LEGISLATIVE UPDATE Designation RightsA New Post-BAPCPA World
The Foundation for Designation Rights
Designation Rights are essentially “the right to direct the debtors to assume and assign...unexpired leases...to third parties qualifying under the Bankruptcy Code,” after the intermediary purchasers holding that right of direction locate the ultimate third-party purchaser/assignee of the unexpired lease. In re Ames Depart-ment Stores Inc., 287 B.R. 112, 114 at n.2 (Bankr. S.D.N.Y. 2002). The actors are thus generally (1) the buyer of the designation rights, who will locate (2) a successor tenant-designee to take assignment of the lease, which will occur when the buyer locates this successor and thereafter directs (3) the debtor to make a motion to assume under §365 or, more commonly, a process is pre-approved by the bankruptcy court for the delivery of “notice of designation” to the landlord, the receipt of which triggers a shortened time period for the landlord to object to the assumption-and-assignment and request a hearing before the bankruptcy court.
The permissibility of the sale of designation rights is essentially settled law. Although the highest court to address the issue is a Bankruptcy Appellate Panel (BAP), the sale of designation rights has been repeatedly approved in at least 15 instances (see Ames, 287 B.R. at 117) and in all reported decisions that have addressed the issue. See In re Ernst Home Ctr. Inc., 209 B.R. 974 (Bankr. W.D. Wash. 1997), appeal dismissed, BC Brickyard Assoc. Ltd. v. Ernst Home Ctr. Inc. (In re Ernst Home Ctr. Inc.), 221 B.R. 243, 248-56 (BAP 9th Cir. 1998) (Russell, J. concurring).
The bases for the sale of designation rights, in short, come from the ability of the debtor to sell rights of value that are estate property. Under §363(b) of the Code, the debtor, “after notice and a hearing, may use, sell or lease, other than in the ordinary course of business, property of the estate.” Innumerable cases have found that unexpired leasehold interests are property of the estate. See, e.g., 48th St. Steakhouse Inc. v. Rockefeller Group Inc. (In re 48th St. Steakhouse Inc.), 835 F.2d 427, 430 (2d Cir. 1987) (“the courts are in agreement that unexpired leasehold interests... constitute property of the bankrupt estate”), cert. denied, 485 U.S. 1035 (1988). It thus derives also from §541 jurisprudence concerning the extent of “property of the estate.” Congress, in enacting §541, wished to “bring anything of value that the debtors have into the estate.” Official Comm. of Unsecured Creditors of Prudential Lines Inc. v. PSS S.S. Co., 928 F.2d 565, 573 (2d Cir. 1991). Thus “property of the estate” is broad, and includes even strictly contingent interests. See Mid-Island Hosp. Inc. v. Empire Blue Cross and Blue Shield (In re Mid-Island Hosp. Inc.), 276 F.3d 123, 128 (2d Cir.), cert. denied, 123 S.Ct. 104 (2002).
Designation rights are now a permanent part of the chapter 11 landscape. Congress, however, has changed the procedural ground rules by targeted provisions in BAPCPA.
BAPCPA Amendments Affecting Designation Rights
1. New Assumption Time Limits. Section 365(d)(4), as amended by BAPCPA, provides 120 days for assumption of nonresidential real property leases, which may be extended only for an additional 90 days. Any subsequent extension must be on the consent of the lessor. §365(d)(4)(B)(ii).
This timing limitation dramatically alters the ability for debtors to complete a designation rights sales process without landlord input. In the past, in large retail cases the bankruptcy courts granted (a) virtually an unlimited number of extensions in which to assume or reject nonresidential real property leases, and (b) periods of well over a year in which the property involved could remain dark while an assignee was found, negotiated with and permitted to make any necessary alterations/build out to the premises. Though debtors’ counsel may believe the limitations on assumption are a congressional overreaction, it is certainly retail debtors’ very success at obtaining essentially open-ended extensions that brought renewed Congressional scrutiny.2 As the legislative history indicates, the amendment to §365(d)(4) “is designed to remove the bankruptcy judge’s discretion to grant extensions of the time for the retail debtor to decide whether to assume or reject a lease after a maximum possible period of 210 days... Beyond that maximum period, the judge has no authority to grant further time unless the lessor has agreed in writing to the extension.” H.R. Rep. No. 109-31, pt. 1, at 86-87, reprinted in 2005 U.S. Code Cong. & Admin. News 152-153.
This constrained timing will have the practical effect of requiring debtors to consult with and involve landlords in virtually all designation rights sale initiatives, and also with respect to any complicated assumption and assignment. This is because, given the time required to complete consummation of a designation rights process (including marketing leases to potential assignees and performing any major build out of a “big box” space), or even in a conventional lease assignment and build-out undertaking, seven months will likely prove to be a difficult and even impossible time frame for any multi-location or “big box” premises-holding debtor. Thus, even ignoring the effect of the specific provisions of BAPCPA that require strict enforcement of lease terms upon assumption (discussed later in this article), it would appear that the era of retail debtors’ use of unilateral omnibus motions to assume and assign leases (with or without a designation rights feature), seeking to “steamroller” undesirable lease provisions and landlord opposition, is a thing of the past.
Given this smaller window of time, (a) prudent debtors will make a more considered focus pre-petition on real estate issues, and (b) some debtors will make mistaken and/or premature assumption of leases.3 The best-prepared debtors will make early, hard decisions, pre-petition, as to which failing/underperforming locations are to be closed or turned around, rather than (as in the past) being able to ride through the bankruptcy process hoping for a better holiday selling season or a “white knight” designation-rights purchaser.
2. New Limitations on Invalidation of “Anti-Assignment” Provisions. Many of the essential concerns for retail landlords are (1) lengthy periods of nonoperation (particularly with shopping centers), (2) protection of landlord rights to control premises alteration (including subdividing and signage), (3) obviously collection of rent, as well as damages for rent reductions and lease termination by other tenants (usually, again, in the shopping center context), during the period of the debtor’s/designation rights purchaser’s marketing of the lease, and (4) preserving landlord rights to object to the identity (type or nature of business) and/or financial wherewithal of the successor tenant who is proposed, and of future tenancies. In pre-BAPCPA cases, debtors generally asked for, and very frequently received, bankruptcy court rulings under §365(f) of the Code providing that none of the provisions in the lease (or local law) that restrict nonoperation (“going dark”), signage, use/tenant mix, premises alteration/subdividing, and future assignments and subletting, were enforceable.4 Some debtors have even obtained rather astonishing rulings “striking” provisions from the lease. See, e.g., Rickel Home Centers, 240 B.R. at 832 (clause restricting premises use as home improvement store permanently stricken from lease to permit office supply store use). From Congress’ strong reaction embodied in BAPCPA, the perception was that some bankruptcy courts were rewriting retail leases.
From this sprung rather convoluted revised language in §365(b)(1)(A). The first new clauses are effectively a legislative overruling of cases exemplified by In re Claremont Acquisition Corp. Inc., 113 F.3d 1029, 1034-35 (9th Cir. 1997), and In re Lee West Enter. Inc., 179 B.R. 204 (C.D. Calif. 1995), which held that historical defaults that are impossible to be cured (e.g., having “gone dark” pre-petition) at the time of assumption are a bar to assumption. By the new language, BAPCPA provides that such historical defaults need not be cured (recognizing that, even in bankruptcy, no one possesses a time machine), but that the default cannot continue after assumption. Thus, new §365(b) provides that any “failure to operate in accordance with a nonresidential real property lease...shall be cured by performance at and after the time of assumption in accordance with such leases, and pecuniary losses from such default shall be compensated in accordance with the provisions of this paragraph....” §365(b)(1)(A) (emphasis supplied); see, also, H.R. Rep. No. 109-31, pt. 1, at 83, reprinted in 2005 U.S. Code Cong. & Admin. News 149-50. Some debtors’ counsel may suggest that the phrase “at and after” leaves maneuvering room for the timing of assumption (e.g., to allow for a lengthy dark period), but the context of the provision and legislative history appear to say strongly otherwise.
As part of BAPCPA, Congress also added a specific cross-reference to §365(b) (as amended) within §365(f). This is clearly a legislative override of the cases that sanctioned debtors’ aggressive invocation of §365(f) to excise lease provisions that are only indirect impediments to the assignment of leases (such as use provisions), and that are not outright anti-assignment clauses prohibited by §365(f).5
BAPCPA has swung the pendulum of negotiating power in lease assumption and assignment proceedings within a chapter 11 dramatically back toward lessors. Where the selling of under-market leases and the subsequent premises build-out is going to take longer than 210 days, the landlord’s permission will have to be obtained. Where the proposed tenant is of a different nature, or requires material signage alterations or subdividing, or needs other relief from the lease for the assignment to work, landlord consent will be required. Some debtors’ counsel have suggested that this is the end of multi-million dollar designation rights deals that benefit unsecured creditors; landlords’ counsel contend that this merely gets them a seat on the chapter 11 train as opposed to being tied to the tracks, and that the economic burdens are now more fairly balanced (e.g., the economic cost of dark stores will not be borne entirely by the lessor). It remains to be seen how much of the value in an under-market lease will be bargained back to the landlord as part of settlements. That may occur, but it is clearly Congress’ paramount intent to alleviate the full onus on landlords, particularly in shopping centers, of open-ended lease assumption “limbo” and what (in some instances) was effectively the re-writing of leases in chapter 11.
1 See Taylor and Tiemstra, “‘Designation Rights’ Sales: Triumph of Expedience over the Code?,” ABI Journal Sept. 2001.
2 Indeed, vacancies have been an issue for well over 20 years and were a specific
focus of prior amendments to §365. Shopping center landlords have asserted
for the past several decades that the limbo of endless extensions of the time
to assume or reject leases were destroying their businesses because (among other
things) it allowed smaller tenants to invoke rent reductions (from anchors going
dark) and the lessened traffic even caused smaller tenants to fold. At the time
of the consideration of the Code amendments enacted in 1984, members of Congress
pointed to the effect of the lack of any real deadline for assumption or rejection
in chapter 11 cases: The first problem which this bill would remedy is the long-term
vacancy or partial operation of space by a bankrupt tenant. [[T]enant space
has been vacated for extended periods of time before the bankruptcy court forced
the trustee to decide whether to assume or reject the lease. During this time,
the other tenants of the shopping center are hurt because of reduced customer
traffic in the shopping center.... The bill would lessen the problems caused
by extended vacancies and partial operation of tenant space by requiring that
the trustee decide whether to assume or reject a nonresidential real property
lease within 60 days after the order for relief in a case under any chapter.
The time period could be extended by the court for cause, such as in exceptional
cases involving a large number of leases.... If the lease is not assumed or
rejected within this 60-day period, or any additional period granted by the
court, the lease is deemed rejected and the trustee must immediately surrender
the property to the lessor.
130 Cong. Rec. S8894-95, 98th Cong., 2nd Sess. (daily ed. June 29, 1984) (remarks of Senator Hatch), reprinted in 1984 U.S. Code Cong. & Admin. News 576, 599.
3 Congress anticipated this by providing a limitation on administrative expense priority for a nonresidential real property lease that is assumed and then subsequently rejected. The priority amount is all monetary obligations due under the lease (excluding penalties and obligations arising from or relating to a failure to operate) for the two-year period following the rejection date or actual turnover of the premises, whichever is later. Section 503(b)(7); H.R. Rep. No. 109-31, pt. 1, 96, reprinted in 2005 U.S. Code Cong. & Admin. News 160-61. The remaining sums are treated as a §502(b)(6) claim. Id.
4 See, e.g., In re Rickel Home Centers Inc., 240 B.R. 826 (D. Del., 1998) (use clause permanently stricken from lease to permit office supply store use; restriction on subdividing or altering the premises constituted de facto anti-assignment clauses); In re Bradlees Stores, Case No. 00-16035 (Bankr. S.D.N.Y.) (order made unenforceable any lease provision that prohibits, restricts or conditions alterations, additions and improvements (except for structural alterations, limited to certain scheduled objecting landlords); premises permitted to be dark for a year); In re Montgomery Ward LLC, et al., Case No. 00-4667 (Bankr. D. Del.) (essentially same). In most of these cases, relief was granted even before an assignee was identified, based on the debtors’ claim that marketing the leases would be difficult if any of these restrictions were in place.
5 The legislative history is emphatic here:
Section 404(b) amends §365(f)(1) to assure that §365(f) does not override any part of §365(b). Thus, §404(b) makes a trustee’s authority to assign an executory contract or unexpired lease subject not only to §365(c), but also to §365(b), which is given full effect. Therefore, for example, assumption or assignment of a lease of real property in a shopping center must be subject to the provisions of the lease, such as use clauses.
H.R. Rep. No. 109-31, pt. 1, at 87, reprinted in 2005 U.S. Code Cong. & Admin. News 153.