtor] 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 [the debtor’s] creditors; and either way the leases would have no value to [the debtor].” Given that circumstance the court concluded that it was conceivable the debtor might terminate the leases based on even a slight irritation.
The debtor further argued that it wanted to get rid of locations that were burdensome to its operations in the hopes that it could avoid bankruptcy. It claimed that even though the 2 stores were profitable, ongoing maintenance, repairs, and other obligations would have cut into profits so that it would have actually lost money if it kept the locations. The 7th Circuit’s alternate interpretation was that the debtor might have expected to emerge from bankruptcy as a going concern, and a fresh start might be easier if it did not have to deal with an “irritating” landlord.
In any event, the debtor argued that it abandoned rather than transferred the leases, and thus there was no preferential or fraudulent transfer. However, the court noted that “transfer” is broadly defined in the Bankruptcy Code to include “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with… an interest in property.” In the court’s view the debtor had an interest in property (the leaseholds) which it parted with by transferring to the landlord. If the debtor still had the leasehold interests, they would have been an asset to the bankruptcy estate.
The landlord made an additional argument under section 365(c)(3) of the Bankruptcy Code: if a lease of nonresidential property is terminated under nonbankruptcy law prior to the bankruptcy filing it may not be assumed or assigned in the bankruptcy. The bankruptcy court concluded that this section was applicable, and thus the committee’s claim failed.
The 7th Circuit disagreed explaining that section 365 forbids interference with new tenants by the trustee or debtor in possession by prohibiting an assignment or assumption that would allow sale of the lease in bankruptcy, entitling someone else to occupy the property. In this case the committee did not want the leases and was not asking the court to turn over the stores to the debtor’s creditors. Rather, it wanted to recover the value of the leases from the landlord for the benefit of the bankruptcy estate.
Accordingly, the 7th circuit reversed the bankruptcy court decision and remanded for determination of the value of the transfer and whether the landlord had any defenses.
Under state law termination of a lease typically affects the remedies available to a landlord. However, if a lease is not terminated prior to bankruptcy, the landlord often will not be able to obtain early resolution of the status of the leased premises. Consequently, in determining a course of action a landlord will need to weigh the benefits of obtaining control over the least premises against any adverse impact on state law remedies.
This case illustrates that should be an additional consideration: if the lease has value the landlord may be exposed to claims for recovery of the value if a bankruptcy is subsequently filed. Typically a preference claim will be an issue only if bankruptcy is filed within 90 days. However, a constructive fraudulent transfer claim based in part on the failure of the debtor to receive reasonably equivalent value can be an issue for 2 years under section 548 and for 4 years or more if there is a “strong-arm” claim based on state law state law under section 544.
Vicki R Harding, Esq.