'Use Clauses' and the Bankruptcy Code: A Cautionary Tale

The recent Chapter 11 bankruptcy of Trak Auto Corporation (“Trak Auto”), the retail auto parts chain, has yielded a reported decision of the U.S. Fourth Circuit Court of Appeals that offers some insights for landlords on how “use clauses” in leases will be put under the bankruptcy microscope. In re Trak Auto Corporation, 42 B.R. 255 (4th Cir. 2004).

Trak Auto filed its Chapter 11 petition on July 5, 2001 and had once operated 196 retail auto parts stores. Trak Auto sought to assume and assign certain of its leases, including one known as the West Town Lease in Chicago. The West Town Lease contained explicit use restrictions. Section 1.1(L) of the lease limited the use to “the sale at retail of automobile parts and accessories and such other items as are normally sold by tenant in its Trak Auto stores.” In Section 8.1 of the lease, Trak Auto covenanted to use the leased premises “only as a Trak Auto store” and for the uses provided for in Section 1.1(L).

None of the bids for the lease came from an auto parts retailer. The high bidder was A&E Stores, Inc. (“A&E”), an apparel merchandiser that offered $80,000 for the lease. A&E planned to open an apparel outlet in the space.

Trak Auto asked the bankruptcy court to authorize it to assume and assign the West Town Lease to A&E. West Town, Trak Auto's landlord, objected and said the proposed assignment would breach the lease provision limiting the use to the sale of auto parts. West Town argued that the assignment would disrupt its shopping center tenant mix in violation of Section 365(b)(3)(d) of the Bankruptcy Code. Trak Auto said the use restrictions in the lease were unenforceable anti-assignment provisions, and that under Section 365(f)(1) of the Bankruptcy Code, the provision was an unenforceable anti-assignment clause.

The bankruptcy court approved the assignment on the ground that the assignment could not be effected to an auto parts business, there being seven such retailers nearby. The court said the use clause was an anti-assignment clause prohibited by Section 365(f)(1) of the Bankruptcy Code. In addition, the bankruptcy court concluded that West Town had not provided sufficient evidence of the significance and importance of its tenant mix. The U.S. District Court affirmed.

The Fourth Circuit was faced with the conflict between Section 365(b)(3)(c) of the Bankruptcy Code on the one hand, which specifically requires a debtor-tenant at a shopping center to assign its store lease subject to any provision restricting use of the premises, and Section 365(f)(1) on the other, which generally allows the debtor to assign its lease notwithstanding a provision restricting assignment. The Fourth Circuit held that Section 365(b)(3)(c) controls and that both lower courts erred in permitting Trak Auto to assign its lease to an apparel merchandiser.

Section 365(a) of the Bankruptcy Code allows the Chapter 11 debtor to assume an unexpired lease. The debtor may in turn assign the lease. When a debtor-tenant in a shopping center seeks to assign its lease, the “adequate assurance of future performance” required by the Bankruptcy Code must include adequate assurance that the assignment “is subject to all provisions thereof including, but not limited to, provisions such as radius, location, use or exclusivity. … ” Section 365(f)(1), on the other hand, contains a general provision that restricts enforcement in bankruptcy of anti-assignment clauses and leases. This section allows the debtor to assign the lease “ notwithstanding the provision … that prohibits, restricts or conditions … assignment.” The Fourth Circuit was required to decide therefore whether Congress intended, notwithstanding Section 365(f)(1), for a debtor's assignee to provide adequate assurance that it will comply with use restrictions in a shopping center lease. Specifically, the court had to determine whether the lease to an apparel retailer breached these restrictions when the lease limited the use to auto parts and accessories.

The Fourth Circuit reversed the rulings below, holding that as a matter of statutory construction, the lease could not be assigned to the apparel store.

The court recognized that Section 365(f)(1) allows assignment of leases “notwithstanding a provision … that prohibits, restricts, or conditions … assignment.” However, Section 365(f)(2)(b) permits assignment of the lease as long as the assignee gives “adequate assurance of future performance.” Section 365(b)(3)(c) directs that, with respect to shopping center leases, such assurance must include assurance that the lease “is subject to all the provisions thereof, including provisions such as radius, location, use and exclusivity (among others).”

The court observed that the Bankruptcy Code has special protections for shopping center landlords and noted that such leases often include use restrictions to ensure that the center has the right mix of tenants.

To resolve the conflict between Sections 365(f)(1) and 365(b)(3)(c), the court applied the rule of construction that gives priority to the more specific provision. As a result, Section 365(b)(3)(c) controls “because it speaks more directly to the issue, that is, whether a debtor-tenant assigning a shopping center lease must honor a straightforward use restriction.” Trak Auto, supra at 243.

The Fourth Circuit said that the Bankruptcy Court improperly focused on market conditions in allowing the assignment. The court also said the Bankruptcy Court did not have authority to undertake this analysis as it deprived the landlord of the benefit of its bargain.

Additionally, the district court erred by deciding that the use restriction was enforceable because the tenant covenanted to use the property “only as a Trak Auto Store.” The court concluded, though, that this was not what the landlord argued – that the landlord sought only the auto parts store restriction.

Perhaps most significantly, the Fourth Circuit observed that the ruling did not sound the death knell for Section 365(f)(1) in shopping center lease assignment cases. “A shopping center lease provision designed to prevent any assignment whatsoever might be a candidate for application of Section 365(f)(1).” Trak Auto, supra at 244.

The case reminds counsel for landlords that, certainly when the use clause is put through the bankruptcy court meat grinder, an overly narrow use clause may be invalidated outright. In other words, a use clause that limits use only to a particular trade name may likely be invalidated in a bankruptcy context because of the stranglehold it puts on tenants' rights to assign. Trak Auto suggests that even an overbroad use covenant may trip up the landlord, as it almost did here. The Bankruptcy Code is clear that tenants are to have an unfettered opportunity to sell their leases so long as (in the case of a “shopping center” which is defined by the Bankruptcy Code and case law, see In re Joshua Slocum Ltd., 922 F.2d 1081, 1090 (3rd Cir. 1991)), the sale does not disrupt the tenant mix, exclusivity provisions and other agreements relating to the center. Any provision that unduly restricts the tenant's opportunity to market its lease will be invalidated.

The recent Chapter 11 bankruptcy of Trak Auto Corporation (“Trak Auto”), the retail auto parts chain, has yielded a reported decision of the U.S. Fourth Circuit Court of Appeals that offers some insights for landlords on how “use clauses” in leases will be put under the bankruptcy microscope. In re Trak Auto Corporation, 42 B.R. 255 (4th Cir. 2004).

Trak Auto filed its Chapter 11 petition on July 5, 2001 and had once operated 196 retail auto parts stores. Trak Auto sought to assume and assign certain of its leases, including one known as the West Town Lease in Chicago. The West Town Lease contained explicit use restrictions. Section 1.1(L) of the lease limited the use to “the sale at retail of automobile parts and accessories and such other items as are normally sold by tenant in its Trak Auto stores.” In Section 8.1 of the lease, Trak Auto covenanted to use the leased premises “only as a Trak Auto store” and for the uses provided for in Section 1.1(L).

None of the bids for the lease came from an auto parts retailer. The high bidder was A&E Stores, Inc. (“A&E”), an apparel merchandiser that offered $80,000 for the lease. A&E planned to open an apparel outlet in the space.

Trak Auto asked the bankruptcy court to authorize it to assume and assign the West Town Lease to A&E. West Town, Trak Auto's landlord, objected and said the proposed assignment would breach the lease provision limiting the use to the sale of auto parts. West Town argued that the assignment would disrupt its shopping center tenant mix in violation of Section 365(b)(3)(d) of the Bankruptcy Code. Trak Auto said the use restrictions in the lease were unenforceable anti-assignment provisions, and that under Section 365(f)(1) of the Bankruptcy Code, the provision was an unenforceable anti-assignment clause.

The bankruptcy court approved the assignment on the ground that the assignment could not be effected to an auto parts business, there being seven such retailers nearby. The court said the use clause was an anti-assignment clause prohibited by Section 365(f)(1) of the Bankruptcy Code. In addition, the bankruptcy court concluded that West Town had not provided sufficient evidence of the significance and importance of its tenant mix. The U.S. District Court affirmed.

The Fourth Circuit was faced with the conflict between Section 365(b)(3)(c) of the Bankruptcy Code on the one hand, which specifically requires a debtor-tenant at a shopping center to assign its store lease subject to any provision restricting use of the premises, and Section 365(f)(1) on the other, which generally allows the debtor to assign its lease notwithstanding a provision restricting assignment. The Fourth Circuit held that Section 365(b)(3)(c) controls and that both lower courts erred in permitting Trak Auto to assign its lease to an apparel merchandiser.

Section 365(a) of the Bankruptcy Code allows the Chapter 11 debtor to assume an unexpired lease. The debtor may in turn assign the lease. When a debtor-tenant in a shopping center seeks to assign its lease, the “adequate assurance of future performance” required by the Bankruptcy Code must include adequate assurance that the assignment “is subject to all provisions thereof including, but not limited to, provisions such as radius, location, use or exclusivity. … ” Section 365(f)(1), on the other hand, contains a general provision that restricts enforcement in bankruptcy of anti-assignment clauses and leases. This section allows the debtor to assign the lease “ notwithstanding the provision … that prohibits, restricts or conditions … assignment.” The Fourth Circuit was required to decide therefore whether Congress intended, notwithstanding Section 365(f)(1), for a debtor's assignee to provide adequate assurance that it will comply with use restrictions in a shopping center lease. Specifically, the court had to determine whether the lease to an apparel retailer breached these restrictions when the lease limited the use to auto parts and accessories.

The Fourth Circuit reversed the rulings below, holding that as a matter of statutory construction, the lease could not be assigned to the apparel store.

The court recognized that Section 365(f)(1) allows assignment of leases “notwithstanding a provision … that prohibits, restricts, or conditions … assignment.” However, Section 365(f)(2)(b) permits assignment of the lease as long as the assignee gives “adequate assurance of future performance.” Section 365(b)(3)(c) directs that, with respect to shopping center leases, such assurance must include assurance that the lease “is subject to all the provisions thereof, including provisions such as radius, location, use and exclusivity (among others).”

The court observed that the Bankruptcy Code has special protections for shopping center landlords and noted that such leases often include use restrictions to ensure that the center has the right mix of tenants.

To resolve the conflict between Sections 365(f)(1) and 365(b)(3)(c), the court applied the rule of construction that gives priority to the more specific provision. As a result, Section 365(b)(3)(c) controls “because it speaks more directly to the issue, that is, whether a debtor-tenant assigning a shopping center lease must honor a straightforward use restriction.” Trak Auto, supra at 243.

The Fourth Circuit said that the Bankruptcy Court improperly focused on market conditions in allowing the assignment. The court also said the Bankruptcy Court did not have authority to undertake this analysis as it deprived the landlord of the benefit of its bargain.

Additionally, the district court erred by deciding that the use restriction was enforceable because the tenant covenanted to use the property “only as a Trak Auto Store.” The court concluded, though, that this was not what the landlord argued – that the landlord sought only the auto parts store restriction.

Perhaps most significantly, the Fourth Circuit observed that the ruling did not sound the death knell for Section 365(f)(1) in shopping center lease assignment cases. “A shopping center lease provision designed to prevent any assignment whatsoever might be a candidate for application of Section 365(f)(1).” Trak Auto, supra at 244.

The case reminds counsel for landlords that, certainly when the use clause is put through the bankruptcy court meat grinder, an overly narrow use clause may be invalidated outright. In other words, a use clause that limits use only to a particular trade name may likely be invalidated in a bankruptcy context because of the stranglehold it puts on tenants' rights to assign. Trak Auto suggests that even an overbroad use covenant may trip up the landlord, as it almost did here. The Bankruptcy Code is clear that tenants are to have an unfettered opportunity to sell their leases so long as (in the case of a “shopping center” which is defined by the Bankruptcy Code and case law, see In re Joshua Slocum Ltd., 922 F.2d 1081, 1090 (3rd Cir. 1991)), the sale does not disrupt the tenant mix, exclusivity provisions and other agreements relating to the center. Any provision that unduly restricts the tenant's opportunity to market its lease will be invalidated.