Lease Termination Fees May Be an Avoidable Preference Under the Bankruptcy Code

Generally, regardless of what “debt” means in other areas of life and law, it means something a little different under the Bankruptcy Code. That definition becomes important when, as is more common these days, your client, or a party obligated to your client, declares bankruptcy.

Background

Recently, the Eleventh Circuit Court of Appeals considered whether future rent under a lease was “debt” for purposes of bankruptcy, and held that a tenant becomes “indebted” to the landlord for all future rental payments for the life of the lease at the moment the lease is executed. In re: Tanner Family, LLC, 556 F.3d 1194 (11th Cir. 2009).

In December 2002, Tanner Family, LLC (“Tenant”) entered into a lease agreement with Midwest Holding # 7, LLC (“Landlord”) for retail space in a northern Georgia shopping center to operate the “Chapter 11 Bookstore,” one of a small chain. The lease was for a five-year term expiring in March, 2008. Under the lease, Tenant was obligated to pay Landlord monthly rent in the amount of approximately $7,500 on the first day of each calendar month. About halfway through the lease term, Tenant wanted out. On Aug. 9, 2005, Landlord and Tenant entered into a Termination Agreement pursuant to which Tenant agreed to pay Landlord $87,172.50, and Landlord agreed to release Tenant from the rest of its obligations under the lease. Tenant made the termination payment and vacated the premises by the end of August, 2005.

On Oct. 15, 2005, Tenant (ironically) filed a Chapter 11 bankruptcy petition, which later was converted to a Chapter 7 proceeding, and the court appointed a bankruptcy Trustee. On Jan. 24, 2007, the Trustee brought an adversary proceeding in the Bankruptcy Court, alleging that the lease termination fee paid to Landlord was an avoidable preference under 11 U.S.C. ' 547 and seeking to recover the $87,172.50 payment from Landlord. In re Tanner Family, LLC, 2007 Bankr. LEXIS 3986 (N.D. Ga. Oct. 9, 2007). (An avoidable preference is a payment made by a debtor to a creditor within 90 days of, or in anticipation of, filing for bankruptcy. In an effort to treat all of the creditors of a bankruptcy debtor equitably, the trustee may “avoid” a preferential transfer to one creditor by retrieving and redistributing the payment.)

On cross motions for summary judgment, the issue before the Bankruptcy Court was whether the termination payment was “for or on account of an antecedent debt,” one of the elements a bankruptcy trustee must prove in order to avoid a transfer as a preference. Relying almost exclusively on a single decision of the Ninth Circuit Bankruptcy Appellate Panel, In re Upstairs Gallery, Inc., 167 B.R. 915 (9th Cir. BAP 1994), the Bankruptcy Court granted the Trustee's motion for summary judgment, holding that the termination fee was paid on account of antecedent debt and, therefore, was an avoidable preference. On appeal to the District Court, the decision was affirmed. Midwest Holding # 7, LLC v. Anderson, 2008 U.S. Dist. LEXIS 33442 (N.D. Ga., Apr. 22, 2008). Landlord appealed to the Eleventh Circuit.

Issue and Analysis

Section 547 of the Bankruptcy Code provides the elements a bankruptcy trustee must show in order to avoid a transfer as a preference:

(b) ' [T]he trustee may avoid any transfer of an interest of the debtor in property '

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made '

(A) on or within 90 days before the date of the filing of the petition; or

(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if–

(A) the case were a case under chapter 7 of this title;

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by the provisions of this title.

11 U.S.C. ' 547(b). Only the second element, whether the termination fee was “for or on account of an antecedent debt,” was in dispute on summary judgment.

First, the Court of Appeals defined “antecedent,” explaining that debt is antecedent “if it is pre-existing or is incurred before the transfer” and “thus depends on when the debt is incurred.” 556 F.3d at 1196 (emphasis in original) (citations omitted). Landlord argued that the debt of a monthly rent payment is incurred only when it is legally collectible, i.e., the first of each month. Id. The Trustee countered that a tenant incurs the obligation to pay rent for the entire term of the lease at the time the lease agreement is signed, not when the rent is due and payable each month. Id.

Because the Bankruptcy Code does not define exactly when a debt is incurred, the court turned to the definitions of “debt” and “claim.” Id. at 1196-97. Section 101 of the Bankruptcy Code states that “[t]he term 'debt' means liability on a claim” and the “term 'claim' means ' (A) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured ' .” 11 U.S.C. ” 101(12), 101(5)(A). Under the court's interpretation, linking the word “debt” to “claim” made it just as broad, and “[a]ccordingly, a debtor incurs a debt to a creditor when the creditor has a claim against the debtor, even if the claim is unliquidated, unmatured, unfixed, or contingent.” 556 F.3d at 1196-97 (emphasis in original). Applying this definition to the termination fee in the case before it, the court found that from the moment Tenant signed the lease, Landlord had an unmatured claim against Tenant to receive future rent payments for the entire five-year term. Id. at 1197. This obligation to pay future rent was debt, regardless of the fact that the debt only matured on the first of each month when rent actually became due. Moreover, the entire debt was incurred at lease signing, well before Tenant made the $87,172.50 termination payment, and thus, the debt was antecedent debt. Id.

Having concluded that the unpaid rent was antecedent debt, the Court of Appeals also concluded, without analysis, that the termination fee was paid “for or on account of” future rent payments. Id. Some guidance on this point can be found in the District Court's opinion, which did consider this element of the statute. The lower court asked:
“[W]hat did the $87,172.50 pay for? Did it pay to extinguish a debt that the debtor incurred back in 2002 when it originally leased the property? Or did it obtain something more than the mere extinguishment of future debt?” 2008 U.S. Dist. LEXIS 33442, at **8. Landlord in this case, the court noted, “concede[d] that the only thing of value that the debtor obtained in exchange for the $87,172.50 was the extinguishment of liability for future payments.” Id.

If courts may characterize a termination fee as payment on antecedent debt and subject to recovery by the trustee as an avoidable preference, then, short of crossing its fingers that a tenant will file for bankruptcy at least 91 days after making a termination payment, what can a landlord do?

Drafting Suggestions

The Tanner court's unequivocal statement that a lease termination fee which only operates to release the tenant from its obligation to pay future rent is a payment “for or on account of an antecedent debt” suggests that there may not be a way to draft around the preference problem. The definitions of “claim” and “debt” are sweeping, and the courts have interpreted the preference provision to “cover any possible obligation to make payment.” 556 F.3d at 1196-97 (citation omitted). However, the court's opinion in Tanner did not provide any details about the substantive provisions of the termination agreement or the lease, and Landlord simply conceded that the termination payment was made only for extinguishment of future rent. Perhaps a court would analyze a carefully drafted lease or termination agreement provision on termination payments differently, especially given American judges' general willingness to enforce contract terms and conform to the parties' intent.

Specifically, based on the district and appellate courts' reasoning in Tanner, paying careful attention to when the debt is incurred and for what the payment is made, together with creative drafting, may give a landlord a better prospect of keeping a termination fee in spite of a trustee's challenge.

The Tanner court could hardly have been clearer about “when” future rental payments become incurred debt for bankruptcy purposes: “We therefore hold that the debt in this case was incurred upon the signing of the lease and thus was antecedent to the $87,172.50 transfer.” 556 F.3d at 1197. But what if Landlord's counsel had negotiated a termination provision in the lease which made it clear that the termination fee was not an unmatured debt at the time of lease signing, but rather became a debt only upon the occurrence of a termination event triggered by some action by Landlord? For example, if the lease defined nonpayment, threat of nonpayment, or Landlord's reasonable insecurity about payment as events of default, then the lease could establish that the termination fee was incurred only upon written notice of termination to the tenant. Payment of the termination fee would be due within a short few days of notice to establish that the debt was not antecedent, but contemporaneous with payment. (Note that this strategy might also add something to a contemporaneous exchange defense under ' 547(c), which is not discussed in this article.) The lease or termination agreement could also provide the landlord with an option to request two or three years of financial reports as a condition of accepting termination.

The interrelated question of “for what” the payment is made also provides some drafting guidance. Again, a court will look for evidence that the tenant obtained “something more than the mere extinguishment of future debt[.]” 2008 U.S. Dist. LEXIS 33442, at **8. To that end, the lease could expressly re-characterize the termination fee, or at least a portion of it, as something other than a payoff for future rent. First, the termination payment provision should include a recitation of additional consideration distinguishing it from a mere release from future rent. The termination payment could be identified as “ marketing support” or “re-letting expense assistance” accompanied by a list of the specific kinds of expenses it is intended to cover. Arguably, a fee to cover such expenses is not incurred upon lease signing, like future rent, but only upon termination. For example, the fee could reimburse for brokerage fees or leasehold improvements associated with re-letting the property. The fee could also serve as a release of future liability for the condition of the premises at surrender of the premises. Furthermore, such payment would be for future, not antecedent, obligations. The size of the termination fee in relation to the monthly rental rate may also be important in avoiding an association with future rent; accordingly, the calculation of the termination fee should be tied to something other than monthly rent.

As further protection, landlords may want to consider asking for a guaranty of the termination fee from a parent company or individual or ask that a letter of credit securing the amount of the termination fee be posted at least during the 90 day preference period.

Conclusion

As discussed above, courts are likely to continue enforcing a broad definition of “debt” intended to capture as much of the debtor's money as possible for equitable distribution among all creditors. The Tanner case demonstrates that lease termination fees may well be characterized as payments on account of antecedent debt, and, therefore, subject to disgorgement by the bankruptcy trustee as an avoidable preference. However, the court's failure to consider the specific terms of the lease, the termination agreement, and other circumstances may leave open the opportunity for the parties to achieve a different outcome. In the end, careful drafting may provide some protection for landlords faced with similar preference claims.

Stephen T. Skaff is an associate in the Corporate Practice Group of Lewis, Rice & Fingersh, L.C. in St. Louis, MO. He may be contacted at [email protected]. Phone: 314-444-7779.

Generally, regardless of what “debt” means in other areas of life and law, it means something a little different under the Bankruptcy Code. That definition becomes important when, as is more common these days, your client, or a party obligated to your client, declares bankruptcy.

Background

Recently, the Eleventh Circuit Court of Appeals considered whether future rent under a lease was “debt” for purposes of bankruptcy, and held that a tenant becomes “indebted” to the landlord for all future rental payments for the life of the lease at the moment the lease is executed. In re: Tanner Family, LLC, 556 F.3d 1194 (11th Cir. 2009).

In December 2002, Tanner Family, LLC (“Tenant”) entered into a lease agreement with Midwest Holding # 7, LLC (“Landlord”) for retail space in a northern Georgia shopping center to operate the “Chapter 11 Bookstore,” one of a small chain. The lease was for a five-year term expiring in March, 2008. Under the lease, Tenant was obligated to pay Landlord monthly rent in the amount of approximately $7,500 on the first day of each calendar month. About halfway through the lease term, Tenant wanted out. On Aug. 9, 2005, Landlord and Tenant entered into a Termination Agreement pursuant to which Tenant agreed to pay Landlord $87,172.50, and Landlord agreed to release Tenant from the rest of its obligations under the lease. Tenant made the termination payment and vacated the premises by the end of August, 2005.

On Oct. 15, 2005, Tenant (ironically) filed a Chapter 11 bankruptcy petition, which later was converted to a Chapter 7 proceeding, and the court appointed a bankruptcy Trustee. On Jan. 24, 2007, the Trustee brought an adversary proceeding in the Bankruptcy Court, alleging that the lease termination fee paid to Landlord was an avoidable preference under 11 U.S.C. ' 547 and seeking to recover the $87,172.50 payment from Landlord. In re Tanner Family, LLC, 2007 Bankr. LEXIS 3986 (N.D. Ga. Oct. 9, 2007). (An avoidable preference is a payment made by a debtor to a creditor within 90 days of, or in anticipation of, filing for bankruptcy. In an effort to treat all of the creditors of a bankruptcy debtor equitably, the trustee may “avoid” a preferential transfer to one creditor by retrieving and redistributing the payment.)

On cross motions for summary judgment, the issue before the Bankruptcy Court was whether the termination payment was “for or on account of an antecedent debt,” one of the elements a bankruptcy trustee must prove in order to avoid a transfer as a preference. Relying almost exclusively on a single decision of the Ninth Circuit Bankruptcy Appellate Panel, In re Upstairs Gallery, Inc., 167 B.R. 915 (9th Cir. BAP 1994), the Bankruptcy Court granted the Trustee's motion for summary judgment, holding that the termination fee was paid on account of antecedent debt and, therefore, was an avoidable preference. On appeal to the District Court, the decision was affirmed. Midwest Holding # 7, LLC v. Anderson, 2008 U.S. Dist. LEXIS 33442 (N.D. Ga., Apr. 22, 2008). Landlord appealed to the Eleventh Circuit.

Issue and Analysis

Section 547 of the Bankruptcy Code provides the elements a bankruptcy trustee must show in order to avoid a transfer as a preference:

(b) ' [T]he trustee may avoid any transfer of an interest of the debtor in property '

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent;

(4) made '

(A) on or within 90 days before the date of the filing of the petition; or

(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if–

(A) the case were a case under chapter 7 of this title;

(B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by the provisions of this title.

11 U.S.C. ' 547(b). Only the second element, whether the termination fee was “for or on account of an antecedent debt,” was in dispute on summary judgment.

First, the Court of Appeals defined “antecedent,” explaining that debt is antecedent “if it is pre-existing or is incurred before the transfer” and “thus depends on when the debt is incurred.” 556 F.3d at 1196 (emphasis in original) (citations omitted). Landlord argued that the debt of a monthly rent payment is incurred only when it is legally collectible, i.e., the first of each month. Id. The Trustee countered that a tenant incurs the obligation to pay rent for the entire term of the lease at the time the lease agreement is signed, not when the rent is due and payable each month. Id.

Because the Bankruptcy Code does not define exactly when a debt is incurred, the court turned to the definitions of “debt” and “claim.” Id. at 1196-97. Section 101 of the Bankruptcy Code states that “[t]he term 'debt' means liability on a claim” and the “term 'claim' means ' (A) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured ' .” 11 U.S.C. ” 101(12), 101(5)(A). Under the court's interpretation, linking the word “debt” to “claim” made it just as broad, and “[a]ccordingly, a debtor incurs a debt to a creditor when the creditor has a claim against the debtor, even if the claim is unliquidated, unmatured, unfixed, or contingent.” 556 F.3d at 1196-97 (emphasis in original). Applying this definition to the termination fee in the case before it, the court found that from the moment Tenant signed the lease, Landlord had an unmatured claim against Tenant to receive future rent payments for the entire five-year term. Id. at 1197. This obligation to pay future rent was debt, regardless of the fact that the debt only matured on the first of each month when rent actually became due. Moreover, the entire debt was incurred at lease signing, well before Tenant made the $87,172.50 termination payment, and thus, the debt was antecedent debt. Id.

Having concluded that the unpaid rent was antecedent debt, the Court of Appeals also concluded, without analysis, that the termination fee was paid “for or on account of” future rent payments. Id. Some guidance on this point can be found in the District Court's opinion, which did consider this element of the statute. The lower court asked:
“[W]hat did the $87,172.50 pay for? Did it pay to extinguish a debt that the debtor incurred back in 2002 when it originally leased the property? Or did it obtain something more than the mere extinguishment of future debt?” 2008 U.S. Dist. LEXIS 33442, at **8. Landlord in this case, the court noted, “concede[d] that the only thing of value that the debtor obtained in exchange for the $87,172.50 was the extinguishment of liability for future payments.” Id.

If courts may characterize a termination fee as payment on antecedent debt and subject to recovery by the trustee as an avoidable preference, then, short of crossing its fingers that a tenant will file for bankruptcy at least 91 days after making a termination payment, what can a landlord do?

Drafting Suggestions

The Tanner court's unequivocal statement that a lease termination fee which only operates to release the tenant from its obligation to pay future rent is a payment “for or on account of an antecedent debt” suggests that there may not be a way to draft around the preference problem. The definitions of “claim” and “debt” are sweeping, and the courts have interpreted the preference provision to “cover any possible obligation to make payment.” 556 F.3d at 1196-97 (citation omitted). However, the court's opinion in Tanner did not provide any details about the substantive provisions of the termination agreement or the lease, and Landlord simply conceded that the termination payment was made only for extinguishment of future rent. Perhaps a court would analyze a carefully drafted lease or termination agreement provision on termination payments differently, especially given American judges' general willingness to enforce contract terms and conform to the parties' intent.

Specifically, based on the district and appellate courts' reasoning in Tanner, paying careful attention to when the debt is incurred and for what the payment is made, together with creative drafting, may give a landlord a better prospect of keeping a termination fee in spite of a trustee's challenge.

The Tanner court could hardly have been clearer about “when” future rental payments become incurred debt for bankruptcy purposes: “We therefore hold that the debt in this case was incurred upon the signing of the lease and thus was antecedent to the $87,172.50 transfer.” 556 F.3d at 1197. But what if Landlord's counsel had negotiated a termination provision in the lease which made it clear that the termination fee was not an unmatured debt at the time of lease signing, but rather became a debt only upon the occurrence of a termination event triggered by some action by Landlord? For example, if the lease defined nonpayment, threat of nonpayment, or Landlord's reasonable insecurity about payment as events of default, then the lease could establish that the termination fee was incurred only upon written notice of termination to the tenant. Payment of the termination fee would be due within a short few days of notice to establish that the debt was not antecedent, but contemporaneous with payment. (Note that this strategy might also add something to a contemporaneous exchange defense under ' 547(c), which is not discussed in this article.) The lease or termination agreement could also provide the landlord with an option to request two or three years of financial reports as a condition of accepting termination.

The interrelated question of “for what” the payment is made also provides some drafting guidance. Again, a court will look for evidence that the tenant obtained “something more than the mere extinguishment of future debt[.]” 2008 U.S. Dist. LEXIS 33442, at **8. To that end, the lease could expressly re-characterize the termination fee, or at least a portion of it, as something other than a payoff for future rent. First, the termination payment provision should include a recitation of additional consideration distinguishing it from a mere release from future rent. The termination payment could be identified as “ marketing support” or “re-letting expense assistance” accompanied by a list of the specific kinds of expenses it is intended to cover. Arguably, a fee to cover such expenses is not incurred upon lease signing, like future rent, but only upon termination. For example, the fee could reimburse for brokerage fees or leasehold improvements associated with re-letting the property. The fee could also serve as a release of future liability for the condition of the premises at surrender of the premises. Furthermore, such payment would be for future, not antecedent, obligations. The size of the termination fee in relation to the monthly rental rate may also be important in avoiding an association with future rent; accordingly, the calculation of the termination fee should be tied to something other than monthly rent.

As further protection, landlords may want to consider asking for a guaranty of the termination fee from a parent company or individual or ask that a letter of credit securing the amount of the termination fee be posted at least during the 90 day preference period.

Conclusion

As discussed above, courts are likely to continue enforcing a broad definition of “debt” intended to capture as much of the debtor's money as possible for equitable distribution among all creditors. The Tanner case demonstrates that lease termination fees may well be characterized as payments on account of antecedent debt, and, therefore, subject to disgorgement by the bankruptcy trustee as an avoidable preference. However, the court's failure to consider the specific terms of the lease, the termination agreement, and other circumstances may leave open the opportunity for the parties to achieve a different outcome. In the end, careful drafting may provide some protection for landlords faced with similar preference claims.

Stephen T. Skaff is an associate in the Corporate Practice Group of Lewis, Rice & Fingersh, L.C. in St. Louis, MO. He may be contacted at [email protected]. Phone: 314-444-7779.