In the Spotlight: Shopping Center Lease Assignments -- Bankruptcy Changes Could Hamper Debtors

Certain amendments to Title 11, United States Code (the 'Bankruptcy Code') implemented by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the '2005 Amendment') received little notice, but one such change made to '365(f)(1), a section commonly utilized by debtor/ tenants to invalidate anti-assignment provisions contained in commercial leases, could have a wide-ranging impact in retail bankruptcy cases.

De Facto Anti-Assignment

Section 365(f)(1), as amended, reads as follows:

Except as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection.

11 U.S.C. '365(f)(1) (emphasis added to highlight amendment).

Although the amendment to '365(f)(1) appears to be innocuous on its face (i.e., adding subsection (b) of '365 of the Bankruptcy Code to '365(f)(1)), this change could have a significant negative impact on debtors who seek to assume and assign shopping center leases, particularly in large retail bankruptcy cases where a primary factor for seeking protection under the Bankruptcy Code is to monetize the value of such leases for the benefit of creditors. Indeed, it is fairly common practice for owners of shopping centers to include 'specific use' provisions in their leases to, among other things, preserve tenant mix and to avoid defaults of similar restrictive use provisions contained in other leases or documents governing the shopping centers.

Generally speaking, in order to obtain court authority to assume and assign a lease, a debtor must cure all defaults under the lease and provide adequate assurance of future performance of the terms of the lease. 11 U.S.C. '365(b)(1); See also, In re Joshua Slocum, 922 F.2d 1081, 1086 (3rd Cir. 1990). If these requirements are satisfied, a court has the discretion, afforded by '365(f)(1) to avoid certain provisions that constitute unreasonable restrictions on assignment. The congressional purpose in granting courts discretion to avoid certain lease provisions under '365(f)(1) was to promote marketability of the leases and to allow debtors to realize the true value of their leases, often a significant asset of a bankruptcy estate. Collen, Buying and Selling Real Estate in Bankruptcy '7.06[3](1997).

Such provisions are often referred to as de facto anti-assignment clauses and are unenforceable under '365(f)(1). Examples of provisions that may potentially and unreasonably restrict assignment include, but are not limited to, a landlord's right of first refusal, restrictions on the type of business permitted to be operated at the premises, and a prohibition against interruptions in business operations. By enacting the 2005 amendment to include reference to subsection (b) in '365(f)(1), however, Congress imposed an additional requirement on debtors who seek to assign their shopping center leases. Specifically, courts must now determine that a proposed assignee will comply with the radius, use, location, and other similar restrictions contained in the operative sections of the lease, provisions that had previously been ignored under '365(f)(1).

Section 365(b)(3) of the Bankruptcy Code provides as follows:

For the purposes of paragraph (1) of this subsection and paragraph (2)(B) of subsection (f), adequate assurance of future performance of a lease of real property in a shopping center includes adequate assurance (C) that assumption or assignment of such lease is subject to all the provisions thereof, including (but not limited to) provisions such as a radius, location, use, or exclusivity provision, and will not breach any such provision contained in any other lease, financing agreement, or master agreement relating to such shopping center; and (D) that assumption or assignment of such lease will not disrupt any tenant mix or balance in such shopping center. 11 U.S.C. '365(b)(3)(A)-(D).

Three A's Holdings

In a recent decision titled In re Three A's Holdings, LLC, 364 B.R. 550 (Bankr. Del. 2007), the United States Bankruptcy Court for the District of Delaware denied the debtors' request to assume and assign a lease of property located in a shopping center, reasoning that so-called 'permitted use' provisions, which include restrictions on the type of business permitted on the leased premises, may not be ignored under the current Bankruptcy Code. The shopping center lease at issue in Three A's Holdings contained few use restrictions; however, the lease was expressly subject to specific use restrictions imposed by a local planning board in a Declaration of Covenants, Conditions and Restrictions (the 'Declaration of Covenants'). The Declaration of Covenants contained a list of permitted businesses within the shopping center. The debtors sought to assume and assign the lease to Walgreens, which planned to operate a pharmacy on the premises, which was not authorized under the Declaration of Covenants.

The Three A's Holdings court initially noted that assumption and assignment of leases belonging to a bankrupt are governed by '365 of the Bankruptcy Code. The court then stated that, although a court's authority to permit assignments of leases that contain anti-assignment provisions under '365(f)(1) is broad, the court's discretion is limited if the assumption or assignment involves a lease of real property in a shopping center. In this regard, the court noted that the 1984 congressional amendments to the Bankruptcy Code imparted heightened restrictions in '365(b)(3) to provide a framework for enforcing common provisions found in shopping center leases since assignment of shopping center leases greatly impacts not only the lessors, but also the other tenants in the shopping center.

The Three A's Holdings court also noted that the 2005 amendment further limited a court's discretion to override what was previously considered a de facto anti-assignment provision in a shopping center lease. Since the court concluded that Walgreens intended use of the space violated the Declaration of Covenants, the court denied the debtor's motion for an order authorizing the assumption and assignment of the lease.

Conclusion

In light of the 2005 amendment, as well as the holding in Three A's Holdings, it now appears that courts may not have the discretion to override radius, use, location, and other similar restrictions as de facto anti-assignment provisions pursuant to '365(f)(1), and that such provisions may be strictly enforced, notwithstanding a debtor's attempt to monetize the value of its shopping center lease.

Moreover, the 2005 amendment could also impact a court's decision to enforce so-called 'go-dark' or 'continuous use' provisions. These provisions, often contained in shopping center leases, require that the tenant operate its premise for a set period of time and not 'go dark' for more than a nominal period of time. Taken at face value, an argument could be made that under the 2005 amendment, these 'go dark' or 'continuous use' provisions should be strictly enforced, effectively requiring the proposed assignees of such leases to forego refitting the premises or risk triggering a default.

A strong argument could also be made, however, that despite the 2005 amendment, 'go dark' or 'continuous use' provisions should not be treated similarly to 'permitted use' provisions since these restrictions do not involve the nature of the proposed assignee's use of the space and do not impact tenant mix. Indeed, 'go dark' and 'continuous use' provisions, if strictly enforced, would preclude the assignment of shopping center leases even in situations where there would be little, if no, negative impact on the owner of the center or other tenants. Prior to the 2005 amendment, courts frequently declined to enforce unreasonable 'go dark' or 'continuous use' provisions when they had the effect of precluding or inhibiting assignments.

Though no case since the 2005 amendment has addressed this very issue, courts could continue to refuse enforcement of such provisions on the basis that, among other things, the owner is merely seeking, at the expense of the bankrupt's estate, to recapture the premises for the purpose of increasing rent. In such an event, the premises would remain dark during the period in between tenancies, a result no different from that in which the debtor had assigned the lease to a new tenant who was granted a short reprieve from the 'go dark' or 'continuous use' provision for the purpose of refitting or remodeling the space. Indeed, it seems clear that the courts, in keeping with the purpose and intent of the Bankruptcy Code, should seek to preserve a debtor's interest in the lease and refuse enforcement of these provisions. Accordingly, despite the 2005 amendment, a strong argument can be made that courts should continue to recognize that the sole effect of 'go dark' or 'continuous use' provisions is an unjustified limitation on assignment that falls far short of meeting the goals of the 2005 amendment.

This article originally appeared in the New York Law Journal, a sister publication of this newsletter.

Jeffrey B. Steiner and Gerard S. Catalanello are members of Thelen Reid Brown Raysman & Steiner. Yevgenia Paikine, a law clerk of the firm, assisted in the preparation of this article.

Certain amendments to Title 11, United States Code (the 'Bankruptcy Code') implemented by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the '2005 Amendment') received little notice, but one such change made to '365(f)(1), a section commonly utilized by debtor/ tenants to invalidate anti-assignment provisions contained in commercial leases, could have a wide-ranging impact in retail bankruptcy cases.

De Facto Anti-Assignment

Section 365(f)(1), as amended, reads as follows:

Except as provided in subsections (b) and (c) of this section, notwithstanding a provision in an executory contract or unexpired lease of the debtor, or in applicable law, that prohibits, restricts, or conditions the assignment of such contract or lease, the trustee may assign such contract or lease under paragraph (2) of this subsection.

11 U.S.C. '365(f)(1) (emphasis added to highlight amendment).

Although the amendment to '365(f)(1) appears to be innocuous on its face (i.e., adding subsection (b) of '365 of the Bankruptcy Code to '365(f)(1)), this change could have a significant negative impact on debtors who seek to assume and assign shopping center leases, particularly in large retail bankruptcy cases where a primary factor for seeking protection under the Bankruptcy Code is to monetize the value of such leases for the benefit of creditors. Indeed, it is fairly common practice for owners of shopping centers to include 'specific use' provisions in their leases to, among other things, preserve tenant mix and to avoid defaults of similar restrictive use provisions contained in other leases or documents governing the shopping centers.

Generally speaking, in order to obtain court authority to assume and assign a lease, a debtor must cure all defaults under the lease and provide adequate assurance of future performance of the terms of the lease. 11 U.S.C. '365(b)(1); See also, In re Joshua Slocum, 922 F.2d 1081, 1086 (3rd Cir. 1990). If these requirements are satisfied, a court has the discretion, afforded by '365(f)(1) to avoid certain provisions that constitute unreasonable restrictions on assignment. The congressional purpose in granting courts discretion to avoid certain lease provisions under '365(f)(1) was to promote marketability of the leases and to allow debtors to realize the true value of their leases, often a significant asset of a bankruptcy estate. Collen, Buying and Selling Real Estate in Bankruptcy '7.06[3](1997).

Such provisions are often referred to as de facto anti-assignment clauses and are unenforceable under '365(f)(1). Examples of provisions that may potentially and unreasonably restrict assignment include, but are not limited to, a landlord's right of first refusal, restrictions on the type of business permitted to be operated at the premises, and a prohibition against interruptions in business operations. By enacting the 2005 amendment to include reference to subsection (b) in '365(f)(1), however, Congress imposed an additional requirement on debtors who seek to assign their shopping center leases. Specifically, courts must now determine that a proposed assignee will comply with the radius, use, location, and other similar restrictions contained in the operative sections of the lease, provisions that had previously been ignored under '365(f)(1).

Section 365(b)(3) of the Bankruptcy Code provides as follows:

For the purposes of paragraph (1) of this subsection and paragraph (2)(B) of subsection (f), adequate assurance of future performance of a lease of real property in a shopping center includes adequate assurance (C) that assumption or assignment of such lease is subject to all the provisions thereof, including (but not limited to) provisions such as a radius, location, use, or exclusivity provision, and will not breach any such provision contained in any other lease, financing agreement, or master agreement relating to such shopping center; and (D) that assumption or assignment of such lease will not disrupt any tenant mix or balance in such shopping center. 11 U.S.C. '365(b)(3)(A)-(D).

Three A's Holdings

In a recent decision titled In re Three A's Holdings, LLC, 364 B.R. 550 (Bankr. Del. 2007), the United States Bankruptcy Court for the District of Delaware denied the debtors' request to assume and assign a lease of property located in a shopping center, reasoning that so-called 'permitted use' provisions, which include restrictions on the type of business permitted on the leased premises, may not be ignored under the current Bankruptcy Code. The shopping center lease at issue in Three A's Holdings contained few use restrictions; however, the lease was expressly subject to specific use restrictions imposed by a local planning board in a Declaration of Covenants, Conditions and Restrictions (the 'Declaration of Covenants'). The Declaration of Covenants contained a list of permitted businesses within the shopping center. The debtors sought to assume and assign the lease to Walgreens, which planned to operate a pharmacy on the premises, which was not authorized under the Declaration of Covenants.

The Three A's Holdings court initially noted that assumption and assignment of leases belonging to a bankrupt are governed by '365 of the Bankruptcy Code. The court then stated that, although a court's authority to permit assignments of leases that contain anti-assignment provisions under '365(f)(1) is broad, the court's discretion is limited if the assumption or assignment involves a lease of real property in a shopping center. In this regard, the court noted that the 1984 congressional amendments to the Bankruptcy Code imparted heightened restrictions in '365(b)(3) to provide a framework for enforcing common provisions found in shopping center leases since assignment of shopping center leases greatly impacts not only the lessors, but also the other tenants in the shopping center.

The Three A's Holdings court also noted that the 2005 amendment further limited a court's discretion to override what was previously considered a de facto anti-assignment provision in a shopping center lease. Since the court concluded that Walgreens intended use of the space violated the Declaration of Covenants, the court denied the debtor's motion for an order authorizing the assumption and assignment of the lease.

Conclusion

In light of the 2005 amendment, as well as the holding in Three A's Holdings, it now appears that courts may not have the discretion to override radius, use, location, and other similar restrictions as de facto anti-assignment provisions pursuant to '365(f)(1), and that such provisions may be strictly enforced, notwithstanding a debtor's attempt to monetize the value of its shopping center lease.

Moreover, the 2005 amendment could also impact a court's decision to enforce so-called 'go-dark' or 'continuous use' provisions. These provisions, often contained in shopping center leases, require that the tenant operate its premise for a set period of time and not 'go dark' for more than a nominal period of time. Taken at face value, an argument could be made that under the 2005 amendment, these 'go dark' or 'continuous use' provisions should be strictly enforced, effectively requiring the proposed assignees of such leases to forego refitting the premises or risk triggering a default.

A strong argument could also be made, however, that despite the 2005 amendment, 'go dark' or 'continuous use' provisions should not be treated similarly to 'permitted use' provisions since these restrictions do not involve the nature of the proposed assignee's use of the space and do not impact tenant mix. Indeed, 'go dark' and 'continuous use' provisions, if strictly enforced, would preclude the assignment of shopping center leases even in situations where there would be little, if no, negative impact on the owner of the center or other tenants. Prior to the 2005 amendment, courts frequently declined to enforce unreasonable 'go dark' or 'continuous use' provisions when they had the effect of precluding or inhibiting assignments.

Though no case since the 2005 amendment has addressed this very issue, courts could continue to refuse enforcement of such provisions on the basis that, among other things, the owner is merely seeking, at the expense of the bankrupt's estate, to recapture the premises for the purpose of increasing rent. In such an event, the premises would remain dark during the period in between tenancies, a result no different from that in which the debtor had assigned the lease to a new tenant who was granted a short reprieve from the 'go dark' or 'continuous use' provision for the purpose of refitting or remodeling the space. Indeed, it seems clear that the courts, in keeping with the purpose and intent of the Bankruptcy Code, should seek to preserve a debtor's interest in the lease and refuse enforcement of these provisions. Accordingly, despite the 2005 amendment, a strong argument can be made that courts should continue to recognize that the sole effect of 'go dark' or 'continuous use' provisions is an unjustified limitation on assignment that falls far short of meeting the goals of the 2005 amendment.

This article originally appeared in the New York Law Journal, a sister publication of this newsletter.

Jeffrey B. Steiner and Gerard S. Catalanello are members of Thelen Reid Brown Raysman & Steiner. Yevgenia Paikine, a law clerk of the firm, assisted in the preparation of this article.