Bankruptcy Code "[§]365(d)(4) does not apply to the [purported lease] because it is not a 'true lease,'" held the Second Circuit in In re Sears Holdings Corporation, 2024 WL 5113165, *3 (2d Cir. Dec. 16, 2024). In the seventh reported decision covering the purported lease assignment in this case — one from the Supreme Court, three from the Second Circuit, and three from the district court — the Second Circuit apparently ended a multi-year litigation by affirming the district court's decision that the landlord's appeal was "moot for lack of a remedy because, although [that] court [had properly] vacated the assignment and assumption of the lease ..., the lease would not revert to [the landlord under Code] §365(d)(4), and that [the landlord] had no alternative remedy." Id. at *1, citing In re Sears Holding Corp., 661 B.R. 298 (S.D.N.Y. 2024) (Sears VI). According to the Second Circuit, the debtor "neither waived nor forfeited the argument that [§]365(d)(4) did not apply here and ... [the district court had properly] return[ed] the lease to the [debtor's estate] outside of the assumption procedures set forth in [Code §]365." Id. at **1, 6.
The principal substantive holding in the complex case ultimately turned on the district court's analysis of the purported lease itself, something never considered in the prior three years of the litigation. First, held the Second Circuit, Code §365(d)(4) applies "only to a 'true' or 'bona fide' lease." Id. at *3, quoting Int'l Trade Admin. v. Rensselaer Polytechnic Inst., 936 F.2d 744, 748 (2d Cir. 1991) (RPI). Focusing "on 'the economic substance of the transaction and not its form,'" the court asked "whether the parties intended to impose obligations and confer rights significantly different from those arising from the ordinary landlord/tenant relationship." Id. Because the lessee, the debtor here, may have "assume[d] and discharge[d] many of the risks and obligations ordinarily attributed to the outright ownership of property [e.g., payment of property taxes]," the landlord would gain "an inequitable windfall" if it were able to recover the "leased" property. Id. In other words, if the debtor effectively owned the property, no "true lease" relationship existed.
The Sears case was governed by the Second Circuit's RPI decision, explained the court. The purported lease here "is for a term of 100 years. [The debtor] prepaid its rent for the first thirty years of the lease term, and owed [the landlord] just $10 in annual rent thereafter. ... [The debtor] paid taxes and other costs associated with the property [and] could, after fifteen years of operation, cease to operate and sublease any portion of the property, or assign the entire lease, all without [the landlord's] consent." Id. To allow the landlord to "recapture" the property "over sixty years before the expiration of" the purported lease "would amount to a windfall [and] would be grossly inequitable." Id.
NO WAIVER OR FORFEITURE
The court also rejected the landlord's argument that the debtor and the proposed assignee of the lease had waived or forfeited the §365(d)(4) issue. On the record here, nothing showed that the debtor and assignee intended to waive their defense of the non-lease issue. Id. at *4. Although the parties had stipulated to "an extension of the section 365(d)(4) period to a future date," they never "affirmatively" stated that Code §365(d)(4) governed. Any "oversight" or "thoughtlessness" was "insufficient to constitute waiver." Id. at *5.
The landlord's "forfeiture" argument also failed. Before the Second Circuit remanded the case to the district court, 2023 WL7294833 (2d Cir. Nov. 6, 2023), "no one argued the point, and no court mentioned" the true-lease defense. Id., quoting Sears VI, 661 B.R. at 326. It was neither "necessary" nor "even appropriate" for the debtor and assignee to raise the defense before, said the court. Id.
REMEDY
The district court also properly returned the purported lease to the debtor's estate represented by a Liquidating Trustee. Id. at *6. Because the district court had previously vacated the assumption and assignment of the lease, it "end[ed] up where 'it began — as part of [the debtor's] bankruptcy estate.'" Id.
BACKGROUND OF LITIGATION
The background of this unique commercial lease case is instructive. According to the district court, the "tortured history of this case represents the antithesis of what a bankruptcy is supposed to be: a relatively quick and comprehensive resolution of a debtor's issues with its creditors." Sears VI, 661 B.R. at 303. In 2023, the Second Circuit, on remand from the U.S. Supreme Court, affirmed the district court's vacating the assumption and assignment of the lease because the Chapter 11 debtor and its assignee failed to give "adequate assurance of future performance of" the lease "as required by [Code] §365(b)(3)(A)," after the debtor had assigned its lease to Transform Holdco LLC (T). It also directed the district court to decide "whether the appeal should be dismissed for lack of any remedy." In re Sears Holding Corp., 2023 WL 7294833 (2d Cir. Nov. 6, 2023) (Sears V).
MOAC Mall Holdings LLC (M), the shopping center landlord/lessor, had previously objected to the lease assignment because the assignee, T, had not met the Code's financial condition requirement; M lost in the bankruptcy court, but initially prevailed in the district court on appeal (613 B.R.5); but M lost again in that court on reconsideration (616 B.R 615) and in the Court of Appeals on jurisdictional grounds (2021 WL 5986997). The Supreme Court, however, rejected the Second Circuit's jurisdictional holding and remanded for a review of the merits of M's appeal. MOAC Holdings LLC v. Transform Holdco LLC, 143 S. Ct. 927, 933 (2023) ("... §363(m) is not a jurisdictional provision.").
The superficially complicated fact pattern in Sears can be simplified. M was a shopping center landlord who challenged the debtor's lease assignment to T because T failed to provide "the requisite adequate assurance of future performance" required by Code § 365(b)(3) ("similar ... financial condition and operating performance" as the debtor when "the debtor became the lessee under the lease"). After the bankruptcy court denied its objection, M initially prevailed on appeal in the district court. In re Sears Holdings Corp., 613 B.R. 51 (S.D.N.Y. 2020). In its initial decision, the district court held that T "failed to prove financial and operating similarity between [the debtor] in 1991 [when lease signed] and [T] today, under any standard ...." Id. at 78. "Congress ... decided that only an assignee with a financial condition and an operating performance that resembled the debtor's ab initio would provide a shopping center landlord with 'adequate assurance' that the bargain originally struck would be performed by the lease's assignee." Id. It further rejected the bankruptcy court's unsupported finding that T was "an entity with equity of $50 million ...." Id. The evidentiary record failed to meet "the congressionally-mandated standard for providing adequate financial assurance of future lease performance." Id. at 79. Because of the inadequate record and erroneous legal analysis, the district court vacated the bankruptcy court's approval of the assignment of the lease to T and remanded for further findings. T then sought a rehearing instead, requiring the district court to dismiss M's appeal on jurisdictional grounds, based on Second Circuit precedent construing Code §363(m) (" ... reversal on appeal ... of a sale ... does not affect validity of ... sale ... unless ... sale stayed pending appeal"). The U.S. Supreme Court, however, held that §363(m) is not jurisdictional, vacated the Second Circuit's affirmance of the district court, and remanded the case to the Second Circuit for a review of the merits. 143 S. Ct. at 305.
The Second Circuit affirmed the district court's initial order of Feb. 27, 2020 on remand. Sears V, 2023 WL 7294833 at *1. The substance of the district court's initial decision on the merits was therefore sound and warrants a brief summary.
INITIAL DISTRICT COURT RULING
The requirement that the Chapter 11 debtor in possession here, acting as trustee, provide "adequate assurance of future performance" under Code §365(b)(3), was triggered when it sought to assign the shopping center lease after assuming it. "Adequate assurance of future performance" for shopping center leases includes the following requirements:
- the source of rent must be assured. §365(b)(3)(A);
- the financial condition and operating performance of the assignee must be similar to that of the debtor when the debtor first became lessee, here, in 1991. §365(b)(3)(A);
- any percentage rent will not decline "substantially." §365(b)(3)(B);
- the assignment will be subject to all the provisions in the lease, including radius, location, use, and exclusivity. §365(b)(3)(C); and
- the assignment will not disrupt any tenant mix or balance in the shopping center. §365(b)(3)(D).
These requirements make "it more difficult for a debtor-tenant ... to assign" a shopping center lease, shifting the balance of power toward the non-debtor commercial lessor. See, In re Trak Auto Corp., 367 F.3d 237, 245 (4th Cir. 2004) (reversed order ignoring lease's use restriction); In re Joshua Slocum, Ltd., 922 F.2d 1081 (3d Cir. 1990) (provisions in debtor's lease concerning termination and minimum sales not to be removed by bankruptcy court as part of debtor's assumption and assignment of lease).
The Second Circuit in Sears V said that the district court's "initial [2020] opinion charted a remedial course it might again consider on remand," while affirming its vacating of the lease assignment. Id. at *1. According to the district court, "[e]ither [T] meets the standard in the [lease] or it does not. There has to be a finding, one way or the other, and that finding has to be supported by substantial evidence," reasoned the district court.
613 B.R. at 79. There was no room, moreover, for the bankruptcy court's unsupported "wholly conclusory supposition" that T's financial condition, among other things, satisfied "the mandate of § 365(b)(3)(A)." Id.
ULTIMATE CONCLUSION
The district court ultimately agreed with the Sears Liquidating Trustee: "this case might well turn out to be Pyrrhic victory for [M]." Sears VI, 661 B.R. at 330. Although M had "eliminated from the books an obviously erroneous outlier [jurisdictional] ruling by" the Second Circuit, M ultimately wanted to "recapture" the property it had purportedly leased to Sears. The court protected M from the assignment of the lease to an "ineligible" party and "all defaults" under the lease had been cured long ago. M had "freely made" a bargain with Sears in 1991. Nothing in the Code allows "landlords to improve their position simply because a tenant" seeks bankruptcy relief. Id. In the end, M had no "remedy in damages against" the Sears Liquidating Trustee," and M's appeal was thus moot because of no alternative remedy. Id. at 328.
Previously published in The Bankruptcy Strategist.
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