Daily Development for Friday, January 28, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
BANKRUPTCY; PROCEDURE; APPEALS; MOOTNESS DOCTRINE: Under the “mootness” doctrine contained in Bankruptcy Code Section 363, the courts’ decision to deny a stay pending landlord’s appeal of a bankruptcy judge’s order authorizing an assumption and assignment of a lease concludes the landlord’s ability to appeal whether such authorization provided “adequate protection” to the landlord as required by Code Section 365.
Weingarten Nostate v. Service Merchandise, 2005 U.S. App. LEXIS 1131 (1/ 24/05)
A shopping center landlord had a long term lease with Service Merchandise, which went into bankruptcy liquidation. Service found a “jobber” for a package of its leases. The “jobber” assumed all the leases for a cash price and then proceeded to parcel out the more desirable ones to various tenants. We’ve seen all this before in other chain store bankruptcies - perhaps most notably Montgomery Ward. In the case of the shopping center in question, the “jobber” sublet portions of the Service Merchandise space to three different subtenants. Apparently this was done prior to confirmation of the plan, so that the landlord was in a position to argue that the subletting to these three parties might not satisfy the “adequate assurance” to which the landlord was supposed to be entitled under 365 that the landlord’s lease rights in the Service lease would be preserved, including the exclusive use provisions.
The court here stated that the Service Merchandise lease had “only loose restrictions on assignment, sublet and use,” although it does not give us the language. But Landlord also had a lease with another tenant in a nearby space in the shopping center that provided that the tenant could reduce rent by one third or terminate if any other space in the center were rented to a tenant engaged in the same business (arts and crafts supplies.) One of the leases that the “jobber” proposed to enter into with the Service space was with Michael’s, a national seller of arts and crafts supplies similar to those sold by the protected tenant.
Landlord objected to the assumption and subletting to Michaels on the grounds that this would not provide the “adequate assurance of future performance” guaranteed to a shopping center landlord under 365(b)(3). Here is the language upon which Landlord relied:
“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. . . .”
(A) of the source of rent and other consideration due under such lease, and in the case of an assignment, that the financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time the debtor became the lessee under the lease; (B) that any percentage rent due under such lease will not decline substantially; (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 that assumption or assignment of such lease will not disrupt any tenant mix or balance in such shopping center.
In addition, the Landlord claimed that it was not receiving “adequate assurance” of performance of the Service lease because the assignee “jobber” was not a good replacement for Service as it existed at the time of letting.
The bankruptcy court rejected the Landlord’s claim and further refused to stay the transfer of the leased property to Michaels while the Landlord appealed the claim. Landlord appealed the refusal to stay the transfer to the District Court and to the Sixth Circuit, and continued to lose on the grounds that these courts concluded that the liklihood of the Landlord’s prevailing on the merits was low.
The lease was assigned to Michaels, and the “jobber” collected a $300,000 fee for assuming and subletting the Service lease.
On Landlord’s appeal of the approval of the jobber’s assumption and subletting of the lease, the Sixth Circuit Court of Appeals concluded that the landlord’s appeal was moot because, under the mootness doctrine contained in Section 363 (not 365) of the Bankruptcy Code, a transfer authorized by the court cannot be affected by a later challenge to the court approval of the transfer so long as there was no collusion or bad faith, even if the transferee was fully aware of the objections made by third parties to the transfer and the fact of the appeal.
In other words, Landlord never “got its day” on the real merits of its claim. As the 6th Circuit commented: “For good or ill, the merits of [Landlord’s] appeal were effectively resolved when the motions for stay were denied, by virtue of the bankruptcy code's statutory mootness provision.”
The court justified this policy as based upon the need for efficiency and certainty in resolving the bankruptcy (read in - maximizing the value of the estate to be distributed among the other creditors - at the expense of those denied a full appeal).
“While the primary goal of § 363(m) is to protect good faith purchasers, it also reflects the more general constitutional consideration that an appeal must be dismissed as moot when, by virtue of intervening events, the court of appeals cannot fashion effective relief.”
The court acknowledged that the “mootness rule” is part of 363, which deals with sale of the estate property (including assumed leases) and not part of 365, which was the section relied upon by Landlord. But it held that necessarily the rule ought to bind appeals based upon 365 considerations. Here, there was a further complication because the 363 sale was to a general jobber, while the actually subletting to Michael’s occurred only after the jobber had retransferred to an intermediate party (apparently related to the jobber.) But the court concluded that, as all of the transfers were two steps in a “unified transaction.” It doesn’t indicate whether such a transaction needs to be part of a common plan, as appears to have been the case here. We’ll have to abide to discover that.
The court also noted that there is something of a split as to whether appeals are always mooted or whether there is a sliver of hope for landlords if they can propose a remedy that would not interfere with the working out of the 363 disposition of the tenant’s assets. The court didn’t decide that issue here, and indeed there would be few cases in which such possibility would be relevant to the landlord faced with loss of 365 protection. Usually the conditions of the 363 sale will wipe out landlord’s hoped for protection.
Comment 1: On the merits, the editor confesses that the Landlord’s case here may have been a bit thin. There was no restriction in the Service lease itself, so the Landlord was left to make arguments about the impact of the assignment to Michael’s on the Landlord’s relations with Landlords other tenant. But note that the Michael’s lease did not “breach” the exclusive use rights of the existing tenant, it simply gave that tenant an option to terminate. Landlords and tenants interesting in getting a better shot at preserving their exclusive agreements under 365 might consider whether to characterize leases to competing tenants as breaches of the protected lease, although the editor acknowledges that more thought will have to be given to the overall business impact of such drafting.
Compare: In Re Martin Paint Stores, Bankruptcy Court, S.D. New York, 1996. (not a shopping center case) where, on similar facts, the court found that a landlord could show no threat to landlord’s revenue stream from the bankruptcy assumption and assignment of another of landlord’s tenant leases to a tenant who competed with an existing tenant protected by an exclusive provision and that the landlord in fact might even benefit if the complaining tenant bailed out when its exclusive was frustrated.
For a more heartening case trending in favor of 365 rights in a 363 sale, see In re E-Z Serve Convenience Stores, Inc., 289 B.R. 45, 51-52 (Bankr. M.D.N. Carolina 2003). (Landlord's right of first refusal to purchase the buildings and permanent improvements constructed on the leased land by the debtor-tenant is not avoidable as a restriction on assignment when the bankrupt tenant assigns the lease.)
Comment 2: As authority for imposing 363 analysis to the 365 issue involved here, the court cited the Third Circuit Court of Appeals case in LRSC Co. v. Rickel Home Centers, Inc. (In re Rickel Home Centers), 209 F.3d 291, 298 (3d Cir. 2000), which it characterized as “well reasoned.” Note that Rickel denied an appeal of a lower court opinion refusing to impose certain lease restrictions on an assignee acquiring out of a bankruptcy. In re Rickel Home Centers, Inc., 240 B.R. 826 (Bkrtcy. D. Del. 1998). (The DIRT DD for 8/11/98). This lower court Rickel decision has since been discredited elsewhere, In re Trak Auto Corporation v. West Town Center, LLC, 2004 WL 856859 (4th Cir., 4/22/04) (the DIRT DD for 5/4/04) and was probably wrong, but the landlord in that case never got a chance to make a substantive argument on the point.
Comment 3: Thus, we see that, believe it or not, it is possible for bankruptcy judges to err on their interpretation of the law. Cynics might say that the degree of a bankruptcy judge’s commitment to following the law, even the bankruptcy law, is closely tied to the question of whether such adherence will give the judge more toys to play with in successfully completing a bankruptcy workout or in maximizing the return from the estate to the creditors as a group. The impact of such priorities, of course, would be to divert value away from the interests of landlords protected by Section 365 and to the other creditors of the estate.
Comment 4: The editor admits that the landlord here did get a chance to argue that it was “likely” to prevail on the merits as it made its way from the predictable denial of the stay from the bankruptcy court, on to the District Court and then to the Sixth Circuit, on the appeal relating to the stay. But these hearings were not hearings on the merits, and other considerations might properly have motivated the courts in affirming the stay. It is indeed unfortunate that the “mootness doctrine” in fact denies parties protected by 365 rights from asserting them fully. One step in the right direction might be to permit these parties to get their first hearing on the stay from a judge other than the one who had just issued the ruling that is being appealed.
Comment 5: The problem goes beyond shopping centers and even goes beyond landlords. Tenants, also, have been disadvantaged by bankruptcy courts refusing to acknowledge rights protected under Section 365. The now infamous Qualitech case is the prime example. Precision Industries, Inc. v. Qualitech, 2003 U.S. App. LEXIS 7612 (7th Cir. April 23, 2003) (the DIRT DD for 4//29/03). This case held that a “free and clear” sale of landlord’s property under Section 363 wiped out the protections that a tenant had pursuant to Section 365 to preserve its possessory rights notwithstanding the landlord’s rejection of the lease. Some Pollyanna commentators have dismissed Qualitech as based entirely on the notion that the tenant did not properly object to the sale in the bankruptcy court, but the editor has pointed out that even if the tenant had objected, the bankruptcy court might have denied the objection, and then refused to stay the sale. Now we see what would happen to that tenan!
t if i
t thwas unable to stay the sale, which might be a problem for the tenant if all the landlord’s property is being “jobbed out” in one sale. A court would be loathe to hold up such an advantageous event for one little tenant. Once the sale had occurred, as we see here, even purchasers with knowledge of the tenant’s objections would buy free of them. .
Yes, Children, the Armageddon clock has moved a few notches along its fateful path for leasaehold rights on bankruptcy.
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