Kmart Bankruptcy: Lessons for Lessors and Secured Parties

Although Varilease treated each Schedule as a separate lease agreement (and thus a separate executory contract for ' 365 purposes) some interested parties in the proceeding claimed that the Schedules should be read jointly as constituting a single executory contract.

Once Kmart executed a Schedule with Varilease and accepted delivery of the equipment, Varilease discounted the rental stream to a secured lender, which took a security interest in the individual Schedule, as well as the pieces of equipment subject to that particular Schedule. The Forms UCC-1 filed by each secured party described the collateral as the equipment listed under each particular Schedule, listed by serial number.

Varilease discounted all 26 of the Schedules, collaterally assigning them to 12 different secured lenders. After pledging the rental stream under each Schedule to a lender (in some cases pledging more than one schedule per lender), Varilease then syndicated the paper, subject to debt, to different leasing companies, and sold title to the equipment under each Schedule, again, subject to the secured party's interest. In all, four different leasing companies purchased the Varilease schedules and title to the equipment therein.

Problems first arose when Kmart decided to close many of its stores, several of which contained the photo-lab equipment, as part of its Joint Plan of Reorganization. The result of the store closings was that on a typical Schedule, some (but not all) of the pieces of equipment were located in stores that were being closed, while a majority were still located in open stores. Presumably, and quite understandably, Kmart did not wish to incur the expense of transporting the equipment from a store it was closing to a new store that did not possess the photo-lab equipment, the most logical option from a lessor's point of view.

At this point in its reorganization, Kmart's other options were (i) to continue to pay rent on those pieces of equipment it would no longer utilize, (ii) to reject the entire schedule, or (iii) to attempt to renegotiate the terms and conditions of each Schedule with the appropriate party, an arduous task that Kmart seemingly did not desire to devote resources to doing.

Faced with this situation, Kmart devised a method designed to allow it to have its cake and eat it, too ' to only pay rent on equipment it was going to keep in open stores without incurring the moving costs, while avoiding the prohibition against 'cherry picking' pieces of a contract it wished to assume while rejecting other portions (The law is well settled that a debtor in possession cannot assume part of a lease but reject other parts, ie, accept the benefits of a lease but reject the burdens. Richmond Leasing Co. v. Capital Bank, 762 F.2d 1303, 1311 (5th Cir. 1985); In re Atlantic Computer Systems, Inc. infra at 849.).

Kmart, as part of its plan, relied on two clauses in the Master Lease. The first section stated: 'Upon prior notice to Lessor, Lessee may move the Equipment to a new location, including any storage facility within the continental United States.' The second clause stated in pertinent part: 'Lessee may at any time substitute like Equipment leased under this Master Agreement upon notice to Lessor and so long as the substituted Equipment is of the same make, model, manufacture, capacity and value as the Equipment being replaced.'

Relying on these clauses, Kmart filed motions (May 9, 2002 motion to reject Schedules 1, 7, 10 and 17; March 25, 2003 motion seeking to reject Schedules 2, 6, 9 and 23) pursuant to 11 U.S.C. ' 365 (providing that, subject to court approval and certain limitations, debtors can assume or reject any executory contract or unexpired lease) seeking authority to reject certain of the Varilease Schedules. The rub is that the Schedules that Kmart sought to assume and reject under these motions were in fact entirely different than the original Schedules under which it leased equipment and incurred rent obligations inasmuch as they contained different pieces of equipment.

Kmart, prior to seeking rejection and assumption, 'moved' equipment from one Schedule to another and 'substituted' equipment from one Schedule to another. The net result was that the 'revised' Schedules Kmart sought to reject all contained equipment located in stores that were to be closed, and the Schedules it sought to assume covered equipment located in stores that were remaining open. Kmart never physically relocated any of the equipment, and claimed that the substituted equipment was 'like' equipment, even though it was encumbered with another secured lender's lien and impaired another owner's title.

Kmart's argument relied heavily on the fact that the Court should defer to a debtor's business judgment and approve the assumption or rejection of an executory contract or unexpired lease [See, e.g., NLRB v. Bildisco and Bildisco, 465 U.S. 513, 523 (1984); Sharon Steel Corp v. National Fuel Gas Distribution, 872 F.2d 36, 39-40 (3d. Cir 1989)] and that Kmart's motion for assumption or rejection should be granted as a matter of course, as it was in the best interests of Kmart. Kmart alleged that its burden was easily met due to the fact it no longer had use for the equipment that it sought to reject. Indeed, it is an understandable argument from Kmart's perspective ' shuffling equipment among the Schedules, even though the equipment was subject to secured lenders' liens and owned by various parties, was economically in Kmart's best interest.

Kmart also took the position that each Schedule was a separate and distinct contract, but still argued that it was permitted to freely 'shuffle' equipment among the Schedules ' an argument that would have been more plausible had it also argued that the 26 Schedules should be treated as a single executory contract. [There are situations in which various writings and contracts are essentially inseparable and will be considered a single indivisible contract for ' 365 purposes. See In re Atlantic Computer Sys., Inc., 173 B.R. 844, 849-55 (S.D.N.Y. 1994)].

The paradoxes in Kmart's argument are numerous, yet were never addressed by the debtor: (i) Kmart was creating a situation in which it used certain equipment without recognizing the obligations tied to that specific piece of equipment; (ii) Kmart was receiving the economic benefit of equipment on a certain schedule while paying rent to a secured party that had no interest in that schedule; (iii) Kmart was attempting to return one owner's piece of equipment to a different owner; and (iv) Kmart was asking 'secured' lenders to repossess equipment which, in many circumstances, they did not possess a security interest, thereby creating a situation in which the secured lender might be liable for conversion to the owner or holder of a valid security interest.

The lessors and secured parties involved all raised numerous objections to the plan, but found Kmart to be unflinchingly tenacious and holding steadfast to the language in the Master Lease. When some interested parties agreed to Kmart's revised Schedules ' so long as the substituted equipment was assigned free and clear, thereby giving the lessor title and enabling it to grant its secured lender a priority perfected security interest ' Kmart sought to invoke the equitable powers of the Bankruptcy Court seeking an order essentially expunging the existing liens of the lenders and ownership interests of lessors and allowing Kmart to grant new title and new liens to the pre-existing lessors and secured lenders under each Schedule [Kmart Motion's dated April 14, 2003 and April 22, 2003 pursuant to '' 105, 363 and 365(a)].

The Court has yet to dispose of the Motions (the hearing has been continued until October 8, 2003), as the interested parties have sought repeated adjournments in an effort to resolve the issues without judicial intervention. This, however, appears to be quite a challenge, as it would require the consent of the secured parties each of whose Schedules are being rejected. Whatever the disposition, there are clearly lessons to be learned.

When granting a lessee a right to substitute equipment, lessors should take care to state explicitly that the new equipment should be granted to the lessor free and clear and the lessor should require many of the same documents with respect to substituted equipment as with the original equipment, such as insurance certificate, bill of sale, and, in appropriate cases, a new appraisal (See, Middle-Market Leasing and Syndication, by Edward K. Gross, as appeared in Equipment Leasing-Leveraged Leasing by Shrank & Gough.). Also, requiring lessor's consent before 'moving' any equipment may avoid similar problems.

Michael A. Reisner is vice president and associate counsel of ICON Capital Corp. in New York City.

One of the most fundamental and critical principles that enables the equipment leasing industry to function on a day-to-day basis is commercial certainty ' certainty in expectations regarding financing; certainty in the meaning of documentation; and reliance on the certainty of the application of legal principles that will be brought to bear in the event of a lease default or bankruptcy.

A currently pending proceeding in the massive Kmart bankruptcy challenges those underpinnings of certainty through the imaginative invocation of the 'equitable powers' of the Bankruptcy Court by a debtor-in-possession who may succeed in bringing about a result which is, by any standard, unfair, unanticipated and 'inequitable' ' at least in any commercial meaning of the word. [Note, On January 22, 2002, Kmart and its affiliate debtors filed a voluntary petition in the U.S. Bankruptcy Court for the Eastern District of Illinois seeking relief under Chapter 11 of Title 11 of U.S.C., 11 U.S.C. '' 101, et seq as amended. On January 24, 2003 Kmart filed its Joint Plan of Reorganization. The Plan was confirmed and Kmart emerged from Bankruptcy on May 5, 2003. Even though Kmart has emerged from Chapter 11, the Plan of Reorganization provided that if a motion for assumption was pending at the time of confirmation, that the Plan would not control, and the motions would.]

By way of background, Kmart entered into a Master Lease Agreement with Varilease Technology Group, Inc. on October 5, 2000. Kmart, at different times thereafter, entered into 26 separate and distinct Equipment Schedules pursuant to the Master Lease. The pieces of equipment covered on each Schedule were various items of photo-lab processing equipment, manufactured by Kodak and Noritsu, for use in different Kmart stores. Each Schedule: (a) incorporated the terms and conditions of the Master Lease, (b) described the equipment covered by serial number, and (c) listed a location where each piece of equipment was located.

Although Varilease treated each Schedule as a separate lease agreement (and thus a separate executory contract for ' 365 purposes) some interested parties in the proceeding claimed that the Schedules should be read jointly as constituting a single executory contract.

Once Kmart executed a Schedule with Varilease and accepted delivery of the equipment, Varilease discounted the rental stream to a secured lender, which took a security interest in the individual Schedule, as well as the pieces of equipment subject to that particular Schedule. The Forms UCC-1 filed by each secured party described the collateral as the equipment listed under each particular Schedule, listed by serial number.

Varilease discounted all 26 of the Schedules, collaterally assigning them to 12 different secured lenders. After pledging the rental stream under each Schedule to a lender (in some cases pledging more than one schedule per lender), Varilease then syndicated the paper, subject to debt, to different leasing companies, and sold title to the equipment under each Schedule, again, subject to the secured party's interest. In all, four different leasing companies purchased the Varilease schedules and title to the equipment therein.

Problems first arose when Kmart decided to close many of its stores, several of which contained the photo-lab equipment, as part of its Joint Plan of Reorganization. The result of the store closings was that on a typical Schedule, some (but not all) of the pieces of equipment were located in stores that were being closed, while a majority were still located in open stores. Presumably, and quite understandably, Kmart did not wish to incur the expense of transporting the equipment from a store it was closing to a new store that did not possess the photo-lab equipment, the most logical option from a lessor's point of view.

At this point in its reorganization, Kmart's other options were (i) to continue to pay rent on those pieces of equipment it would no longer utilize, (ii) to reject the entire schedule, or (iii) to attempt to renegotiate the terms and conditions of each Schedule with the appropriate party, an arduous task that Kmart seemingly did not desire to devote resources to doing.

Faced with this situation, Kmart devised a method designed to allow it to have its cake and eat it, too ' to only pay rent on equipment it was going to keep in open stores without incurring the moving costs, while avoiding the prohibition against 'cherry picking' pieces of a contract it wished to assume while rejecting other portions (The law is well settled that a debtor in possession cannot assume part of a lease but reject other parts, ie, accept the benefits of a lease but reject the burdens. Richmond Leasing Co. v. Capital Bank , 762 F.2d 1303, 1311 (5th Cir. 1985); In re Atlantic Computer Systems, Inc. infra at 849.).

Kmart, as part of its plan, relied on two clauses in the Master Lease. The first section stated: 'Upon prior notice to Lessor, Lessee may move the Equipment to a new location, including any storage facility within the continental United States.' The second clause stated in pertinent part: 'Lessee may at any time substitute like Equipment leased under this Master Agreement upon notice to Lessor and so long as the substituted Equipment is of the same make, model, manufacture, capacity and value as the Equipment being replaced.'

Relying on these clauses, Kmart filed motions (May 9, 2002 motion to reject Schedules 1, 7, 10 and 17; March 25, 2003 motion seeking to reject Schedules 2, 6, 9 and 23) pursuant to 11 U.S.C. ' 365 (providing that, subject to court approval and certain limitations, debtors can assume or reject any executory contract or unexpired lease) seeking authority to reject certain of the Varilease Schedules. The rub is that the Schedules that Kmart sought to assume and reject under these motions were in fact entirely different than the original Schedules under which it leased equipment and incurred rent obligations inasmuch as they contained different pieces of equipment.

Kmart, prior to seeking rejection and assumption, 'moved' equipment from one Schedule to another and 'substituted' equipment from one Schedule to another. The net result was that the 'revised' Schedules Kmart sought to reject all contained equipment located in stores that were to be closed, and the Schedules it sought to assume covered equipment located in stores that were remaining open. Kmart never physically relocated any of the equipment, and claimed that the substituted equipment was 'like' equipment, even though it was encumbered with another secured lender's lien and impaired another owner's title.

Kmart's argument relied heavily on the fact that the Court should defer to a debtor's business judgment and approve the assumption or rejection of an executory contract or unexpired lease [ See, e.g., NLRB v. Bildisco and Bildisco , 465 U.S. 513, 523 (1984); Sharon Steel Corp v. National Fuel Gas Distribution , 872 F.2d 36, 39-40 (3d. Cir 1989)] and that Kmart's motion for assumption or rejection should be granted as a matter of course, as it was in the best interests of Kmart. Kmart alleged that its burden was easily met due to the fact it no longer had use for the equipment that it sought to reject. Indeed, it is an understandable argument from Kmart's perspective ' shuffling equipment among the Schedules, even though the equipment was subject to secured lenders' liens and owned by various parties, was economically in Kmart's best interest.

Kmart also took the position that each Schedule was a separate and distinct contract, but still argued that it was permitted to freely 'shuffle' equipment among the Schedules ' an argument that would have been more plausible had it also argued that the 26 Schedules should be treated as a single executory contract. [There are situations in which various writings and contracts are essentially inseparable and will be considered a single indivisible contract for ' 365 purposes. See In re Atlantic Computer Sys., Inc., 173 B.R. 844, 849-55 (S.D.N.Y. 1994)].

The paradoxes in Kmart's argument are numerous, yet were never addressed by the debtor: (i) Kmart was creating a situation in which it used certain equipment without recognizing the obligations tied to that specific piece of equipment; (ii) Kmart was receiving the economic benefit of equipment on a certain schedule while paying rent to a secured party that had no interest in that schedule; (iii) Kmart was attempting to return one owner's piece of equipment to a different owner; and (iv) Kmart was asking 'secured' lenders to repossess equipment which, in many circumstances, they did not possess a security interest, thereby creating a situation in which the secured lender might be liable for conversion to the owner or holder of a valid security interest.

The lessors and secured parties involved all raised numerous objections to the plan, but found Kmart to be unflinchingly tenacious and holding steadfast to the language in the Master Lease. When some interested parties agreed to Kmart's revised Schedules ' so long as the substituted equipment was assigned free and clear, thereby giving the lessor title and enabling it to grant its secured lender a priority perfected security interest ' Kmart sought to invoke the equitable powers of the Bankruptcy Court seeking an order essentially expunging the existing liens of the lenders and ownership interests of lessors and allowing Kmart to grant new title and new liens to the pre-existing lessors and secured lenders under each Schedule [Kmart Motion's dated April 14, 2003 and April 22, 2003 pursuant to '' 105, 363 and 365(a)].

The Court has yet to dispose of the Motions (the hearing has been continued until October 8, 2003), as the interested parties have sought repeated adjournments in an effort to resolve the issues without judicial intervention. This, however, appears to be quite a challenge, as it would require the consent of the secured parties each of whose Schedules are being rejected. Whatever the disposition, there are clearly lessons to be learned.

When granting a lessee a right to substitute equipment, lessors should take care to state explicitly that the new equipment should be granted to the lessor free and clear and the lessor should require many of the same documents with respect to substituted equipment as with the original equipment, such as insurance certificate, bill of sale, and, in appropriate cases, a new appraisal (See, Middle-Market Leasing and Syndication, by Edward K. Gross, as appeared in Equipment Leasing-Leveraged Leasing by Shrank & Gough.). Also, requiring lessor's consent before 'moving' any equipment may avoid similar problems.

Michael A. Reisner is vice president and associate counsel of ICON Capital Corp. in New York City.