Landlords Beware: Seventh Circuit Rules That Lease Terminations May Be Voidable In Bankruptcy

Kelley Drye Client Advisory

The Seventh Circuit Court of Appeals recently handed down a decision with significant implications for landlords contemplating lease termination agreements with distressed tenants. Ruling on a direct appeal in the chapter 11 case In re Great Lakes Quick Lube LP, the court held that a lease termination agreement between a landlord and a financially distressed tenant can be voided as either a fraudulent conveyance or a preferential transfer in the tenant’s subsequent bankruptcy case.

The debtor-tenant owned and operated a chain of automotive maintenance stores in the Midwest. Less than two months before its chapter 11 filing, the debtor agreed with one of its landlords to terminate leases at five locations; two were profitable and three were not. After the bankruptcy filing, an official committee of unsecured creditors was formed and eventually granted standing to pursue an action against the landlord on behalf of the debtor-tenant’s bankruptcy estate to recover the alleged value of the leases for the two profitable locations.

The bankruptcy court ruled that the lease terminations were not transfers” for purposes of the avoidance statutes and that, even if a transfer had occurred, they could not be avoided and recovered by the estate because Section 365(c)(3) of the Bankruptcy Code prevents the assumption or assignment of a lease that has been validly terminated prior to the bankruptcy filing. The bankruptcy court also found that the debtor’s estate had received a benefit from being relieved of the lease payments at the three unprofitable locations.

The Seventh Circuit reversed. The court determined that a transfer” did occur when the debtor’s rights under the lease were terminated, and disagreed with the bankruptcy court’s finding regarding the non-avoidability of the value of such transfer. Judge Richard Posner, writing for the court, disregarded the effect of Section 365(c)(3) of the Bankruptcy Code because the creditors’ committee was only trying to recover the value of the leaseholds, and not the leaseholds themselves. Judge Posner also focused solely on the potential value lost by the debtor’s bankruptcy estate from the leases for the two profitable locations, and remanded the case back to the bankruptcy court to determine such value. The bankruptcy court’s finding regarding value from the release of lease obligations at the three unprofitable locations did not insulate the transactions from further scrutiny regarding the possible value lost by the debtor’s estate from the termination of the profitable leases.

This is an important decision for landlords, as it stands as an invitation to trustees and creditors’ committees to, at a minimum, investigate and possibly commence similar actions, where leases have been validly terminated pre-petition. Although the opinion is very short and scant in its reasoning, Judge Posner is a highly regarded jurist and for that reason alone the decision is likely to draw the attention of other judges. Landlords contemplating terminating leases with distressed tenants, particularly in the Seventh Circuit states of Illinois, Wisconsin and Indiana, will need to focus closely on the potential value of any leasehold interests being recovered and any benefits the tenants will be realizing in connection with the release from obligations under such leases. We will monitor and report on developments in this case and any similar cases.

For more information please contact:

James S. Carr
(212) 808-7955

Robert L. LeHane
(212) 808-7573

Benjamin D. Feder
(212) 808-7974