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Terminating a Distressed Tenant’s Lease – Part II

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07.12.2017 | Advisory

Last year the Seventh Circuit determined that a lease termination constituted a “transfer” within the meaning of the Bankruptcy Code and ordered litigation to continue against a landlord that had entered into a lease termination agreement. We wrote about this decision here. Recently, the bankruptcy court presiding over the remanded litigation determined that the landlord received a constructively fraudulent transfer in accepting back the premises.

Key Takeaways

  • Landlords considering lease termination agreements should be prepared for similar challenges in the future and know how to minimize the risk of such an adverse result.
  • The Seventh Circuit’s opinion is an invitation to challenge voluntary pre-bankruptcy lease terminations in a subsequent bankruptcy filing. Landlords should build defenses at the time of termination by clearly establishing the value exchanged for a termination and the reasonably equivalent nature of such value.
  • Landlords exercising contractual lease terminations due to a tenant default can rely on some existing caselaw that doing so cannot subject the termination to avoidance.
  • That said, landlords exercising contractual rights must be aware of the potential for attack and the desirability of building defenses rooted in reasonably equivalent value to the extent feasible.

Do Terminations Qualify As “Transfers”?

Great Lakes Quick Lube Limited Partnership operated a chain of Valvoline Instant Oil Change stores. As part of its restructuring effort, the company entered into voluntary terminations of certain leases with one of its landlords. Under the agreement, the landlord agreed to forgive delinquent rent and real estate taxes in the stipulated amount of $46,110 in exchange for surrender of leased premises.

Within two months, the company filed for bankruptcy. The Creditors’ Committee appointed in the case sued the landlord seeking to avoid the lease terminations and to recapture the value of the leases for the bankruptcy estate.

The landlord argued that the terminations did not qualify as “transfers” for avoidance purposes. The bankruptcy court agreed with the landlord. On direct appeal, the Seventh Circuit reversed and remanded the case back to the bankruptcy court.

Proceedings on Remand

The remanded proceedings focused on whether the lease termination agreement was a constructively fraudulent transfer. Citing the relevant section of the Bankruptcy Code, the bankruptcy court identified the single disputed issue to be whether the debtor “received less than a reasonably equivalent value in exchange for such transfer or obligation.” 11 U.S.C. § 548(a)(1)(B)(i).

After considering the positions of each party on the value of the asset transferred, the bankruptcy court concluded that the debtor did not receive reasonably equivalent value from the landlord. The bankruptcy court explained its conclusion in a memorandum decision issued on May 23, 2017 (available here).

This result is surprising as the opinion begins very much in favor of the landlord. Specifically, the bankruptcy court rejected valuation testimony offered by the Creditors Committee as support for its view that the value of the terminated leases equaled $490,000. Instead, the bankruptcy court agreed with the landlord that precedent supported using the present value of the difference between the contract rent and the market rent for the remaining term of the lease to determine the value of the “transferred” lease.

The court accepted present value calculations made by the Creditors Committee indicating that new leases entered into by the landlord would allow the landlord to receive an additional $57,000 in rent payments over the relevant term. Adopting that figure, the court then subtracted the stipulated value of $46,110 received by the debtor and concluded that the landlord received a constructively fraudulent transfer in the amount of $10,890.

Analysis and Recommendations

As noted by the Seventh Circuit last year, the debtor testified it terminated the leases for a variety of reasons, including a strained relationship with the principal of the landlord who was “demanding and inflexible” in insisting on prompt payment. The debtor also generally feared eviction and litigation by the landlord.

  • None of those considerations flowed into the stipulated value of $46,110 received by the debtor (which represented only delinquent rent and real estate taxes). In stipulating to value received by a debtor, a landlord should think creatively as to the full range of value created for a debtor by a termination. A statement of value might include both economic (for example, legal fees saved by avoiding litigation) and non-economic (increased focus on core locations and strategy) grounds. In this case, the limiting nature of the stipulated number cost the landlord victory.

The landlord succeeded in discrediting the Committee’s valuation testimony and in having the court adopt its view of the proper methodology to value the lease rights for the balance of the term. However, when it came time for the court to actually assess valuation, it appears that the only analysis the court had to rely on was drawn from the Committee’s valuation expert.

  • When litigating valuation issues, it is critical to have an independent valuation expert when cost effective to do so. In this case, such a person could have evaluated the Committee’s report and offered alternative perspectives on the value of the lease rights “transferred” in a manner more favorable to the landlord.

In conclusion, the Seventh Circuit last year opened up a new avenue of attack on landlords by broadly construing the word “transfer” to include a prepetition lease termination. The recent bankruptcy court decision issued in the remanded proceedings proves that the risk to landlords is real as the court determined that the particular terminations at issue in that case constituted constructive fraudulent conveyances.

Although the bankruptcy court limited the judgment to a relatively nominal sum, the landlord incurred legal expense as well as the distraction of litigation for the past few years. Landlords considering entering into a lease termination agreement with a distressed tenant will want to guard against the risk of a challenge in a subsequent bankruptcy case of the tenant by keeping the above points in mind.

This advisory was prepared by John G. Loughnane, a member of Nutter's Corporate and Transactions Department. For more information, please contact John or your Nutter attorney at 617.439.2000.

This advisory is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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