Contributed by Ginger Ellison.
Nothing says “closure” quite like a termination agreement reaffirmed by a bankruptcy court – right? Apparently not. As demonstrated in In re Great Lakes Quick Lube Limited Partnership, under certain circumstances, a prepetition agreement for an early lease termination might provide unsecured creditors an opportunity to commence an action in the bankruptcy court seeking to avoid the lease termination as a preferential or fraudulent transfer.
In February 2012, less than two months prior to filing a chapter 11 petition, the debtor and its landlord entered into a lease termination agreement under which the debtor agreed to relinquish its leasehold interests in five retail stores. Nine months after the debtor filed for bankruptcy, the committee of unsecured creditors brought a complaint against the landlord claiming that the agreement should be avoided as a preferential or fraudulent transfer under the Bankruptcy Code, alleging that two of the five leases that were terminated held a combined value of $825,000. At issue was whether the lease termination agreement was an avoidable preference or fraudulent transfer under either section 547(b) or section 548(a)(1)(B).
The bankruptcy court’s initial inquiry as to whether the lease termination was an avoidable preference or fraudulent transfer under either section 547(b) or section 548(a)(1)(B) hinged on whether the terminating agreement qualified as a “transfer” under the Bankruptcy Code. In this regard, it noted that the case law treats executory and non-executory contracts differently. Citing In re Jermoo’s, Inc. the court found a difference between the loss of rights under a contract and a transfer of property and noted that a “separate section (11 U.S.C. §365) governs the treatment of executory contracts.” This provision specifically prohibits a trustee from assuming a debtor’s executory contract or unexpired lease in specific circumstances – one of which being where the lease is of nonresidential real property and has been terminated under applicable nonbankrutpcy law prior to the order of relief (section 365(c)(3)).
Although the bankruptcy court conceded that the literal definition of “transfer” captured termination of a lease, it noted that authorizing the avoidance of a terminated contract as a preference or fraudulent transfer under sections 547(b) or 548(a)(1)(B) would, in certain cases, be inconsistent with the statutory framework. Here, the court determined that it would run afoul of the operation of section 365(c)(3) when the contract in question was an unexpired nonresidential lease validly terminated under applicable nonbankruptcy law, pre-petition. On that basis, it held that section 365(c)(3) controls. Guided by that provision, the bankruptcy court went on to find that the subleases were validly terminated under Wisconsin law prior to the order for relief, and as such, they could not be assumed for the benefit of the debtor’s creditors. Thus, the court held that the lease termination agreement could not be avoided in bankruptcy.
Courts sometimes will provide guidance in an opinion that does not directly impact the specifics of the case before it, but is helpful for practitioners. This is referred to as “dicta”. For the benefit of future creditors claiming an avoidable transfer or preference in connection with a lease termination, the bankruptcy court focused the majority of its discussion on why, even if the termination did qualify as a transfer, it would not have qualified as an avoidable transfer. In this case, it found that this was due to a lack of evidence of collusion – namely, an absence of proof that the debtor had a fraudulent or deceitful purpose in terminating the lease agreement took the lease termination outside the purview of a preference or fraudulent transfer. Analyzing the facts of the case, the bankruptcy court found that it was in the debtor’s best interest to terminate the two subleases in question, and as such, the decision to enter into the termination agreement reflected appropriate business judgment on the debtor’s part. It concluded that the debtor and its counterparty engaged in arm’s-length negotiations and found no evidence that the termination agreement was engineered to produce a financial gain to either party at the expense of the Debtor’s other creditors. These findings, combined with its determination that the termination agreement was valid under Wisconsin law, led the bankruptcy court to conclude that it was not collusive – and therefore, still would not have been avoidable in bankruptcy.
Where a particular provision of the Bankruptcy Code was specifically drafted to resolve an issue created under the facts at hand, a bankruptcy court will keenly turn to that provision. Such was the case here. While the court could have held that the definition of “transfer” encompasses termination of leases – as it would if one were to define “transfer” as it is used, generally – it veered away from endorsing a literal interpretation on the basis that doing so would run afoul of its duty to interpret the Bankruptcy Code as a harmonious whole. Instead, the court pointed to multiple cases holding that section 365 controls the treatment of validly terminated nonresidential leases in lieu of more general statutes allowing for the avoidance of fraudulent transfers and preferences and, under that provision, the termination agreement in question could not be avoided.
Importantly, however, the bankruptcy court went on to explain the requirements that must be met for it to hold that an agreement qualifying as a transfer under the Bankruptcy Code is avoidable. In dicta, the court noted that to be avoidable, the agreement must either be forbidden by law or serve a fraudulent or deceitful purpose. In assessing the purpose of the agreement, the bankruptcy court will evaluate whether entering into the agreement was in the debtor’s best interest, whether the debtor engaged in arm’s-length negotiations with the counterparty to the agreement, and whether there was any evidence that the contract was entered into with the aim, by either party, of producing a windfall or financial gain to either party at the expense of the debtor’s other creditors.
Through its dicta, the bankruptcy court reminded creditors that not every lease termination agreement made during the relevant prepetition timeframe and qualifying as a transfer under the applicable provisions of the Bankruptcy Code will be avoidable under the statutory sections dealing with preferential and fraudulent transfers. To hold that such a transfer is avoidable, the court must also determine that it was collusive. Going forward, creditors claiming that lease terminations qualify as avoidable preferences or transfers on the basis that they are collusive in that that they serve a fraudulent or deceitful purpose should pay heed to the specific circumstances that the court reviewed in its dicta, as those factors may provide bankruptcy courts with a persuasive guideline that may be referenced when tasked with assessing whether any given transfer is avoidable.
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