Lease Terminations As Fraudulent Transfers

Is an insolvent debtor's pre-bankruptcy termination of a commercial lease a fraudulent transfer? The Third Circuit said no when it held that a lessor's pre-bankruptcy termination of the debtors' lease and purchase option "was not a transfer under Bankruptcy Code §548(a)(1)(B)." In re Pazzo Pazzo Inc., 2022 WL 17690158 (3d Cir. Dec. 15, 2022). But the Seventh Circuit held that a Chapter 11 debtor's pre-bankruptcy "surrender of [two] … leases to [its landlord] could be regarded as a preferential [or fraudulent] transfer." In re Great Lakes Quick Lube L.P., 816 F.3d 482 (7th Cir. 2016). Reversing the bankruptcy court's holding that "the terminations were [not] transfers, … preferential or fraudulent," the Seventh Circuit stressed that the debtor's termination of its "interest in property — … the leaseholds — which it parted with by transferring that interest to [the landlord]," fell within the broad definition of "transfer" in the Bankruptcy Code (Code). Id. at 485. A close reading of both Pazzo and Great Lakes, however, shows that the circuits are not split, and that the reasoning of both courts can be reconciled on their facts.

Pazzo

The debtors in Pazzo had intended to abandon their property, receiving the lessor's ample notice of termination of a lease and repurchase option. Their "radio silence" after receiving warning notices from the lessor, based on their non-payment of taxes and utility bills, their lapsed liquor and food licenses, their non-existent employment force and multiple maintenance issues, "provided ample grounds for the finding that the debtors had intended to vacate the premises." On these facts, the bankruptcy court properly held the lease to have been abandoned. Indeed, the debtors knew that the lessor considered the lease and option to be terminated, but they never responded. They made no claim of an interest in the lease or the option until after filing a bankruptcy petition several months later. Although the purchase option was a "future contingent interest protected under the Bankruptcy Code," the debtors' "failure to convert this contingent interest into actual ownership did not amount to" disposing or parting with their property "interest." Id. at *4. Thus, the debtors "did not transfer their option rights," but only "failed to pursue a business opportunity" by allowing that property interest to lapse. They no longer had a property interest before they even commenced their bankruptcy case. Termination of the option was therefore not a "transfer" under Code §548(a)(1)(B).

Great Lakes

The facts in Great Lakes were different. The debtor there operated a number of retail stores and had "negotiated the termination of the leases [on two stores] 52 days before bankruptcy." At the time, the debtor was in serious financial trouble and had agreed with the landlord "to terminate the two leases… even though the leased stores were profitable." 816 F.3d at 485.