In a recent decision, the Chief Judge of the District Court for the Southern District of New York reversed a decision of the bankruptcy court in the Sears bankruptcy case that was prejudicial to the interests of shopping center landlords whose tenants become chapter 11 debtors.
The district courtâs decision in MOAC Mall Holdings, LLC v. Transform Holdco LLC (In re Sears Holding Corporation, et al.), Case 7:19-cv-09140-CM (S.D.N.Y. Feb. 27, 2020) (Doc. 26), held that section 365(b)(3)(A) of the Bankruptcy Codeâwhich provides that âadequate performance of future performanceâ of a shopping center lease includes proof that âthe financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time the debtor became the lessee under the leaseââmeans exactly what it says. Thus, âonly an assignee with a financial condition and operating performance that resembled the debtorâs ab initio would provide a shopping center landlord with âadequate assuranceâ that the bargain originally struck would be performed by the leaseâs assignee.â
According to the district court, âCongress adopted this provision to âinsure that the assignee itself will not soon go into bankruptcy.ââ Id. at p. 34.
In Sears, the bankruptcy court had approved the assignment and assumption of Searsâ lease at the Mall of America, one of Searsâ hundreds of leases, to a newly-formed entity known as Transform Leaseco LLC (âTransformâ), headed by Searsâ final CEO, Eddie Lampert. Transform had purchased substantially all of Searsâ assets through a section 363 sale, including the right to designate certain leases for assumption and assignment.
Mall of Americaâs owner, MOAC Mall Holdings LLC (âMOACâ), opposed the assignment, seeking to regain control over the space. MOAC insisted that, under certain provisions in the Bankruptcy Code that were passed to protect the owners and tenants of shopping centers, the requirements for approval of an assignment of the lease to Transform had not been met.
The bankruptcy court, however, disagreed with MOACâs argument that sections 365(b)(3)(A) and/or (b)(3)(D) of the Bankruptcy Code prohibited the assignment of the Mall of America lease (the âMOAC Leaseâ) and approved the assignment to Transform. On appeal, the district court agreed that nothing in section 365(b)(3)(D) of the Code prohibited the transfer of the MOAC Lease to Transform, but disagreed with the bankruptcy courtâs conclusion that section 365(b)(3)(A) did not bar the proposed assignment, and reversed the courtâs order.
Under section 365(f)(2)(B) of the Bankruptcy Code, a debtor may assign an executory contract or unexpired lease, even if otherwise prohibited by its terms, provided that the debtor âassumes such contract or lease in accordance with the provisions of this sectionâ and âadequate assurance of future performance by the assignee of such contract or lease is provided, whether or not there has been a default in such contract of lease.â
However, the Bankruptcy Code imposes additional restrictions on the assignment of a âshopping centerâ lease in bankruptcy. In particular, section 365(b)(3) âadds meatâ to the phrase âadequate assurance of future performanceâ by specifying four types of assurance to which the shopping center landlord is entitled, including:
(A) . . . that the financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time the debtor became the lessee under the lease; and
(D) that assumption or assignment of such lease will not disrupt any tenant mix or balance in such shopping center.
MOAC argued that the assignment to Transform contravened both of these provisions.
With regard to section 365(b)(3)(D), the bankruptcy court concluded that, unlike many other leases, because the MOAC Lease did not require Sears to operate a retail store in its building or substantially limit the type of entity to whom Sears could sublease the space, there was effectively no âtenant mixâ requirement and therefore the assignment to Transform would not violate section 365(b)(3)(D)âs requirement that the âtenant mixâ of the shopping center be preserved.
The district court agreed with the bankruptcy courtâs holding and reliance upon the Second Circuitâs decision in In re Ames Department Stores, Inc., 127 B.R. 744 (Bankr. S.D.N.Y. 1991) for the proposition that section 365(b)(3)(D) had to be read in conformity with the MOAC Leaseâthe contract whose performance was being âadequately assuredââso as not to confer on MOAC more rights than it enjoyed under the MOAC Lease prior to the bankruptcy filing.
With regard to section 365(b)(3)(A), however, the district court disagreed withâand overruledâthe bankruptcy courtâs determination that the requirement that âthe financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time the debtor became the lessee under the leaseâ could be met based on âTransformâs putative net worth or shareholder equity.â Id. at p. 34 (emphasis added). In that regard, the bankruptcy court determined that it was âhighly likely that [Transformâs] equity exceeds $50 million,â even though there had been no testimony upon which the court could have relied in reaching that conclusion. Id. at p. 13.
The bankruptcy court focused on that number because, under the terms of the MOAC Lease, if Sears had assigned the lease outside of bankruptcy to an entity with at least $50 million in net worth or shareholder equity, it would be relieved of liability under the MOAC Lease. Thus, according to the district court, â[t]he bankruptcy judge reached his factual finding, not on the basis of Transformâs financial statements, but because, âI cannot believe that third-party lenders would provide the level of financing that they have to Transform without at least that level of solvency.ââ Id. at. p. 13.
The bankruptcy court then decided that assignment to an entity that had at least $50 million in equity/net worth was sufficient under section 365(b)(3)(A) because, like section 365(b)(3)(D), it had to be read in conformity with anything that guaranteed future performance under the MOAC Lease. The bankruptcy court determined that section 365(b)(3)(A), like section 365(b)(3)(D), ârequires reference back to the part[ies]â actual agreement, and that Congress did not create independent requirements that would not go to actual assurance of future performance, but rather wanted to focus the Court on, obviously still subject to Section 365(e), taking into account the landlordâs rights under the lease, as implicated by these four subsections.â Id. at p. 14.
The district court disagreed. While acknowledging that it would âbe impossible to locate a tenant of any sort that boasted the precise âfinancial condition and operating performanceâ of Sears Roebuck back in 1991,â the court found that âby using the word âsimilarâ rather than âidentical,â Congress indicated that identity of financial condition and operating performance is not required.â Id. at p. 34.
The district court noted that the few courts that have considered the meaning of the phrase âsimilar to the financial condition and operating performance of the debtorâ have concluded that âit requires at the very least that there be proportionally comparable financial health between the assignee and/or its guarantors and the debtor as of the leaseâs inception.â With respect to a newly-formed entity, like Transform, âcourts have looked to whether the strength of business experience of the assigneeâs owner and operator is comparable to that of the debtor at the time the lease was signed.â
In reversing the bankruptcy courtâs approval of the assignment, the district court held:
In § 365(b)(3)(A), Congress provided a rigorous standard that an assignee of a bankruptâs shopping center lease must meet in order to give the landlord adequate assurance that the new tenant will not shortly end up in bankruptcy. In this case, the Bankruptcy Court found that the tenant did not meet that standard. The judgeâs decision that an alternative provision in Searsâ Lease could be substituted for the statutory standard effectively read the congressionally-mandated standard out of the Bankruptcy Code. I do not believe that result can be justified.
The proposed assignment is, therefore, disallowed.
Id. at p. 3Â (emphasis added).
The district court went on to note that âas the Supreme Court reminded us only this week, legislating is not our proper role.â  Id. at p. 39 (citing Rodriguez v. FDIC, 589 U.S. ___, No. 18-1269, slip op. at 4, 6 (Feb. 25, 2020))
Since very few cases have addressed this issue to date, the district courtâs decision in Sears is highly instructive. Moreover, given the ongoing âretail apocalypse,â it will provide shopping center landlords with additional comfort regarding to whom a failed retailer in chapter 11 may assign its lease.