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Precautions Against Cherry Picking for Developers and Other Lessors of Multiple Nursing Home Facilities

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For many years in the nation's nursing home industry, sizeable management companies have operated multiple facilities in different locations. Often, a management company will operate nursing homes in facilities that it leases or purchases with credit from a single, specialized developer. Today, the nursing care industry is in a state of transition. Industry reformers have experimented with management of larger numbers of smaller, related facilities. Meanwhile, challenged by rising health care costs, many nursing home management companies have been forced to reorganize under chapter 11.

These developments present a particular challenge for developers and other owners of nursing homes that lease multiple facilities to single management companies. Section 365 of the U.S. Bankruptcy Code authorizes a debtor, with the court's approval, to assume or reject executory contracts and unexpired leases that are part of the bankruptcy estate. This section gives a reorganizing debtor an opportunity to withdraw from burdensome contractual obligations while maintaining beneficial contracts. If a debtor assumes an unexpired lease, the landlord is effectively forced to continue leasing the affected property to the debtor.1 (Any lease a debtor assumes must be assumed in its entirety, cum onere, taking the bad with the good. National Labor Relations Board v. Bildisco and Bildisco, 465 U.S. 513, 531 (1984).) If the debtor rejects a lease, the rejection is treated as a breach of contract occurring immediately before the commencement of the bankruptcy case. While rejection gives the property owner a claim against the debtor's estate, this claim is not given any priority over those of unsecured creditors. See 11 U.S.C. §§356(g) and 502(g). A debtor managing a group of nursing homes in facilities leased from a single property owner will be inclined to reject the leases of facilities that are losing money in order to close those facilities and to assume the leases of those facilities that are profitable or have the potential to be profitable. If a debtor is allowed to "cherry pick" profitable facilities to maintain under lease while rejecting unprofitable facilities, the property owner will be left with properties that are more difficult to market and that, before new tenants are found, will generate no income.


In bankruptcy, whether a nursing home operator will be authorized to selectively assume and reject leases will turn on whether there has been a single integrated agreement between the operator and the property owner for lease of the facilities.

When negotiating the lease of several nursing home facilities to a single management company, a property owner should be mindful of the following issues in order to reduce the risk that a debtor will reject the less profitable and less marketable facilities in bankruptcy. In bankruptcy, whether a nursing home operator will be authorized to selectively assume and reject leases will turn on whether there has been a single integrated agreement between the operator and the property owner for lease of the facilities. This is a question of the parties' intent, as determined from the lease or leases. Stuart Title Guaranty Co. v. Old Republic National Title Insurance Co., 83 F.3d 735, 741 (5th Cir. 1996). A bankruptcy court will determine "whether there was a single assent to a whole transaction involving several kinds of property or a separate assent to each of the several [properties] involved." In re T & H Diner Inc., 108 B.R. 448, 454 (D. N.J. 1989). "[E]quity will not countenance the debtor's exercise of §365 to relieve itself of conditions which are clearly vested by the contracting parties as an essential part of their bargain...[There is] no federal policy which requires severance of a lease condition solely because it makes a debtor's reorganization more feasible." In re East Hampton Sand & Gravel Co. Inc., 25 B.R. 193 (Bankr. E.D.N.Y. 1982) (emphasis added).

Factors relevant to determining the parties' intent with respect to this issue are identified under applicable state law because property interests are created and defined by state law.2 In re Bridgeport Jai Alai Inc., 215 B.R. 651 (Bankr. D. Conn. 1997), citing Butner v. United States, 440 U.S. 48, 55 (1979). Applying this law, bankruptcy courts have not developed any definitive test for determining parties' intent as to the unity or divisibility of leases. However, based on case law and general contract principles, the following factors appear to be important to determining whether an integrated agreement exists:

  1. Whether the parties' language evidences an intent to form an integrated agreement. (This could be the single most important factor.) See In re Karfakis, 162 B.R. 719, 725 (Bankr. E.D. Pa. 1993).
  2. Whether the instruments were executed at substantially the same time by the same parties, relating to the same subject matter. (This factor has been held to be especially important in the context of real estate leases.) See In re Eastern Systems Inc., 105 B.R. 219, 228 (Bankr. S.D.N.Y. 1989).
  3. Whether the nature and purpose of the contract are susceptible to division and apportionment, and whether the obligations in various documents are independent. See In re GP Express Airlines Inc., 200 B.R. 222, 227 (Bankr. D. Neb. 1996).
  4. Whether the leases are coterminous.
  5. Whether a single rental or single check is paid for all properties, and whether it is apportioned among the leases.
  6. Whether termination of one lease constitutes termination of all.
  7. Whether the leases may be separately assigned or sublet.
  8. Whether separate consideration exists for each lease.
  9. Whether a cross-default provision is present. (Cross-default provisions are discussed in greater detail below.)

In addition to these factors, a property owner should consider the structure of the documents under which it leases multiple facilities to a nursing home operator. If all of the facilities are leased under a single instrument, this places the property owner at an advantage. A single instrument does not guarantee the property owner protection, however. Multiple leases can be incorporated into a single document, but still recognized as separate leases that a debtor may selectively assume or reject. See In re Gardinier Inc., 831 F.2d 974, 976 (11th Cir. 1987). It is more common for a group of nursing home facilities to be leased under separate instruments. Here, it works to a property owner's advantage if, in addition to the separate instruments for individual properties, there is a single "master lease agreement" containing terms applicable to all of the properties.

If properties are leased under separate instruments, another factor that can work to the property owner's advantage is a cross-default provision in the leases, stating that a default under any one lease shall be treated as a default under all of them. Such provisions suggest that the parties have regarded the leases to be a single agreement. However, while cross-default provisions can place the property owner at an advantage, they often do not. In most published cases that address cross-default provisions in the context of §365 of the Bankruptcy Code, courts have refused to enforce them. See, e.g., In re Sanshoe Worldwide Corp., 139 B.R. 585, 597 (S.D.N.Y. 1992); In re Braniff Inc., 118 B.R. 819, 845 (Bankr. M.D. Fla. 1989); In re Wheeling-Pittsburgh Steel Corp., 54 B.R. 772, 777-779 (Bankr. W.D. Pa. 1985); and In re Sambo's Restaurants Inc., 24 B.R. 755 (Bankr. C.D. Cal. 1982). Bankruptcy courts view cross-default provisions unfavorably, at least where their enforcement limits debtors' ability to assume beneficial contracts. A court will therefore "carefully scrutinize the facts and circumstances surrounding [a] particular transaction to determine whether enforcement of the [cross-default] provision would contravene [this] overriding federal bankruptcy policy and thus impermissibly hamper the debtor's reorganization." In re Koppel, 232 B.R. 57, 64 (E.D.N.Y. 1999). "Federal bankruptcy policy is offended where the non-debtor party seeks enforcement of a cross-default provision in an effort to extract priority payments under an unrelated agreement...However, the enforcement of a cross-default provision should not be refused where to do so would thwart the non-debtor party's bargain." Id. at 65-66 (emphasis added). Applying this standard, a property owner will have a better chance at enforcement of cross-default provisions if each lease in a group also contains language emphasizing that the parties have intended that the leases be entered into together, and that a default of any one lease will breach the parties' overall bargain. It will also work to the property owner's advantage to identify any "special consideration furnished by the [property owner] in connection with the [cross-default] provision." In re Madison's Partner Group Inc., 67 B.R. 633, 635 (Bankr. D. Minn. 1986).

For a developer or other owner of real estate that leases multiple facilities to a nursing home management company, there is no fail-safe formula that will prevent a tenant in bankruptcy from selectively rejecting leases of less profitable and less marketable facilities. However, when negotiating the lease of a group of facilities, if the property owner is mindful of the above principles and negotiates the documentation to address the issues highlighted by the courts in determining the integrated nature of leases, the risk of a debtor "cherry picking" in bankruptcy may be lessened.


Footnotes

1 Section 365(b) provides three prerequisites for assumption of an unexpired lease. First, if the lease is in default at the time it is to be assumed, the debtor must promptly cure all defaults, or at least provide "adequate assurance" that the defaults will be promptly cured. Second, the debtor must compensate, or provide adequate assurance of prompt compensation, for "actual pecuniary loss" to the non-debtor party resulting from such default. Third, the debtor must provide adequate assurance of future performance under the contract. 11 U.S.C. §365(b)(1)(A)-(C). Return to article

2 Where related leases involve properties in different states, choice-of-law provisions (or the absence of such provisions) in the leases can be factors relevant to determining whether they constitute a single agreement. If each lease is subject to a different body of substantive law, it will be difficult for the property owner to argue that the combined group is a single contract. Return to article

Bankruptcy Rule: 
Journal Date: 
Wednesday, May 1, 2002

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