The Seventh Circuit recently issued a ruling in a bankruptcy proceeding that has important implications for asset protection planners. In In re: Great Lakes Quick Lube LP, No. 15-2093 (7th Cir. March 11, 2016), the Seventh Circuit concluded that a lease termination in anticipation of a tenant’s bankruptcy constituted a fraudulent transfer, entitling the creditors in bankruptcy to reach the unamortized value of the lease that had been surrendered to the landlord at termination.
Facts
Great Lakes Quick Lube LP ran a chain of oil change and automotive maintenance shops throughout the midwestern United States. Great Lake’s business model for acquiring locations was to find a suitable site, purchase it, and then flip the site to investors, who would lease the premises back to the company.
In 2012, the chain filed for bankruptcy, but not before arranging a termination of leases on two profitable locations with one of its investment landlords, T.D. Investments I, LLP. At the same time, the chain terminated three leases on unprofitable locations with affiliates of T.D.
At bankruptcy, the creditors’ committee challenged the lease terminations, arguing that they constituted a preference and a fraudulent transfer. Citing 11 U.S.C. § 548(a)(1)(B), the creditors argued that the lease terminations amount to constructive fraudulent transfers, contending that the leases had residual value and making them valuable property of the bankruptcy estate. However, the bankruptcy judge disagreed, finding that the terminations did not constitute a “transfer” governed by the Bankruptcy Code.
Ruling
In the course of the trial, executives of Great Lakes testified at length about the strained relationship they had with T.D. as financial pressures mounted. The Seventh Circuit noted that the type of bankruptcy which Great Lakes had requested – a Chapter 11 reorganization aimed at reviving the company – gave the executives of Great Lakes a powerful incentive to jettison locations where the landlord might make reorganization difficult. However, on balance, Judge Posner – writing for the Seventh Circuit – concluded that the termination was a preferential transfer:
The creditors’ committee presented evidence that the two stores together were worth between $327,000 and $450,000 to Great Lakes, figures derived from projections of how well the stores were likely to have done before the leases expired. The value estimates would make little difference to Great Lakes if, to repeat, it knew it was going to lose the stores regardless, whether to T.D. or to its other creditors. But to the extent that the leases would have had comparable or at least significant value to creditors of the bankrupt estate, Great Lakes’ surrender of the leases to T.D. could be regarded as a preferential transfer.
Id. at 4 (emphasis added).
For its part, T.D. contended at trial that the leases had been abandoned rather than transferred, such that the creditors did not have a fraudulent transfer remedy in the absence of a transfer. The Seventh Circuit did not buy into this argument, noting that the the Bankruptcy Code defines “transfer” broadly to include “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with—(i) property; or (ii) an interest in property.” Id. at 5, citing 11 U.S.C. § 101(54)(D) (emphasis in original).
T.D. also pointed to 11 U.S.C. § 365(c)(3), which provides that “the trustee [in bankruptcy] may not assume or assign any … unexpired lease of the debtor … if … such lease is of nonresidential real property and has been terminated under applicable non-bankruptcy law prior to the order for relief.” The Seventh Circuit, however, explained that this statute is aimed at preventing a trustee from interfering with the occupancy of leased premises by a new tenant, so as to help foster the re-leasing of property inside the bankruptcy estate. Thus, the trustee is barred from assuming or assigning a lease, “as in selling a lease to someone who as lessee would be entitled to occupy the property.” Id. at 6, citing Robinson v. Chicago Housing Authority, 54 F.3d 316, 319 (7th Cir. 1995). Judge Posner further observed that the creditors committee did not want the leases, but wanted to recover their unamortized value. Since this would not require “assuming” or “assigning” the leases, the Seventh Circuit reasoned that the statutory prohibition on lease interference was inapplicable.
Analysis
The Seventh Circuit’s opinion on this matter is brief, with very little reasoning given to the conclusion that the lease termination was a “transfer,” or – more specifically – a “preferential transfer.” However, the opinion raises three concerns which are unlikely to be revisited absent a rehearing en banc:
- Great Lakes surrendered three leases on unprofitable locations at the same time as these two leases on profitable locations. It is hard to believe that this was not part of a package deal whereby Great Lakes determined that, to cut its losses on three losing locations, it would also have to give up two profitable locations. Judge Posner says that “we can ignore” the termination of the three leases that were with unprofitable locations. If the court unwinds the two profitable terminations, one would expect the whole package deal to be unwound. Instead, the court engages in a cherry-picking contest, winding back the clock on two contracts while neglecting to include three other contracts that were interconnected.
- How can the lease terminations be unwound economically without entailing an assumption or assignment of the lease, in direct conflict with 11 U.S.C. § 365(c)(3)? The Seventh Circuit’s holding now obligates the Bankruptcy Court to ascertain the value of the leases that were terminated and to fashion an appropriate remedy against T.D. The Seventh Circuit’s ruling indicates that the creditors cannot order the premises to be re-leased to another tenant in order to capture this value. All signs point in the direction of a money judgment against T.D.
- How do you properly value the unamortized term of a lease in the hands of the bankrupt tenant? Particularly in the case of a tenant with multiple locations, is it reasonable to perceive value in one location which happens to be profitable, where name recognition and brand identity owe to the fact that multiple unprofitable locations must also be operated simultaneously?
The most significant impact of this ruling is to demonstrate just how broad the term “transfer” can be interpreted in the context of preferential or fraudulent transfers. Judge Posner’s holding in Great Lakes is a warning that practically any intangible of perceived value can be reclaimed by creditors, even when the perceived value is given as part of a comprehensive exchange (such as when Great Lakes terminated leases on five locations, the majority of which were unprofitable).
Franchisors have reason to be worried. Based on this ruling, McDonalds cannot terminate a franchise agreement with a franchisee, even if the aggregate of franchised locations is losing money, so long as any of the franchised locations might offer value to creditors. Consider also the potential for application of this doctrine in the licensing arena, or to a celebrity who files for bankruptcy in a state which acknowledges a property right in name and likeness.
In the case of landlords, could a lease be drafted in such a way as to prevent an outcome similar to this case? What if a lease provides that the landlord owns any residual value in the case of a lease assignment?
Conclusion
The Seventh Circuit’s holding leaves room for improvement. As much as the court is right to interpret the term “transfer” broadly to include lease terminations, the facts of the case raise genuine concerns about how the Bankruptcy Court should go about valuing a termination and fashioning an appropriate remedy. Those looking to guard against a similar outcome should consider whether the residual value in an intangible can be protected under contract.