There are many tenants that are, shall we say, “problem children.” They pay late, open late, breach, junk up your strip or building, threaten, the works. Sometimes, the landlord finds it easier just to reach a lease termination agreement with such a tenant, with the parties walking away with a mutual release. If the lease is below market, or the landlord is really motivated to move this tenant along, the landlord even provides some “keys money” to terminate the lease.

This normal practice may now be turned on its head. In a recent opinion, the Seventh Circuit ruled that a pre-bankruptcy lease termination was a “transfer” under the Bankruptcy Code. Because it was a “transfer,” if the tenant did not receive “reasonably equivalent value” for the value of the lease (such as where the tenant alleges it was a below market lease, which could have been assigned in bankruptcy for cash, or even for more cash than the tenant/debtor received), then the landlord can be sued. The damages? The difference between that which the ne’er-do-well tenant received (even if that amount is $0) and the amount that the tenant’s expert witness says could have been received had the lease not been terminated, and the debtor had instead assigned it to a third party during the bankruptcy in an open sale process.[1] In re Great Lakes Quick Lube LP, 2016 WL 930298 (7th Cir. March 11, 2016).

The Seventh’s Circuit’s opinion in Quick Lube is very problematic because it ignores:

First, Section 8(e)(1) of the Uniform Fraudulent Transfer Act, which states a transfer is not voidable if it “results from . . . termination of a lease upon default by the debtor when the termination is pursuant to the lease and applicable law.” Indeed, the drafters of this uniform law, promulgated all the way back in 1984, noted in their commentary (see page 32 of this link) that Section 8(e)(i) of UFTA was intended to “reject[] the rule adopted in Darby v. Atkinson (In re Farris), 415 F.Supp. 33, 39-41 (W.D. Okla. 1976), that termination of a lease on default in accordance with its terms and applicable law may constitute a fraudulent transfer.”

Second, as Judge Markell once noted, the much wiser approach to transactions of this type is that “a noncollusive termination of a lease is not a transfer at all” and hence cannot be avoided by mischievous debtors and their hired guns experts. See here for the full opinion.

Third, Section 365(c)(3) of the Bankruptcy Code provides that the “trustee … may not assume or assign any … unexpired lease of the debtor … if … such lease . . . has been terminated under applicable nonbankrupty law prior to” the bankruptcy case. See 11 U.S.C. § 365(c)(3). That is, if a properly terminated lease cannot be assumed or assigned in bankruptcy by one very specific section of the Code, then how can its pre-bankruptcy termination be voided due to a generic separate section of the Code? The Seventh Circuit side-stepped this argument too in Quick Lube, by saying the debtor and its creditors simply wanted the value of the lease and not the actual lease itself. That’s a tautology – how can there be value in a lease that no longer exists?

Finally, and most importantly, this entire line of reasoning ignores the need for certainty in commercial transactions involving lease transactions. So what do we do?

First, be aware of this decision, and make the client aware if it is ever negotiating over a lease termination with a tenant, especially a financially troubled tenant. There are no foolproof workarounds to this decision, and so the client needs to be fully aware of this risk. Maybe it is just easier to declare a default and go through a dispossessory, if weeks (months?) of careful negotiation over termination can be up-ended by a later litigation against the landlord to pay for the “actual value” of the lease?

Second, thoroughly document in the termination agreement the benefits the tenant is receiving. Bankruptcy trustees and creditors like easy cases, not hard ones. If they can see more benefit that the tenant received in the termination agreement, or clearly spelled out provisions showing the tenant’s ability to forego late fees, attorneys’ fees, ongoing rent, other charges, and the like through the lease termination, a litigious trustee may think twice.

Third, if a lease termination is accompanied by any “keys money,” make sure it is paid to the actual tenant, and not any affiliate. A sure-fire path to litigation begins with paying the wrong tenant or an affiliate, instead of the actual obligor on the lease. (This is fundamental, we know, but we have seen unsuspecting parties many times be persuaded to pay a parent company, or affiliate.)

The Seventh Circuit has long been a leading court on bankruptcy issues. We at The Bankruptcy Cave will continue to monitor this decision, which we think, unfortunately, is going to be used often in the upcoming downturn.