Even before Congress added section 365(c)(3) to the Bankruptcy Code in 1984, it was generally understood that a nonresidential real property lease which has been validly terminated under applicable law prior to a bankruptcy filing by the debtor-former tenant cannot be assumed or assigned in bankruptcy. Moreover, the terminated leasehold interest is excluded from the debtor’s bankruptcy estate, and any action by the landlord to obtain possession of the formerly leased premises is not prohibited by the automatic stay.

However, a ruling recently handed down by the Seventh Circuit Court of Appeals indicates that, even if a nonresidential real property lease has been terminated prepetition, the termination may be avoidable in bankruptcy as a preferential or fraudulent transfer. In Official Committee of Unsecured Creditors v. T.D. Investments I, LLP (In re Great Lakes Quick Lube LP), 2016 BL 74950 (7th Cir. Mar. 11, 2016), the Seventh Circuit ruled that a debtor-tenant’s voluntary prepetition termination of a commercial real estate lease may be an avoidable “transfer” under section 547 or 548 of the Bankruptcy Code, thereby allowing the bankruptcy trustee or chapter 11 debtor-in-possession (“DIP”) to seek recovery of the value of the lease from the landlord.

Power to Assume or Reject Contracts Excludes Terminated Nonresidential Real Property Leases

Section 365 of the Bankruptcy Code authorizes a trustee or DIP to assume, assume and assign, or reject most kinds of executory contracts and unexpired leases.

However, section 365(c)(3) provides that:

[t]he trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if . . . such lease is of nonresidential real property and has been terminated under applicable nonbankruptcy law prior to the order for relief.

Correspondingly, section 541(b)(2) of the Bankruptcy Code provides that “property of the estate” does not include:

any interest of the debtor as a lessee under a lease of nonresidential real property that has terminated at the expiration of the stated term of such lease before the commencement of the case under this title, and ceases to include any interest of the debtor as a lessee under a lease of nonresidential real property that has terminated at the expiration of the stated term of such lease during the case.

In addition, the automatic stay in section 362 does not preclude any act to obtain possession of leased premises by a lessor under a nonresidential lease of real property “that has terminated by the expiration of the stated term of the lease” prepetition. 11 U.S.C. § 362(b)(10).

The purpose of all of these related provisions, which were added to the Bankruptcy Code in 1984, is to facilitate “the re-leasing of commercial property during bankruptcy proceedings by forbidding the trustee to interfere with the occupancy of the new tenants.” Great Lakes, 2016 BL 74950, *3 (citing Robinson v. Chicago Housing Authority, 54 F.3d 316, 319 (7th Cir. 1995)); accord In re Lakes Region Donuts, LLC, 2014 BL 83792, *4 (Bankr. D.N.H. Mar. 27, 2014). 

Many courts have interpreted these provisions as not being limited simply to instances where the calendar date specified as the end of the lease term has passed—rather, these courts have held, their scope extends to cases where a lease has been effectively terminated under applicable non-bankruptcy law prior to the expiration of its stated term. See, e.g., In re Policy Realty Corp., 242 B.R. 121 (S.D.N.Y. 1999), aff’d, 213 F.3d 626 (2d Cir. 2000); Lakes Region Donuts, 2014 BL 83792, *5; In re G. Force Invs., Inc., 442 B.R. 646 (Bankr. N.D. Ohio 2010); In re Southcoast Express, Inc., 337 B.R. 739 (Bankr. D. Mass. 2006); see also Robinson, 54 F.3d at 320 (explaining that the Bankruptcy Code “draw[s] no meaningful distinction between ‘unexpired’ and ‘terminated’ ” leases in the context of section 365).

Avoidance of Preferential or Fraudulent Transfers

Section 547(b) of the Bankruptcy Code provides that the trustee may avoid any “transfer” by a debtor within 90 days of filing for bankruptcy (or up to one year, if the transferee is an insider) if: (a) the transfer was to a creditor on account of an antecedent debt; (b) the debtor was insolvent or was rendered insolvent due to the transfer; and (c) the creditor, by reason of the transfer, receives more than it would have received if, assuming the transfer had not been made, the debtor were liquidated in chapter 7.

Section 548(a)(1) of the Bankruptcy Code authorizes the trustee to avoid any “transfer” of an interest of the debtor in property or any obligation incurred by the debtor within the two years preceding a bankruptcy filing if: (i) the transfer was made, or the obligation was incurred, “with actual intent to hinder, delay, or defraud” any creditor; or (ii) the transaction was constructively fraudulent because the debtor was insolvent and received “less than a reasonably equivalent value in exchange for such transfer or obligation.”

Section 550 of the Bankruptcy Code authorizes the trustee or DIP, in the event that a transfer is avoided under section 547 or 548 (among other provisions of the Bankruptcy Code), to recover the property transferred or its value from the transferee(s).

“Transfer” is defined in section 101(54) of the Bankruptcy Code (as most recently amended in 2005) as “the creation of a lien; . . . the retention of title as a security interest; . . . the foreclosure of a debtor’s equity of redemption; or . . . each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with . . . property; or . . . an interest in property.” 11 U.S.C. § 101(54) (emphasis added).

Focusing on the broad definition of “transfer,” some courts have held that the termination of a lease or contract is a transfer subject to avoidance under sections 547 and 548. See, e.g., In re Indri, 126 B.R. 443 (Bankr. D.N.J. 1991); In re Harvey Co., Inc., 68 B.R. 851 (Bankr. D. Mass. 1987);In re Queen City Grain, Inc., 51 B.R. 722 (Bankr. S.D. Ohio 1985); In re Fashion World, Inc., 44 B.R. 754 (Bankr. D. Mass. 1984).

Other courts, reasoning that other provisions in the Bankruptcy Code specifically govern executory contracts and unexpired leases, have ruled to the contrary. See, e.g.Sullivan v. Willock (In re Wey), 854 F.2d 196 (7th Cir. 1988); In re Coast Cities Truck Sales, Inc., 147 B.R. 674 (D.N.J. 1992); Edwards v. Federal Home Loan Mortgage Corp. (In re LiTenda Mortgage Corp.), 246 B.R. 185 (Bankr. D.N.J. 1999); In re Egyptian Bros. Donut, Inc., 190 B.R. 26 (Bankr. D.N.J. 1995); Haines v. Regina C. Dixon Trust (In re Haines), 178 B.R. 471 (Bankr. W.D. Mo. 1995); In re Jermoo’s, Inc., 38 B.R. 197 (Bankr. W.D. Wis. 1984).

The Seventh Circuit weighed in on this issue in Great Lakes.

Great Lakes

Great Lakes Quick Lube LP (“GLQ”) owns a chain of oil change and automotive maintenance stores throughout the Midwest. GLQ leased five of its more than 100 locations from T.D. Investments I, LLP (“TDI”).

On February 10, 2012, with GLQ’s debts mounting, GLQ and TDI agreed to terminate the leases for these five locations, even though two of the leased stores were profitable. According to GLQ, it decided to terminate the profitable leases for a number of reasons, including a strained relationship with TDI and fear of eviction because GLQ had fallen behind on its lease payments.

GLQ filed for chapter 11 protection in the Eastern District of Wisconsin on April 2, 2012. It later sought and obtained court authority to reject a number of leases, including the leases with TDI, to the extent that the leases had not already been terminated prior to the petition date.

The bankruptcy court confirmed a chapter 11 plan for GLQ in January 2013. The plan assigned avoidance claims owned by GLQ’s estate to the official committee of unsecured creditors.

The committee sued to avoid the termination of the two profitable leases as either preferential or constructive fraudulent transfers under sections 547(b) and 548(a)(1)(B). In its complaint, the committee alleged that the value of the two store leases to GLQ’s estate was at least $825,000. It accordingly sought recovery of that amount from TDI under section 550 of the Bankruptcy Code.

The bankruptcy court dismissed the complaint, ruling that “if a nonresidential lease has been terminated under state law prior to the petition, the termination is not an avoidable transfer under § 547 or § 548 of the Bankruptcy Code.” Official Comm. of Unsecured Creditors of Great Lakes Quick Lube, LP v. T.D. Invs. I, LLP (In re Great Lakes Quick Lube LP), 528 B.R. 893, 898 (Bankr. E.D. Wis. 2015). According to the bankruptcy court, “The specific statutory provision regarding validly terminated nonresidential leases in § 365(c)(3) must control over the more general statutes allowing the avoidance of preferences and fraudulent transfers.” Id. On this point, the court was persuaded by the reasoning of Egyptian Bros., where the court wrote: 

The structure of the Bankruptcy Code reflects this understanding of the difference between the loss of rights under an executory contract and other transfers of property. A separate section (11 U.S.C. § 365) governs the treatment of executory contracts. It would be anomalous, to say the least, to expect that the drafters of a generally thrifty codification of bankruptcy law would devote a substantial section of the Code to the subject of the assumption or rejection of executory contracts and unexpired leases, while at the same time allowing a portion of that subject to spill over into the section governing fraudulent transfers and obligations. . . . A statute should be construed as a harmonious whole.

Id. (citing Egyptian Bros., 190 B.R. at 30; Jermoo’s, 38 B.R. at 204). TDI was granted permission to appeal the ruling directly to the Seventh Circuit.

The Seventh Circuit’s Ruling

A three-judge panel of the Seventh Circuit reversed.

Writing for the panel, circuit judge Richard Posner rejected TDI’s two-step argument that the leases were abandoned rather than transferred, “and if they were not transferred the creditors have no valid avoidance claims.” He explained that section 101(54)(D) defines “transfer” broadly to include “parting with . . . an interest in property.” GLQ parted with its leasehold interests, Judge Posner concluded, by transferring them to TDI.

The Seventh Circuit ruled that the bankruptcy court’s reliance on section 365(c)(3) was misguided because it “would place section 365(c)(3) on a collision course with section 101(54)(D).” According to Judge Posner, section 365(c)(3) simply does not apply because the relief sought by the committee is not at odds with the purpose of section 365(c) in preventing the trustee from interfering with the occupancy of a terminated leasehold estate by new tenants. GLQ’s creditors, the judge wrote, “are seeking not the leases but the value of the leases.” He further explained that the distinction between the value of the leases and the leases themselves “enables the purpose of section 365(c)(3) to be fulfilled without making inroads into section 101(54)(D).”

The Seventh Circuit accordingly reversed the bankruptcy court’s ruling and remanded the case below for a determination of the value of the leasehold interests transferred to TDI as well as an assessment of any defenses to avoidance that TDI might have.

Outlook

Great Lakes is a cautionary tale for commercial landlords. At least in the Seventh Circuit, even if a pre-bankruptcy lease termination is voluntary and valid under applicable non-bankruptcy law, the trustee or DIP may be able to recover the value forfeited by the debtor due to the termination of a profitable or below-market lease. It remains to be seen whether courts elsewhere will embrace this approach, which would appear to be the minority view.

Faced with that possibility, landlords would do well to consider measures designed to limit their potential liability in avoidance litigation, such as specifically quantifying—ideally in a lease termination agreement negotiated at arm’s length—the value of benefits provided to the tenant (which presumably would affect the value surrendered by the tenant, at least to some degree) in connection with terminating a lease or group of leases.

Interestingly, in its ruling, the Seventh Circuit failed to mention Wey or an earlier Seventh Circuit decision—In re Commodity Merchants, 538 F.2d 1260 (7th Cir. 1976), which interpreted the avoidance provisions of the Bankruptcy Act of 1898. In both rulings, the Seventh Circuit concluded, albeit under circumstances not involving a voluntary pre-bankruptcy termination, that “[w]hen a termination is pursuant to the terms of a contract, there is no transfer” for purposes of the avoidance provisions.Wey, 854 F.2d at 199 (citing Commodity Merchants, 538 F.2d at 1063).