Daily Development for Monday, May 5, 2003
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

The Reporter for this DD was Jack Murray, of First American Title Insurance Company, Chicago
office.  The editor has revised Jack's original comments, and added a number of his own, but has
attempted to retain the substance of Jack's report.

PROVISIONS; RIGHT OF FIRST REFUSAL:  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.

In re E-Z Serve Convenience Stores, Inc., 289 B.R. 45, 51-52 (Bankr. M.D.N. Carolina 2003)

In bankruptcy proceedings, a question may arise as to whether  365(f)(1) of the Bankruptcy
Code renders a right of first refusal contained in a lease unenforceable. Section 363(f)(1)
provides that, "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" if the trustee assumes the lease and provides adequate assurance of future performance.

Here, the bankruptcy trustee put a group of properties out to bid, and received a bid for a large group "all or none" from one buyer.  The trustee sought to obtain the court's approval of the assumption, assignment and sale of the debtor-lessee's interest under the lease to this purchaser, and the landlord, holder of the right of first refusal for the improvements, objected, offering to buy the single parcel subject to the right of first refusal for a higher price than that offered in the other buyer's "package" for that parcel.  The landlord argued that it had a right to have its right of first refusal protected, and that failure to sell to the landlord in this instance frustrated that right.

The trustee argued that the right of first refusal was unenforceable under  365(f) as an
impermissible restraint on assignability of the lease. The court stated that "courts have applied 365(f) to 'lease provisions that are so restrictive that they constitute de facto anti-assignment provisions'"  The court also acknowledged that "[w]hile a trustee is required to assume a contract as a whole, the court may strike provisions that are contrary to the provisions of the Bankruptcy Code such as those that place restrictions on assignment."

Nevertheless, the court ruled in favor of the landlord based on the undisputed facts that the
landlord had submitted the highest bid for the property in question, the clause was heavily
negotiated by the parties as consideration for below-market rent, the landlord planned to develop the adjacent land, and the clause was necessary to protect the landlord from violating a non-compete clause in another lease to another party on nearby property. The court stated that "[n]umerous courts have recognized a right of first refusal with no analysis of the application of

A review of these cases reveals that the concern of these courts when presented with a
contractual right of first refusal is not whether to enforce such right, but how to incorporate a right of first refusal into the bidding and sale procedures of the bankruptcy auction in a fair and equitable manner that still allows for maximization of the value of the estate."

The court also noted that the majority of courts hold that a right of first refusal is an executory contract, but stated that "[w]hether the right of first refusal is part of a larger executory contract or lease, or stands alone, should not alter the treatment of that right. The Trustee has chosen to assume the lease, which includes [the landlord's] right of first refusal." .

Reporter's Comment 1:  This was a fact-specific decision, and the court ruled for the landlord, as the holder of the first right of refusal, based on the following specific factual and evidentiary findings: (1) the landlord presented uncontested evidence of economic harm to him if the provision were not enforced; (2) the right of first refusal was a material and bargained-for provision of the lease, with consideration to the tenant in the form of below-market rent; (4) there was no "chilling effect" on the sale of the property; (5) the right of first refusal did not restrict or burden the assignment of the lease and therefore did not fall within the framework of 365(f)(1); (6) absent the right of first refusal, the trustee could not give adequate performance of future performance; (7) the landlord's offer was equal or better than the terms of competing offers; (8) the court had not yet entered a final order approving the sale; and (9) disregard of the landlord's interest would be unfair and inequitable where there appeared to be no benefit to the estate and a clear detriment to the holder of the interest.

The court also noted that it "retains some discretion in determining whether a lease provision that does not explicitly prohibit assignment qualifies as a de facto anti-assignment clause thereby rendering it unenforceable."  The court stated further that it "disagrees with the conclusion that the statutory language of  365(f)(1) renders any right of first refusal unenforceable and finds that [the landlord's] right of first refusal is not within the scope of  365(f)."

The court, in its analysis, referred to the bankruptcy court decisions in In re Auto Trak Corp., 277 B.R. 655 (Bankr. E.D. Va. 2002) and In re Rickel Home Centers, Inc., 240 B.R. 826, 831 (Bankr. D. Del. 1998), with respect to its analysis of whether  365(f) should be applied to lease provisions that are so restrictive that they should be deemed to be de facto impermissible anti-assignment provisions. (These cases were discussed in recent DIRT postings).

Reporter's Comment 2:  The E-Z Serve case highlights the importance of specifically stating, in the lease provision setting forth an option right or first right of refusal, that the provision was bargained for, was a material part of the lease, and would cause economic detriment to the holder
if it were not upheld.

Reporter's Comment 3:  Unlike an option, a right of first refusal does not entitle the holder of the right to force the other party to sell or lease the asset.  Instead, if and when the other party decides
to sell or lease the asset to any third party, the holder of the right of first refusal can require the asset to be sold or leased to him or her for the same price and terms that the owner is willing to accept from the third party.  Obviously, a right of first refusal is much weaker from the standpoint of the holder that an option: it does not set the price for the asset in advance, and it allows the owner of the asset to decide whether and when to sell or lease.

Notwithstanding the fact that a right of first refusal is less problematic for its grantor than an option,  a property owner generally will resist granting a right of first refusal because of its chilling effect on the marketability of the property.  In the E-Z Serve case, however,  the court specifically found that "there is no evidence that the existence of a right of first refusal had a chilling effect on the sale procedure." . This was so because the testimony demonstrated that the party that submitted the bid for the property accepted by the later indicated that it would not stand by its "all or nothing" requirement and would buy the balance of the properties for which it bid. Since the landlord submitted the highest bid for the single property in question, there was no detrimental impact on the estate.

Editor's Comment 1: Because of the facts last stated above - that the estate got the highest price
by selling to the landlord, the rest of the case is pretty much moot.  But the discussion is
interesting, if somewhat disorganized.

First, the court says that rights of first refusal might not be subject to the "de facto anti-restraint" rule at all, since they are less onerous than options.  But the court continually turns back to the particular facts of the case, so we don't get a good read on this point.

Second, the court says that courts can analyze rights of first refusal to determine whether they ought to be subject to "de facto anti-restraint" rule, but the factors that it uses to analyze this question are, in the editor's mind , bizarre.  It focusses largely on the economic significance of the provisions on the landlord - was the landlord paid enough outside of this provision and would the landlord be injured in connection with other properties the landlord owned.  To this, the editor notes, most other courts likely would say: "So what?"  The question is the impact on the saleability of the property by the bankrupt's estate, not the economic impact on others.  One would assume that when the parties spend oodles of money litigating these issues in court, it is because they will suffer economic loss (or at least lost expectations) if they lose.

In short, the Editor finds little in this case to like other than the outcome.

Editor's Comment 2:   Wondering why the right of first refusal comes into the picture when the owner subject to the right is taking bids for a larger group of properties, of which the subject property is only one?  See Stuart v. Stammen, 590 N.W.2d 224 (N.D. 1999), the DIRT DD for 11/19/99), holding that a right of refusal cannot be avoided by selling the subject parcel as part of a larger lot, and that the refusal right holder can exercise that right as against a buyer of the larger lot that takes with notice of the right by buying the subject property for a pro rata amount.

Editor's Comment 3: Note that this case assumes that Section 365 preserves lease rights in the face of a "free and clear sale" under Section 333, a conclusion now under some fire based upon the Seventh Circuit decision in Precision Industries, Inc. v. Qualitech, 2003 U.S. App. LEXIS 7612 (7th Cir. April 23, 2003), the DIRT DD for 4/29/03).

Readers are encouraged to respond to or criticize this posting.

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