The Nonexistent Debtor and Indefinite Contract Terms: Better to Dot the I’s and Spell Out the Agreed Upon Terms

In re Delaware Sports Complex, LLC, 573 B.R. 543 (Bankr. D. Del. 2017) –

The debtor, a limited liability company, purportedly entered into a ground lease before it was formed. The bankruptcy court considered the validity of the lease, whether the lease was properly terminated due to uncured defaults, and the effect of an agreement to subordinate the lessor’s interests to the interests of debtor’s lender.

The debtor was formed to develop a sports complex. To that end, a lease was executed naming the debtor as tenant and a local municipality (the Town) as landlord. However, the debtor was not formed until more than a year after execution of the lease.

The court raise the preliminary question of whether the lease was void ab initio because the debtor did not exist when it executed the lease. Although the court noted decisions recognizing de facto limited liability companies (analogous to de facto corporations) where there was a bona fide attempt to organize, these decisions did not seem to apply in this case since there was no attempt to file a certificate of formation until after the landlord issued a notice of default.

Instead, the court concluded that the debtor could enter into the lease even though it was not formed because when an agent contracts for a principal that is subsequently formed, the principal can assume the contract. Further, the Town was estopped from denying the existence of the debtor since it had accepted the debtor as a limited liability company from the beginning.

The next issue was whether the lease was properly terminated due to the debtor’s failure to cure defaults. The Town’s default notice identified several items: (1) the debtor represented in the lease that it was “formed and validly existing” with full power to enter into the lease, which was untrue; (2) the debtor failed to meet certain bonding requirements; and (3) the debtor failed to execute a recoupment agreement with the Town and the state DOT.

After receiving the notice of default, the debtor filed a certificate of formation with the state – which the Town conceded cured that default. On the issue of bonding, apparently the requirements were not clear, and the debtor was unable to obtain clarification from the Town. Consequently, the debtor did the best it could. The court concluded the debtor acted in good faith with no help from the Town, which was sufficient to cure the default.

The third default related to a requirement that as a condition of development the debtor must either provide a full traffic impact study or participate in a recoupment agreement with the state DOT. Both choices would cost the debtor in excess of $2 million. Although the debtor initially indicated that it would sign the recoupment agreement, it never did. The debtor’s reticence stemmed from the fact that it decided it might want to develop only a portion of the project, which would mean there would be less traffic and thus no requirement for the recoupment agreement.

In connection with assessing the third default, the court noted that under state law “there is an implied covenant of good faith and fair dealing which ensures that the reasonable expectations of the parties are fulfilled.” Consequently, the court was required to “‘focus on what the parties likely would have done if they had considered the issues involved.'”

The difficulty in declaring the third default was that the lease did not include a timeline for development. Notwithstanding this failure, the court concluded that the expectation of the parties was clear: the debtor was to develop numerous fields and facilities. Since the lease contained a “time is of the essence” clause, this meant that the debtor should promptly fully develop the project. Thus, a failure to enter into the recoupment agreement based on the possibility that the debtor would only partially develop the project constituted a default. Since the debtor did not cure this default, the lease was properly terminated.

That left the final question of the effect of the lease requirement that the Town execute a subordination, non-disturbance agreement with debtor’s lender. However, the court concluded it did not have to reach this question given that the lease was properly terminated.

It would have been difficult to predict the outcome of this case. For example, typically analysis of a contract will focus on the terms of the contract, and it would be unusual for a court to consider “what the parties likely would have done if they had considered the issues involved.” Better to avoid the uncertainty in the first place and include appropriate terms in the contract.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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