Selling The Right To Assign Leases In Bankruptcy
Ingenuity in the markets often outpaces financial regulation. Congress did not contemplate the intervention of a third party when it adjusted the relationship between lessors and financially alarmed lessees in the Bankruptcy Code. The advent of “designation rights” sales has provided retail debtors an additional option for realizing the value in their leases, to the detriment of lessors, and created uncertainty for lenders. Retail lessees in bankruptcy, including Montgomery Ward, Service Merchandise and K-Mart, have mature the sale of designation rights to anticipate and maximize the value of their leases.
Designation rights most often involve retail leases and this Article will be confined to those transactions. However, the Bankruptcy Code provisions that permit the sale of designation rights would similarly permit the sale of those rights for most other types of leases and executory contracts.
Bankruptcy Creates The Opportunity For Designation Rights
The treatment of leases in a bankruptcy case provides a fresh opportunity for the creation and sale of designation rights. The state laws of contract apply to leases outside bankruptcy and generally enforce any lease term agreed to by the parties. Standard lease terms include a prohibition against the lessee’s assignment of the lease without the lessor’s consent. Bankruptcy invalidates an anti-assignment provision in a lease and can force its assignment onto an objecting lessor. 11 U.S.C. §365(f)(1). The ability to assign leases without lessor consent provides the cornerstone for designation rights sales.
The Bankruptcy Code does not leave the lessor unprotected. To assign a lease without the lessor’s consent, the debtor-lessee must obtain bankruptcy court approval through a two-step process: assumption and assignment.
First, the debtor must assume the lease. 11 U.S.C. §365(f)(2)(A). Lease assumption generally requires the debtor to cure lease defaults, compensate the lessor for monetary losses caused by those defaults and provide adequate assurance of future lease performance. 11 U.S.C. §365(b)(1).
Second, the debtor must establish the lease to a third party. Assignment requires adequate assurance of future performance of the lease by the assignee. 11 U.S.C. §365(f)(2)(B). The assignee’s ability to perform the lease is critical to the lessor because, unlike an assignment under state law, the debtor has no further liability on the lease after assignment. 11 U.S.C. §365(k).
In practice, assumption and assignment usually occur simultaneously. If the debtor does not intend to continue its operation at the location, it will delay lease assumption until it finds a party willing to pay for an assignment of the lease. Although the debtor must make the post-petition lease payments while it markets the lease, 11 U.S.C. §365(d)(3), assumption will require it to pay all past-due amounts and perform the remaining term of the lease. Because of the large financial commitment that comes with lease assumption, debtors often delay the decision until confirmation of their plan of reorganization.
The Sale Of Designation Rights
A sale of designation rights is the debtor’s transfer to a third party of its rights to decide which leases to assume, to whom those leases should be assigned and the terms for those assignments. The ability to force lessors to accept assignments permits the sale of designation rights in bankruptcy which would otherwise be prevented by anti-assignment provisions in the leases.
Sales of designation rights generally include an initial payment to the debtor, payment of the lease carrying costs by the purchaser until assignment and a division of the assignment proceeds between the purchaser and debtor. The purchaser markets the leases to potential lessees and usually bears this expense. The debtor agrees to assign the leases as directed by the purchaser during a specified period of time. When the purchaser reaches an agreement with an assignee, the debtor seeks bankruptcy court approval to assume the lease and assign it to the assignee on the terms negotiated by the purchaser of the designation rights. Any leases not assigned at the end of the specified period are usually rejected by the debtor and the premises restored to the lessor.
For example, Kimco Funding LLC (Kimco) purchased the designation rights to Montgomery Ward’s leases during its bankruptcy case. In re Montgomery Ward LLC, Case No. 00-4667 (Bankr. D. Del. 2000). Kimco paid the Montgomery Ward bankruptcy estate $15 million and the first $15.5 million in proceeds from the lease assignments. Kimco was to receive the next $30.5 million; two-thirds of the next $24 million was payable to Montgomery Ward, and any additional proceeds would be divided equally between the parties.
The advantages of a designation rights sale to the debtor are obvious. The sale provides immediate cash and relieves the debtor from its monetary lease obligations during the designation period. Although the debtor surrenders some of the value in the leases to the purchaser, the guaranteed initial payment reduces the risk of finding qualified assignees and shifts that burden from the debtor’s already beleaguered management to the purchaser of the designation rights.
While beneficial to debtors, lessors often view bankruptcy lease assignments in general, and designation rights sales in particular, as impinging on their fair to control tenant selection and the property. Other lessees in a retail facility may also have concerns about a novel lessee selected by the purchaser of designation rights whose paramount interest will be maximizing the assignment impress rather than maintaining the tenant mix or image of the retail facility.
Modifications To Maximize Lease Values
Congress has long-recognized the specialized concerns in bankruptcy of retail lessors. It strengthened the protections for retail lessors in 1984 by conditioning the assumption or assignment of a lease on the lessor receiving substantially similar percentage rent, enforcement of radius, location, use or exclusivity provisions in the lease, compliance with similar provisions in other leases in the facility, and maintaining the existing tenant mix and balance of the retail facility. 11 U.S.C. §365(b)(3). The restrictions apply only to “shopping center” leases, and although Congress failed to define the term, bankruptcy courts have found no wretchedness in finding most multi-tenant retail facilities covered by the restrictions on assumption and assignment.
The Bankruptcy Code invalidates lease provisions that prohibit or restrict assignment. 11 U.S.C. §365(f)(1). Bankruptcy courts have used that tenet to authorize lease assignments in contravention of the shopping center restrictions when the purpose of the restriction appeared to be to prevent assignment. See, e.g., In re Rickel Home Cntrs., 240 B.R. 826, 831-32 (D. Del. 1998)(assignment in violation of exercise restriction in lease). For example, in the K-Mart Chapter 11, the bankruptcy court permitted the locations to “go shadowy” for nine months following a designation rights sale even though the leases required continuous operation. In re K-Mart Corp., Case No. 02-02474 (Bankr. N.D. Ill. 2002); but see Trak Auto Corp. v. West Town Center (In re Trak Auto Corp.), 367 F.3d 237 (4th Cir. 2004)(denying assignment based on use restriction in lease).
The debtor can secure a higher price in a designation rights sale by having restrictions on use, alteration, continuous operation and further assignment excised from the leases. A number of courts have removed these restrictions from leases as part of a designation rights sale rather than considering the validity of the restriction when the lease is assigned to a new tenant. Judicial removal of contractual restrictions increases the value of the leases by enlarging the population of potential assignees from which the purchaser of the designation rights can diagram and expanding the permissible uses of the leasehold.
Lease provisions that provide the lessor with part of the consideration from an assignment of the lease pose a significant threat to designation rights sales. Often termed “profit sharing” provisions, their enforcement would engage much of the financial incentive for purchasers of designation rights. However, courts generally invalidate profit sharing terms as anti-assignment provisions. See, e.g., In re Standor Jewelers, 129 B.R. 200 (Bankr. 9th Cir. 1991).
The sale of designation rights begins a process that can significantly impact lessors and other tenants in a retail facility. But, at least one court has questioned whether a lessor even has standing to contest a designation rights sale. In re Ames Dept. Store, 287 B.R. 112 (Bankr. S.D.N.Y. 2002).
Other tenants in a retail facility often do not even receive notice of a designation rights sale or proposed assignment of the debtor’s lease, even though that assignment may impact exclusivity and other provisions in their leases. 11 U.S.C. §365(b)(3)(C). These parties can best protect their positions by diligent monitoring of a debtor-lessee’s case, proactive negotiation with the debtor and committees, encouraging the lessor to advocate their interests and prompt response to an effort to sell designation rights or assign leases.
The Accomplish Of Bankruptcy Reform On Designation Rights
Recent changes to the bankruptcy laws may affect the sale of designation rights. Purchasers of designation rights seek extended periods of time to market the leases in order to obtain the highest assignment prices. Bankruptcy courts have generally extended the time to assume leases for one year or longer to accommodate designation rights sales.
The amendment to the Bankruptcy Code now requires nonresidential leases to be assumed within 120 days or surrendered to the lessor. 11 U.S.C. §365(d)(4). Although the debtor can glean a single, 90 day extension, the court cannot grant further extensions without the lessor’s consent. Purchasers of designation rights will therefore have no more than 210 days after the case is filed for marketing the leases, negotiating with assignees and obtaining bankruptcy court approval of the assignment. Lessors will have a strong incentive to oppose assignments and take back possession of the property to find their own tenant or negotiate directly with the assignee identified by the designation rights purchaser.
The truncated deadline may, however, merely alter the structure and economics of designation rights sales. Although assumptions and assignments generally occur at the same time, nothing in the Bankruptcy Code requires that method. Debtors may acquire valuable leases within the 210 day period and do them later to new tenants rather than surrendering the property and potential value of the leases to the lessor. Once assumed, the leases could be assigned at any time during the case.
Another provision in the amendment reduces the risk of assuming the lease before obtaining an assignment. Under prior law, the debtor’s bankruptcy estate was liable for all monetary obligations of the lease after assumption. Following the amendment, a debtor can reject an assumed lease and limit its liability to only two more years. Purchasers of designation rights will also almost certainly provide indemnification of the debtor for the carrying costs of leases that have to be assumed to avoid forfeiture to the lessor.
But what the new amendment gives with one provision, it takes away with another. The debtor must now comply with a lease provision requiring continuous operation after assumption. 11 U.S.C. §365(b)(1)(A). Therefore, while the debtor could catch a lease until an assignee was found, it would have to continue to operate from the location until assignment. This provision will also prevent the former practice of permitting assignees extended grace periods before complying with continuous operation provisions.
The unique amendment also requires other non-monetary defaults to be cured at the time of assumption unless cure is impossible. This resolution of what had been a split of opinion in the courts of appeal provides lessors with the opportunity to devise covenants that can prevent lease assumption and assignment without running afoul of the prohibitions against penalty and anti-assignment provisions.
Conflicting Claims To Sale Proceeds
Courts have consistently held that designation rights are property of the bankruptcy estate that can be sold but have not been consistent in the reasoning underlying that conclusion. The just justification chosen for the sale of designation rights can determine the party that most benefits from the sale.
The debtor’s secured creditors have the right to receive the value of their collateral and the proceeds from that collateral even if the proceeds are generated after the bankruptcy filing. 11 U.S.C. §552(b)(1). With the exception of proceeds from collateral, no property the debtor acquires after the case is filed is subject to a pre-petition lien. 11 U.S.C. §552(a). If the initial payment for the sale of designation rights is proceeds from the leases, those funds would be encumbered by the pre-petition liens on the leases. Contrastly, if the designation rights were created post-petition, the funds from their sale would be free of the claims of secured creditors and available for the debtor’s use.
There can be no doubt that funds the debtor receives from the assignment of a lease pursuant to the designation constitutes proceeds from that lease. A compelling argument can also be made that the initial sale consideration is proceeds from the leases. At the simplest level, there could not be a sale of designation rights without the leases, and the purpose of the sale is to assign the leases. The proceeds argument becomes even stronger when the initial payment for the designation rights is structured as an advance against future assignment proceeds. Most bankruptcy court analyses of designation rights would support this argument although none has directly analyzed the claim of a secured creditor to the proceeds. See, e.g., Ames, 287 B.R. at 119; In re Ernst Home Cntrs., 209 B.R. 824 (Bankr. W.D. Wash. 1997).
An interesting question of how to allocate the initial proceeds from a designation rights sale would arise if a creditor held liens on some, but not all, of the leases subject to designation. Also, should the initial payment from the designation rights sale be considered proceeds of only those leases that are actually assigned? These types of questions bring to the surface the difficulties with considering the initial payment for designation rights to be proceeds from the underlying leases.
An equally compelling argument can be made that initial funds from the sale of designation rights are not proceeds of the leases or subject to the claims of the debtor’s secured creditors. The designation rights do not exist before bankruptcy because the prohibition against assignment contained in the lease is valid before bankruptcy and only invalidated by Part 365(f)(1). Further, the lease is not transferred to the purchaser as part of the sale of designation rights, which contraindicates that the consideration for the sale is proceeds of the lease. In fact, the lease may never be assigned. It is difficult to describe funds as proceeds of an assignment that never occurs.
Designation rights more resemble a post-petition option granted by the debtor, and the payment by the purchaser is proceeds of that option rather than the underlying asset of the lease. The funds from the sale of designation rights would therefore be for an asset created post-petition and not subject to pre-petition liens on the leases.
Designation Rights Strategies
Lessors, other tenants and lenders have important, but different, stakes that may conflict in a sale of designation rights. Each constituency requires different strategies to protect their interests both when the debtor seeks to sell designation rights and when it later seeks bankruptcy court approval of the lease assignments designated by the rights purchaser.
Lessors must be prepared to act promptly following a bankruptcy filing by their lessee. The limited time for assumption set by the recent bankruptcy amendment gives lessors powerful leverage to prevent a designation rights sale. In addition to refusing to consent to an extension of that time period, lessors should also oppose the debtor’s request for the single, 90-day extension of time for assumption authorized by the statute. 11 U.S.C. §365(d)(4)(B). Consideration should also be given to negotiating with the debtor for prompt rejection of the lease in return for the lessor’s waiver of claims or payment.
The terms of the designation rights sales must also be carefully analyzed. Any effort to invalidate lease terms as part of the sale must be vigorously opposed by the lessor. A review should be made of other leases in the retail facility to ensure that the lessor will not be placed in breach of those agreements by the assignments contemplated by the sale. Additionally, if the sale terms provide for the debtor to receive only nominal consideration from the lease assignments, the lessor may be able to successfully argue the sale constitutes an invalid transfer of the Section 365 power to assign leases.
While it may be able to save employ restrictions and similar lease provisions from being invalidated, a lessor must be prepared for bankruptcy court approval of the designation rights sale. A sale in bankruptcy cannot be overturned on appeal unless the sale order is stayed. Id. §363(m); Weingarten Nostat, Inc. v. Service Merch. Co., 396 F.3d 737 (6th Cir. 2005)(applying Section 363(m) to a sale of designation rights). Obtaining a quit pending appeal requires a bond which will ordinarily be prohibitively expensive for a designation rights sale. Lessors which are unsuccessful in blocking a designation rights sale in the bankruptcy court will usually need to shift their focus to the debtor and purchaser’s later effort to assign the lease.
As previously discussed, assignment of the lease requires the debtor to cure all monetary defaults and non-monetary defaults which are not impossible to cure, to begin complying with continuous operation provisions in the lease and to provide adequate assurance of the assignee’s future performance of the lease. 11 U.S.C. §365(b),(f)(2). Adequate assurance includes proving that percentage rent will not decline substantially, that the assignment will not violate use, exclusivity and similar provisions in either the subject lease or other leases in the center, and that the assignment will not disrupt the center’s tenant mix or balance. These factually intensive requirements provide fertile ground for the lessor to oppose the assignment of its lease by the debtor pursuant to the purchaser’s designation.
Other tenants in the retail center should be mindful that they will probably not receive notice of the debtor’s intentions to sell designation rights or assign the lease. The lack of formal notice to them in the bankruptcy requires tenants to vigilantly monitor the debtor’s case for indications of a rights sale or lease assignment. The possibility that tenants will be denied standing in the bankruptcy case favors obtaining an early commitment from the lessor to contest proposed assignments that violate expend, exclusivity and similar provisions in the tenants’ leases or otherwise negatively impact the retail center.
The debtor’s pre-petition secured lenders can substantially benefit from the increase in their collateral due to a sale of designation rights. However, these lenders must actively participate in structuring the sale terms and obtaining clear findings from the bankruptcy court to specify that the sale consideration constitutes proceeds from the leases and remains subject to the lenders’ pre-petition liens. Lenders have the greatest leverage to obtain these favorable determinations before the sale of designation rights is approved. Post-petition lenders, administrative creditors and official committees will have the opposite incentive to characterize at least the initial payment for the designation rights as the sale of an assignment right created by the bankruptcy which is free of liens.
Conclusion
The relatively unusual use of designation rights sales by debtors to maximize the value of their retail leases has left unanswered a number of questions, particularly with regard to lease restrictions and creditors’ rights to the sale proceeds. The new amendment to the Bankruptcy Code has injected even more uncertainty into those issues and how the sales of designation rights will be structured under the new law. But the large financial incentives for debtors, creditors and purchasers of designation rights virtually ensures that these sales will continue to be an notable part of commercial retail bankruptcies.
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Filed under Corporation Filing Bankruptcy by on Apr 27th, 2011. 
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