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Terminating a Distressed Tenant’s Lease?

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Landlords contemplating terminating a lease with a distressed tenant in advance of a possible tenant bankruptcy will want to consider carefully a recent decision from the Seventh Circuit. The decision, In re Great Lakes Quick Lube LP, reversed and remanded a bankruptcy court decision in favor of a landlord. In so doing, the Seventh Circuit allowed an action to proceed against the landlord brought by the Official Committee of Unsecured Creditors (Committee) appointed in the tenant’s chapter 11 proceeding.

Fifty-two days prior to the commencement of the tenant’s bankruptcy case, the landlord and tenant entered into a voluntary termination of certain leases of the tenant. After the tenant commenced its chapter 11 proceeding, the Committee sued the landlord in the bankruptcy court. The Committee sought a determination that the prepetition terminations constituted either avoidable preferential transfers or fraudulent conveyances. Further, the Committee sought an order determining that the value of the leases belonged to the bankruptcy estate. Under the Committee’s theory, that value should be recoverable from the landlord and shared with all of the tenant’s creditors.

The landlord, of course, opposed the lawsuit on the basis that the prepetition terminations did not qualify as “transfers” for bankruptcy purposes. Even if the terminations qualified as transfers, the landlord argued that nothing about the terminations could be considered preferential or fraudulent. The bankruptcy court agreed with the landlord in a decision issued in April 2015. Specifically, the bankruptcy court concluded that the terminations did not constitute transfers and thus could not be challenged by the Committee. Not content with that ruling, the Committee took a direct appeal to the Seventh Circuit.

In an opinion written by Judge Posner, the Seventh Circuit reversed. The court based its reversal on the expansive definition of the term “transfer” found in the Bankruptcy Code. Specifically, the Bankruptcy Code defines “transfer” broadly, as including “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property.” 11 U.S.C. § 101(54)(D). In just two sentences the Seventh Circuit concluded that valid prepetition lease terminations can be subject to avoidance in a subsequent bankruptcy: “[the debtor] had an interest in property—namely the leaseholds—which it parted with by transferring that interest to [the landlord]. That was a transfer to one creditor of what might have been an asset to [the debtor’s] other creditors had the transfer not taken place; and if so it was a preferential transfer and therefore avoidable.”

The Seventh Circuit stopped short of concluding that the terminations actually were voidable on the record before it. Instead, the court remanded to the bankruptcy court for further proceedings and a factual determination about the value to the landlord of the terminations and whether the landlord could mount any defenses to the avoidance action.

As is usually the case in any litigation, the particular facts matter. In the Great Lakes case, the Committee presented evidence that the terminated leases were worth up to $450,000 to the debtor. Evidence also existed that the landlord relet the premises to a competitor of the debtor with the implication that the bankruptcy estate could have benefited from any value generated had the leases been assumed and assigned to a new tenant during a chapter 11 proceeding.

The Seventh Circuit decision should cause landlords to think through carefully any prepetition termination of a lease with a distressed tenant. In the event of a subsequent bankruptcy proceeding, the Great Lakes opinion is an invitation to bankruptcy trustees and official committees to review voluntary terminations critically. Although technically only the law in the Seventh Circuit (which includes Illinois, Indiana and Wisconsin), the opinion is likely to be cited nationally by fiduciaries of bankruptcy estates seeking to maximize value for creditors. Other courts may follow the expansive view of voluntary terminations as “transfers” for bankruptcy purposes. A landlord can best build its defenses at the time of termination by clearly establishing the value received by the distressed tenant in exchange.

Left unclear from the Great Lakes opinion is whether a landlord exercising contractual lease termination rights due to a tenant default needs to worry about a potential avoidance action in a subsequent tenant bankruptcy. Given the broad definition of the term “transfer” in the Bankruptcy Code, landlords should be concerned about the implications of the decision on their exercise of such rights. Nothing in the opinion provides any comfort to landlords on this point. Bankruptcy estate fiduciaries may push the envelope and seek to apply the decision even to such terminations. If that occurs, landlords will want to point to opinions such as In re Egyptian Bros. Donut, 190 B.R. 26, 28 (Bankr. D.N.J. 1995). That opinion (and others cited in the now-reversed Great Lakes bankruptcy court decision) held that the valid exercise of rights in terminating a lease cannot be subject to avoidance.

This advisory was prepared by John G. Loughnane, a member of the Business Department at Nutter McClennen & Fish LLP. 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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