Navigating Bankruptcy Exposure for Landlords Arising from Anticipated Lease Terminations During COVID-19

While frustrating for landlords to learn, several courts hold that a lease termination agreement is a transfer by the tenant to the landlord of the tenant’s interests in real estate, and at least a few courts hold that the unilateral termination of a lease by a landlord also constitutes a transfer.¹ Consequently, when the transfer occurs before the tenant’s bankruptcy, the landlord may have exposure for preference or fraudulent transfer liability under Sections 547 and 548 of the Bankruptcy Code. A preference is a transfer by the debtor to an unaffiliated creditor during the 90 days before the bankruptcy that satisfies or collateralizes the debtor’s preexisting debt and enables the creditor to receive more than it would in a chapter 7 liquidation. A transfer is constructively fraudulent if the debtor receives less than reasonably equivalent value in exchange for the transfer and the transfer is made while the debtor is insolvent or leaves the debtor insolvent or with unreasonably small capital. More frustrating for the landlord to learn is that, had the tenant rejected the lease in bankruptcy instead of terminating pre-bankruptcy, the risk of the subject avoidance action would be eliminated.

While some lower courts have held otherwise, the leading case with precedential value (and the only U.S. Court of Appeals decision) is Official Committee of Unsecured Creditors of Great Lakes Quick Lube LP v. T.D. Investments I, LLP, 816 F.3d 482 (7th Cir. 2016), which held that a consensual lease termination was a transfer that could be avoided. There, the debtor leased more than one hundred locations at which it provided oil change and other automobile maintenance services. After the debtor encountered business-wide financial difficulties, it entered into lease termination agreements at two locations with landlord T.D. Investments pursuant to which the properties were surrendered and the debtor’s unpaid rent and future lease obligations were forgiven. Within two months, Great Lakes commenced a chapter 11 case, and confirmed a plan around leases at its promising locations, rejecting the others.

Under the terms of the confirmed plan, the creditors’ committee inherited the right to pursue avoidance actions, including to avoid preferential and fraudulent transfers. Claiming that the two locations surrendered to T.D. Investments were worth between $327,000 and $450,000 based on the debtor’s projections, the committee sued T.D. Investments to recover, as either preferential or fraudulent, the value of the transfer to T.D. Investments that resulted from the lease termination agreement.

After conducting a trial, the bankruptcy court in Great Lakes ruled in favor of the landlord, concluding that the lease termination was not an avoidable transfer. The court reasoned that the debtor could not assume the leases because they had been properly terminated under state law, and found that the lease termination agreement was enforceable and non-collusive. The court also found that the debtor’s attempt to reject the leases in bankruptcy, without the committee objecting, weakened the committee’s argument that the leases had significant value. The bankruptcy court’s ruling is consistent with that of other bankruptcy courts that have declined to apply Sections 547 and 548 of the Bankruptcy Code to lease terminations on the basis that (a) debtors do not have cognizable property rights at the time of termination that can be transferred or reacquired and (b) to hold otherwise would violate Section 365(c)(3) of the Bankruptcy Code, which mandates that a debtor cannot assume or assign a lease that has been terminated prior to the bankruptcy.²

Following the bankruptcy court’s ruling, the committee took a direct appeal to the U.S. Court of Appeals for the Seventh Circuit. In a relatively curt decision, the Seventh Circuit reversed. The court found no conflict between the Bankruptcy Code’s avoidance provisions and its lease assumption provisions (i.e., Sections 547 and 548 on one hand and Section 365(c)(3) on the other). In other words, the fact that a lease cannot be assumed does not, as a matter of law, mean that the estate cannot challenge a transfer arising from a lease termination and recover based on the lease’s value.

The Seventh Circuit remanded the case to the bankruptcy court to determine whether the debtor received reasonably equivalent value for the lease termination. After holding a second trial, the bankruptcy court found that the lease termination deprived the debtor of $57,000 (above the present value of the debtor’s future rent payments), and that after deducting approximately $46,000 in rent owed as of the lease termination date, the committee was entitled to a judgment of roughly $11,000.³

Great Lakes is not an “outlier” decision⁴ and should be afforded due attention by landlords considering lease terminations. Perhaps the greatest lesson learned by the landlord in Great Lakes is that if it had kept the lease in place for another 60 days (through the bankruptcy filing), then the landlord would likely have avoided costly avoidance litigation. Instead, the debtor would have rejected, assumed or assigned the leases, and while the debtor decided what to do with the leases, the landlord would have collected postpetition rent on an administrative priority basis.

Presently, we have perhaps the greatest level of cooperation between landlords and tenants who cannot pay rent. Many real estate investors, landlords and lenders reiterate, “we are all in this together,” and that cooperation and shared pain will result in the best outcomes. In this environment, it may seem less likely that tenants who are relieved of rent obligations will file lawsuits against their former landlords in a subsequent bankruptcy. But a creditors’ committee or trustee, who has the fiduciary duty to maximize recoveries for all creditors, will bring avoidance actions against landlords and challenge lease terminations if warranted.

Other than hunkering down and enforcing one’s rights as a landlord in the tenant’s bankruptcy, there is no one-size-fits all solution to this conundrum. Of course, not all tenants that downsize their businesses will land in bankruptcy. If they do, landlords do not have a crystal ball predicting when the tenant’s bankruptcy will occur. But there are strategies that may help landlords reduce the likelihood of litigation because of a lease termination; recognizing that none are “silver bullets,” as the bankruptcy court is free to make its own independent findings.

At the outset, we note that all lease termination agreements should document (with supporting financial data) that the tenant is receiving reasonably equivalent value for surrendering the premises and for relief from rent and other obligations, and landlords should consider itemizing all financial obligations such as taxes, repairs, common area maintenance, and property insurance. To the extent that the landlord has a guaranty for the lease, as part of the negotiations the landlord should ask the guarantor to provide an indemnification or new guaranty against future avoidance actions. If the lease termination is not memorialized in a written agreement, then landlords should contemporaneously document that which would otherwise go into an agreement.

If the outgoing tenant’s lease is demonstrably overmarket, the risk that the lease termination will later be challenged in bankruptcy should be significantly reduced; though if a committee is able to show that the debtor could have been profitable at the leased locations, such as in Great Lakes, the outcome is less certain. In addition to the recitals regarding reasonably equivalent value noted above, the recitals should document that the rent under the lease is above market. If the tenant has left or clearly manifested an intent to leave, then, from a bankruptcy perspective, the landlord may terminate the lease by agreement or unilaterally (by doing whatever is required by the lease or applicable law) before it has a replacement tenant, but the benefits to the landlord in doing so may be minimal as compared to searching for a replacement tenant while keeping the lease in place in case the tenant files for bankruptcy in the interim. If the landlord has a new tenant waiting in the wings, then the termination agreement or the landlord’s records should reflect any downward adjustments to the rent and corresponding damage to the landlord. Simultaneously obtaining an opinion of value for the terminated lease may also help defeat a future avoidance claim.

If the lease is undermarket and the landlord cannot wait to deal with it in the tenant’s bankruptcy or does not think a bankruptcy is likely, then in addition to detailing the benefits to the tenant and reasonably equivalent value, the termination agreement or the landlord’s records should document that the tenant’s projections show continued losses at the property. The landlord should also keep a record of the costs of disposing of the outgoing tenant’s belongings and of any repairs or upgrades that justify a higher rent for its new tenant.

There are additional options for the landlord that may reduce the chances of future avoidance litigation in a bankruptcy case; though to the extent they require the landlord to come out of pocket, they are probably much less appetizing than documenting the facts.

Leases come in all shapes and sizes, and the economic exposure to landlords must be evaluated on a case-by-case basis. Not every lease termination will require the exacting analysis and preventive measures suggested by Great Lakes. As is often the case, the issue is less about which party is correct on the law and its application to the facts, and more about the cost and risk to find out. For lease terminations that justify it from a size and risk perspective, it may be worth sweating the details and either wait to see if a bankruptcy is inevitable or have a lease termination agreement or record that does its best to establish that the tenant received reasonably equivalent value.

For more information, please reach out to your regular Pillsbury contact or the authors of this client alert.

Pillsbury’s experienced multidisciplinary COVID-19 Task Force is closely monitoring the global threat of COVID-19 and providing real-time advice across industry sectors, drawing on the firm’s capabilities in crisis management, employment law, insurance recovery, real estate, supply chain management, cybersecurity, corporate and contracts law and other areas to provide critical guidance to clients in an urgent and quickly evolving situation. For more thought leadership on this rapidly developing topic, please visit our COVID-19 (Coronavirus) Resource Center.

^{[1]   See, e.g., In re Indri, 126 B.R. 443 (Bankr. D. N.J. 1991); In re Ferris, 415 F. Supp. 33 (W.D. Okla. 1976); In re Thompson, 186 B.R. 301 (Bankr. N.D. Ga. 1995).}

^{[2] See, e.g., In re Durso Supermarkets, Inc., 193 B.R. 682 (Bankr. S.D.N.Y. 1996); In re 130/40 Essex Street Development Corp., 2008 WL 4845639 (Bankr. S.D.N.Y. 2008); In re Haines, 178 B.R. 471 (Bankr. W.D. Mo. 1995).}

^{[3] In re Great Lakes Quick Lube Limited Partnership, 2017 WL 2266769, at *5 (Bankr. E.D. Wis. 2017).}

^{[4] See, e.g., In re White, 559 B.R. 787 (Bankr. N.D. Ga. 2016); In re Indri, 126 B.R. 443 (Bankr. D. N.J. 1991); In re Edward Harvey Co., 68 B.R.851 (Bankr. D. Mass. 1987); In re Ferris, 415 F. Supp. 33 (W.D. Okla. 1976); In re Thompson, 186 B.R. 301 (Bankr. N.D. Ga. 1995); In re Fashion World, Inc., 44 B.R. 754 (Bankr. D. Mass. 1984).}