Daily Development for Tuesday, May 4, 2004
>by: Patrick A. Randolph, Jr.
>Elmer F. Pierson Professor of Law
>UMKC School of Law
>Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri
>dirt@umkc.edu
>
>Harris Ominsky was the Reporter for this item. The editor, however, due to stylistic foibles that not even he can explain, has substantially altered the “report” section, and has made minor non-substantive changes in the comments section as well.
>
>BANKRUPTCY; LEASES; ASSIGNMENT; SHOPPING CENTERS: First decision by a federal Court of Appeals court on “de facto” anti-assignment provisions tilts in favor of shopping center landlords.
>
>In re Trak Auto Corporation v. West Town Center, LLC, 2004 WL 856859
>(4th Cir., 4/22/04)
>
>The case revolved around a limitation in the Trak lease that permitted only the retail sale of automobile parts and accessories and such other items as are customarily sold by Trak at its other auto stores. Tenant Trak also agreed to use the leased property only as a Trak Auto Store.
>
>When Trak Auto went into bankruptcy and tried to assign the lease, it did not receive any interest from auto parts retailers. Perhaps this was because there were then seven auto parts stores within three miles of the center. Instead, Trak found an apparel merchandiser who offered $80,000 to buy the lease, and use the store to sell brand-name family apparel at discount prices. Over objection from the landlord, the bankruptcy court approved that assignment which, of course, would make the bankruptcy estate $80,000 richer, and leave the landlord with a discount clothing store it did not want.
>
>The federal district court affirmed (the DIRT DD of 4/23/03) and the landlord appealed to the United States Court of Appeals, which reversed the lower courts and agreed with the landlord .
>
>The central issue in the case involved the interpretation of two apparently contradictory sections of the Bankruptcy Code. Under one section, Section 365(b)(3), "a debtor may assign a lease if the assignee provides adequate assurance of future performance." When the lease in question involves a retail tenant in a shopping center, that adequate assurance must include additional specific assurances that are spelled out in the Code. Most importantly to this case, there must be adequate assurance that the assignment "is subject to all the provisions of the lease including (but not limited to) provisions such as a radius, location, use or exclusivity provisions," and will not breach any such provision contained in any other lease or agreement relating to the shopping center.
>
>On the surface that seems pretty clear, but the conflict occurs because
>another section of the Code, Section 365(f)(1), contains a general
>provision that prohibits the enforcement of "anti-assignment" clauses
>in leases. This section allows a debtor to assign a lease
>"notwithstanding a provision . . . that prohibits, restricts or
>conditions . . . assignment." That simple provision has been the basis
>over the years for millions of dollars of value in shopping center
>leases winding up in the hands of tenants' creditors, over the
>objections of numerous shopping center owners. Cases have held that
>various use restrictions and other, similar lease provisions in
>shopping center leases operated as de facto anti assignment clauses,
>and refused uphold them on assignment notwithstanding the specific
>“adequate protection” requirements of 365 (b)(3). See e.g. In re Paul
>Harris:, 1992 Bankr. LEXIS 2418 (U.S. Bktcy Ct.,S.D. Ind.) (assignment
>of a women's apparel store to a maternity store,
despite lease requiring that tenant operate under same name and for same purpose, upheld, because restriction was "antiassignment"clause and invalid); In re Rickels Home Centers, Inc., 240 B.R. 826 (Bkrtcy. D. Del. 1998). (The DIRT DD for 8/11/98) (Restrictions on the purpose and size of the store operations in a shopping center were de facto restrictions on assignment and invalid under the Bankruptcy Code.
>But compare: Sun TV & Appliances, Inc., 234 B.R. 370 (Bkrtcy. D. Del.
>1999) (upholding use restriction in appliance store in a shopping
>center.)
>
> Judge Michael, speaking for the three judge circuit court in the instant case, analyzed the legislative history and concluded that the more specific provision, intended to protect shopping center owners, trumped the more general legislative provision intended to prohibit anti-assignment clauses. Judge Michael noted that the House Judiciary Committee was concerned about a shopping center being a "carefully planned enterprise" where "the tenant mix in the shopping center may be as important to the lessor as the actual promised rental payments, because certain mixes will attract higher percentage of the stores in the center."
>
>Pursuant to Congressional hearings in 1984, Congress concluded that the practice of avoiding use restrictions in bankruptcy was creating problems with tenant mix and adversely affecting shopping centers. This was being done to facilitate assignments by debtor-tenants. "These locations were losing their balance-of-merchandise drawing card which was a threat to overall sales revenues in the shopping center sector of the economy." Therefore, Congress responded in 1984 by amending the shopping center provisions in the Bankruptcy Code.
>
>As stated by the court: "Among other things, Section 365(b)(3) (C) was amended to delete the word 'substantially' from the provision previously requiring that assignment of the shopping center lease must not 'breach substantially' certain restrictions. This section was also amended to provide that any assigned shopping center lease would remain subject to all of the provisions of the lease and not just the provisions of 'any other lease' relating to the center. Again, the amended provision that we interpret today provides: 'adequate assurance of future performance of a lease of real property in a shopping center includes adequate assurance . . . 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.'"
>
>It is noteworthy that the landlord sought only to enforce the use provision concerning the sale of automobile parts and accessories. It wisely did not attempt to enforce the restriction that the store could be used only as a "Trak Auto Store." That provision would have presented a more difficult issue for the landlord because it would have forbidden assignments even to other companies in the auto supply business. As Judge Michael pointed out, Senator Hatch, in explaining the 1984 amendment to Section 365(b)(3)(C) said that it was not intended to enforce requirements to operate under a specified trade name.
>
>In reaching its decision, the court weighed the potential advantages to the bankruptcy estate of permitting freer assignability of leases against the advantages of honoring Congressional intent and deferring to shopping-center owners' judgments about what is good for their shopping centers. In criticizing the bankruptcy court's decision, the circuit court held: "This analysis overlooks the fact that West Town, the shopping center landlord, made the judgment that an auto parts retailer is important to a successful mix of stores in the center. And, in its lease with Trak Auto, West Town successfully negotiated to have the leased space dedicated to the sale of auto parts. West Town insists that this use restriction be honored by any assignee of Trak Auto, and that is West Town's right under Section 365(b)(3)(C), regardless of market conditions. Section 365 (b)(3)(C) simply does not allow the bankruptcy court or us to modify West Town's 'original bargain with the debtor.' "
>
>Reporter’s Comment 1: There have been a host of recent major bankruptcies involving such companies as Rickel Home Centers, Bradley Stores, Montgomery Ward, Service Merchandise and Kmart. Many of the issues in those cases would have been decided differently by the Fourth Circuit Court of Appeals.
>
>This case will also support arguments by landlords to enforce other common restrictions and obligations which appear in retail leases, such as provisions forbidding alterations or closing of a store without the landlord's consent, percentage rent clauses and provisions requiring tenants to share profits they may receive on assignment or subleasing.
>
>The case may also undercut a recent trend to commerce in what are
>sometimes called "designation rights" in shopping center bankruptcy
>cases. Those sales, often involving tenants with dozens of shopping
>center sites, are often structured as auction sales of rights to a
>number of retail stores. When a debtor sells these designation rights,
>sometimes for millions of dollars, it typically transfers to the
>purchaser of these rights the exclusive right to select and designate
>which of the leases may be assumed and assigned and to whom, and which
>ones are to be excluded from these transactions. The successful bidder
>is usually given a period of time within which to market these leases
>to other buyers, and the profits are then split based on some
>negotiated arrangement between the debtor and the bidder. Obviously,
>these rights become more valuable if the leases can be assigned free of
>the lease restrictions and other limits that have often been carefully
>negotiated in the leases by
the shopping center owners. While the Trak decision will undoubtedly please landlords, it will strike a blow against those companies that deal in these designation rights.
>
>While some of the opinions in the bankruptcies listed earlier may be distinguishable in their facts, the Trak opinion presents a different perspective on Congressional intent than these other cases. For example, in the often-cited Rickel case (supra), the bankruptcy court overrode a use requirement for a "Rickel's type home improvement store," and permitted the assignee, Staples, to subdivide the space and use it for retail sale of office supplies. The court characterized the restriction as a "de facto anti-assignment clause," because market conditions were such that these type centers would become "obsolete," or at least would struggle to compete against stores like Home Depot. Essentially, the court bought Rickel's argument that its type of operation was no longer feasible. It appears that the Fourth Circuit Court of Appeals would have come to the opposite conclusion on those facts.
>
>The message of Trak is clear. Bankruptcy courts cannot invalidate use restrictions merely because another use will be more valuable, or even if the court determines that the tenant has not been able to find anyone interested in occupying the space for the required use. It seems that the landlord's choice of tenant mix in a shopping center lease must be honored, whether or not it is a wise choice by the owner, or even whether it is presently feasible because of changes in market conditions.
>
>Reporter’s Comment 2: The Trak decision should go down in legal history as a turning point in upholding a landlords rights to enforce lease restrictions on use, alterations and other operating issues in shopping center leases. This case is one of the first at the circuit court level to support these rights in bankruptcy. This well-reasoned opinion that should send a message to bankruptcy courts and bankruptcy and real estate lawyers throughout the country. It will undoubtedly become a leading case and will frequently be cited in future battles between bankrupt tenants and shopping center owners.
>
>Editor’s Comment 1: The editor, like the Reporter, has been troubled by the facility with which the courts have set aside the seemingly specific language of the Congress protecting the integrity of shopping center clauses. But the editor’s sensibilities have been bruised and battered enough by the bizarre legal/political/economic process in the bankruptcy courts to convince him that Trak may be a battle won by the shopping center landlords, and even a salient gained, but certainly does not represent the end of the war. As the Reporter notes, the economic “juice” behind the forces supporting the “de facto anti assignment clause analysis” is very powerful. Parties acquiring designation rights can provide massive infusions of cash to a bankrupt’s estate - cash that will please everyone involved other than the victimized center landlords.
>
>Although the court’s analysis here suggests that the landlord is able to retain its desired exclusive use requirement for an auto parts store, it seems clear that in fact this store location is highly unlikely ever to be an auto parts store in the near future. The question resolved in the case really has to do with economic power. Who will profit from the reuse of the space - the bankruptcy estate or the landlord? If unable to assign except for an auto parts store, the bankruptcy estate likely will reject the lease, leaving the landlord to relet to a tenant of its own choosing - and almost certainly (in light of the local competition - not an auto parts store.) Was it the Congressional intent really to shift the power balance in this way, or only to preserve the landlord’s expectations in particular uses? Maybe it’s impossible to do one without the other.
>
>This case may have the salutory effect of focussing the bargaining in retail center leases with national tenants on the formulation of use restrictions with which both parties are more comfortable. Bankruptcy in big boxes has become virtually a way of life, and consequently the tenants in the future may be more careful about how they limit their options as to future use - perhaps giving up something elsewhere in the lease to preserve more flexibility on assignment. But the really powerful landlords will be able to exploit unique locations to continue to obtain very restrictive provisions.
>
>Editor’s Comment 2: The editor still believes in the advice he formulated in his comments on the original Trak decision DD (supra). Landlords who truly want to protect their control over the tenant mix and retail activities in their centers should have a rational “comprehensive plan” that they regularly review and revise as marketplace conditions change. Where a landlord opposes an assignment of a bankrupt’s lease on apparently arbitrary grounds, even when it has good language in its lease, simply to exploit economic advantage, it is likely that many bankruptcy courts will be less generous to the landlord than the Trak court. Courts still have the power to apply state “good faith and fair dealing” concepts or other interpretive tools to avoid apparently arbitrary or overreaching positions taken by landlords in these cases.
>
>The Reporter for this item was Harris Ominsky of the Blank, Rome Philadelphia office.
>
>
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