Seventh Circuit Reminds Landlords of Risks in Voluntary Lease Termination

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Seventh Circuit Reminds Landlords of Risks in Voluntary Lease Termination

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J. Mark Fisher

Landlords beware when consensually terminating a lease with a delinquent commercial tenant. If the lease is “below market” or the tenant’s business at the location was profitable, the tenant’s bankruptcy trustee or creditors may sue to avoid a fraudulent or preferential transfer if the tenant later files a bankruptcy case. Although the Seventh Circuit’s recent opinion found a consensual lease termination to be a “transfer,” it did not limit the scope of the doctrine or guide how the bankruptcy court should assess value or the other elements of the claims or defenses. In re Great Lakes Quick Lube LP, No. 15-2093 at 5 (7th Cir., Mar. 11, 2016).

The tenant operated more than 100 oil change shops in the Midwest, including two locations that profitably operated at premises leased from the defendant, T.D. Investments I, LLP. The tenant’s financial condition and relationship with the landlord had deteriorated. The tenant owed past due rent and pass through reimbursements, but no default had been declared since the grace periods had run out. Instead of paying these obligations, the tenant and landlord agreed to a voluntary lease termination agreement that forgave these and future tenant obligations in exchange for moving out and abandoning trade fixtures to the landlord, in what the parties agreed was “reasonably equivalent consideration.” The tenant later filed bankruptcy and reorganized into a smaller footprint. It nevertheless allowed its creditors’ committee to sue the landlord to recover what it considered to be the far larger value of the terminated leases — between $327,000 and $450,000 based on an expert’s valuation of the tenant’s lost business. The bankruptcy court granted summary judgment for the landlord on the legal ground that termination of a lease is not a “transfer” that can be avoided as a preference or fraudulent transfer. 

The Seventh Circuit reversed because of the broad definition of “transfer” under section 101(54)(D) of the Bankruptcy Code, 11 U.S.C. § 101(54)(D). Judge Posner concluded that the leaseholds were “an interest in property” with which the debtor had “parted.” Accordingly, the Court remanded the case to the bankruptcy court with directions to determine the value of the transfer and whether T.D. had any other defenses to the creditors’ claims. This may be expensive and tricky since the landlord undoubtedly knew of the tenant’s financial issues and raised rents to the new tenant. Great Lakes may impact the consensual termination of other types of contracts that confer an interest in property to the debtor, such as franchise agreements and license agreements.

Since there is no “silver bullet” in negotiating the termination of a lease to a shaky tenant, what can a landlord do?

  • First, nonpayment of rent when due should be an automatic default under the lease and nonpayment of pass-throughs should have a short grace period before becoming a default. Even if the tenant has a further “cure” period before the landlord can terminate the lease, the termination still would be after default. Section 8(e)(1) of the Uniform Fraudulent Transfer Act (n/k/a Uniform Voidable Transactions Act) insulates a landlord from liability for termination “upon default.” An analogy may persuade a bankruptcy judge applying Sections 547 and 548 of the Bankruptcy Code.
  • Second, if appropriate, the landlord should serve any notices required under state law to terminate the leasehold, or commence summary proceedings to do so. The voluntary surrender agreement can settle those proceedings and include the tenant’s admission of default and inability or unwillingness to cure as provided in the lease.
  • Third, the landlord should be prepared to fight the assertion, at the root of the Great Lakes suit, that the leasehold was valuable because of the going concern value of the tenant’s business located there. The only value that the landlord obtains by a termination is the value of the premises, subject to the costs of getting it ready for reletting, not any business formerly operated by the tenant.  The fact that the replacement tenant was also in the lubrication business may have clouded that distinction in Great Lakes. The value lost by the tenant is the present value of any “below market” rental, which must be discounted to the extent that the tenant may lose the premises due to its inability to pay its obligations or other defaults.
  • Fourth, any voluntary surrender agreement should document the good deal that the tenant is getting by relief from future rent (at future value), pass-throughs, and move-out and restoration expenses. Get the tenant’s admission that it is losing money at the location or at risk of losing franchise or license rights that affect its use of the premises.
  • Fifth, the landlord should document any lease comparables at the time of termination to rebut any argument that any rent increase showed the leasehold to be “below market” and, hence, a valuable asset of the tenant. Similarly, the landlord should document the costs of disposing of any contents, reletting, repairing or upgrading the vacant premises that it may recoup in higher rents to any replacement tenant.

If you have questions about voluntary lease terminations after Great Lakes, please contact Mark Fisher, 312.258.5710, mfisher@schiffhardin.com or any other member of the firm’s Restructuring, Bankruptcy and Creditors’ Rights Practice Group.