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The Assignment of Leases in Bankruptcy Free of Prohibitions, Restrictions and Conditions

In the era that preceded the Bankruptcy Reform Act of 1978 and its enactment of the Bankruptcy Code, bankruptcy estates often lost the value of leases and other contracts that could have been realized for creditors by use or sale as a result of termination provisions (either discretionary or ipso facto), limitations or outright prohibitions on assignment, and counterparty self-help.[1] The Code sought to preserve that value for creditors by a skein of related provisions that (among other things) greatly strengthened the automatic stay,[2] rendered bankruptcy termination provisions unenforceable,[3] and constrained provisions that limit the assignment of contracts for value by bankruptcy estates.[4]

The constraint on provisions limiting assignments not only outlaws any provision in a contract or lease (and not only so, but also “in applicable law”) that “prohibits . . . the assignment of such contract or lease” by the bankruptcy estate[5] or that “terminates . . ., or permits a party other than the debtor to terminate . . ., such contract or lease or a right or obligation under such contract or lease on account of an assignment of such contract or lease . . . .”[6] It also strikes down any provision that “restricts or conditions the assignment of such contract or lease”[7] or that “modifies, or permits a party other than the debtor to . . . modify, such contract or lease or a right or obligation under such contract or lease on account of an assignment of such contract or lease . . . .”[8]

Many commercial leases in Manhattan and elsewhere include provisions that seek to capture for the landlord some or all of the tenant’s net revenue arising from an assignment of the lease or a sublease of some or all of the leased premises.  I have heard landlords’ lawyers explain that, if a tenant bargains for the right to assign or sublet and then does so at a profit, landlords believe that they are fairly entitled to share in some (or capture all) of that profit. A typical provision might be (or be a more elaborate version of) the following:

In the event of any assignment of this Lease by Tenant or any subletting, fifty percent (50%) of any rentals and/or consideration paid or payable by the assignee of this Lease or sublessee of the Premises in excess of the rentals reserved and/or payable under this Lease (on a per square foot basis) shall be paid by Tenant as and when received by Tenant to Landlord as additional rent, after deducting from such excess, the Permitted Expenses (as hereinafter defined) proven to have been incurred by Tenant in effecting such assignment or sublease. 

Precisely such a provision was recently held by the Court of Appeals for the Third Circuit to be a restriction on assignment that is unenforceable as a result of Section 365(f)(1) over the objection of the landlord who asserted that the profit-sharing provision had been specifically bargained for in exchange for which the landlord had made concessions to the now-bankrupt tenant in other provisions of the lease.[9] The Bankruptcy Court in Delaware had authorized assignment of the lease and “prohibited enforcement of the Profit Sharing Provision.”[10]

Similarly, the Bankruptcy Court for the Eastern District of Virginia recently held the following use limitation to be a restriction on assignment that is unenforceable under Section 365(f)(1):

"The demised premises shall not be used for a store which has as its principal business the sale at retail of . . . furniture”

and approved an assignment of the lease of what had been a toy store to a furniture retailer.[11]

Section 365(f) does not mandate the per se avoidance of the provision that is claimed to be a prohibition, restriction or condition of assignment. A landlord may prevail (in a dispute over a profit-sharing provision, although they are “routinely invalidated”[12]) by showing that it is one of the “relatively rare cases” in which there would be “material prejudice” to the landlord “other than the loss of a prospective windfall”[13] or (in a dispute over a use limitation) by showing that the failure to enforce the limitation would cause the landlord to incur “actual and substantial detriment.”[14] However, success in opposing a lease assignment free of a profit-sharing or use-limitation provision--or any other provision that is alleged to be a non-explicit restriction on assignment--cannot be assumed or predicted at the time of lease negotiation.

 

[1] See, e.g., Finn v. Meighan, 325 U.S. 300, 301 (1945)(“an express covenant of forfeiture [in a lease] has long been held to be enforceable against the bankruptcy trustee”). Some courts developed equitable exceptions on a case-by-case basis, see, e.g., Queens Blvd. Wine and Liquor Corp. v. Blum, 503 F.2d 202 (1974), but they were controversial.

[2] See Bankruptcy Code § 362(a).

[3] See Bankruptcy Code § 365(e).

[4] Bankruptcy Code § 365(f)(1) and (3).

[5] Id. § 365(f)(1).

[6] Id. § 365(f)(3).

[7] Id. § 365(f)(1).

[8] Id. § 365(f)(3).

[9] Haggen Holdings, LLC v. Antone Corp., No. 17-3159 (3rd Cir. July 17, 2018)(not precedential), aff’g 2017 WL 3730527 (D. Del. 2017). Section 5.3 of the Third Circuit’s Internal Operating Procedures provides for certain opinions to be indicated to be “not precedential.” The only consequence of a decision being “not precedential” appears to be that provided in I.O.P. 5.7: “The court by tradition does not cite to its not precedential opinions as authority.  Such opinions are not regarded as precedents that bind the court because they do not circulate to the full court before filing.”

[10] Id. slip op. at 3.

[11] In re Toys ‘R’ Us, Inc., 2018 Bankruptcy LEXIS 1604 (Bankr. E.D. Va. May 31, 2018). Toys ‘R’ Us is consistent with a long line of non-shopping center cases. Different rules apply to shopping center leases under Section 365(b)(3).

[12] 4 Collier Bankruptcy Practice Guide ¶ 68.08[2][a], at 68-44 (A.N. Resnick & H.J. Sommer eds. 2017).

[13] Toys ‘R’ Us at *5, quoting In re Adelphia Communications Corp., 359 B.R. 65, 73 (Bankr. S.D.N.Y. 2007).

[14] Id., quoting In re U.L. Radio Corp., 19 B.R. 537, 544 (Bankr. S.D.N.Y. 1982).