Sears Roebuck (“Sears”) and Mall of America (“MOAC”) have been fighting for years regarding the impact of Sears’ chapter 11 bankruptcy proceedings on MOAC’s pre-chapter 11 lease with Sears (the “Lease”). The District Court for the Southern District of New York recently held that the Lease was not a true lease subject to assumption and assignment under Bankruptcy Code Section 365(d)(4). Landlords and Tenants should closely study the series of decisions made in these proceedings in drafting lease terms and calibrating expected outcomes in a distressed scenario.
The Lease
In 1991, Sears negotiated the Lease with MOAC on very favorable terms in exchange for Sears building its store on its own dime and anchoring the mall as a department store.[1] The tenancy of the Lease was set to run for 100 years, costing Sears merely $10 per year in rent that it prepaid through 2021.[2] Sears was not responsible for paying any percentage rent, but had other obligations to MOAC, including taxes, common area payments, and insurance, which totaled approximately $1.1 million a year.[3] Sears also had the right to lease or sublease all or any portion of the building to another party without MOAC’s approval.[4]
Notably, the Lease contained very few restrictions on Sears. Sears was permitted to assign the Lease to any other tenant in the mall for “any conceivable use” so long as it was not illegal or a nuisance, or would result in the space being used primarily for offices.[5]
MOAC preserved for itself a few protections, including a provision that, after 2007 and for the remainder of the Lease term, if Sears no longer operated in the building or chose to transfer its interest in the premises, it was required to give MOAC a right of first refusal to match any bona fide offer for the space or a buy-out option.[6] Additionally, after 2007, if Sears ceased to operate or sublet the premises, Sears would remain liable unless it found an assignee that had a net worth or shareholder equity value of at least $50 million.[7]
Sears’ Sale and Assumption And Assignment of the Lease to Transform
On October 15, 2018, Sears and its affiliates (the “Debtors”) filed petitions for relief under chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”).[8] Following a public auction, on January 17, 2019, the Debtors entered into an asset purchase agreement (“APA”) with the winning bidder, Transform Holdco LLC (collectively with its affiliates, “Transform”) for substantially all of the Debtors’ assets pursuant to Bankruptcy Code Section 363, including the Debtors’ right to designate certain leases for assumption and assignment to Transform.[9]
Transform purchased approximately 660 leases of the Debtors, including the Lease.[10] Transform indicated that it planned to market the space to undetermined subtenants that would pay the highest price for the premises.[11] As adequate assurance of future performance, Transform agreed to put one year’s rent and consideration due under the Lease into escrow, and provided that it had experienced management available to market the premises, it had obtained substantial financing with respect to its portfolio, it had equity of at least $50 million as required under the Lease terms, and that it agreed to be bound by the terms of the Lease, including with respect to MOAC’s right of first refusal.[12]
On January 30, 2019, MOAC objected to the assumption and assignment to Transform,[13] arguing that the Debtors had not established that Transform met the statutory qualifications for assignment of a shopping center lease pursuant to Bankruptcy Code Section 365(b)(3).[14]
The Bankruptcy Court Decision
On September 6, 2019, the Bankruptcy Court entered an order approving the assumption and assignment to Transform.[15]
The Bankruptcy Court analyzed whether the requirements of section 365(b)(3) were met.[16]
First, with respect to subsection (D), the Bankruptcy Court held that because the Lease did not contain any restrictions or requirements as to occupancy, and that Sears was not required to operate a retail store in its building nor was it restricted in the type of entity to which Sears could sublease post-2007, the assignment would not violate section 365(b)(3)(D)’s requirement that the “tenant mix” of the shopping center be preserved.[17] In so ruling, the Bankruptcy Court found that the Bankruptcy Code had to be read in connection with the contract or lease at issue so as not to provide MOAC with more rights than it had bargained for under the Lease.[18]
Second, with respect to subsection (A), which requires that the assignee of a shopping center lease have the “financial condition and operating performance” that is similar to that of the assignor back when the lease was signed, the Bankruptcy Court turned to the language of the Lease.[19] Sears and MOAC had negotiated for the level of financial security of any new tenant or assignee by including language in the Lease that Sears could assign its Lease to a tenant with at least $50 million in net worth.[20] Accordingly, Judge Drain found that Sears provided MOAC with all its assurance required by finding an assignee with at least $50 million.[21]
However, the Bankruptcy Court expressly held that Transform did not satisfy the clear “substantial similarity” requirement of Bankruptcy Code Section 365(b)(3)(A), instead choosing to impose a judge-made standard that it satisfied the requirements under the bargained-for lease.[22]
Consequently, the Bankruptcy Court approved the assumption and assignment to Transform.[23]
Assumption and Assignment Appeal
On appeal the District Court considered whether Transform satisfied the requirements under Bankruptcy Code Section 365(b)(3)(A) and (D). The District Court found that the assignment was not in violation of Bankruptcy Code Section 365(b)(3)(A), noting that the Lease contained virtually “no restrictions” on the kind of tenant that could occupy the building and to find otherwise would “radically expand” MOAC’s rights under the Lease.[24]
Nevertheless, the District Court ruled that the Bankruptcy Court did not have authority to substitute its owns standard for Bankruptcy Code Section 365(b)(3)(A).[25] Transform did not provide evidence that it had the financial condition and operating performance that was similar to Sears in 1991 under any standard; in fact, the Bankruptcy Court expressly found that Transform’s condition was not similar.[26]
The District Court rejected the Bankruptcy Court’s conclusions that the level of assurance negotiated for in the Lease was satisfactory, as it bore “no resemblance to the standard set out in subsection (A).”[27] On November 6, 2023, the Second Circuit upheld the District Court’s ruling.[28]
363(m) Jurisdictional Litigation
After the District Court vacated the Bankruptcy Court’s assignment order, Transform moved before the District Court arguing that Bankruptcy Code Section 363(m)[29] is jurisdictional, that Transform cannot be estopped from raising the issue of jurisdiction belatedly, and accordingly, that the sale of the Lease to a good faith purchaser could not be undone if reversed on appeal unless the Bankruptcy Court’s order had been stayed.[30]
In response, the District Court withdrew its order vacating the assumption and assignment and concluded that the transfer of the Lease to Transform was a “sale” governed by Bankruptcy Code Section 363(m) both as a matter of law and under the terms of the APA, and remanded the case to the Bankruptcy Court for further proceedings.[31]
After the Second Circuit affirmed the vacatur of the Sears I ruling,[32] MOAC appealed to the Supreme Court.[33] The question before the Supreme Court was whether 363(m) was jurisdictional or a defense that can be raised by the proponents of a sale on appeal. Transform argued that the appeal was moot because the assignment of the Lease could not be rewound, an argument that the Supreme Court rejected outright as a disfavored mootness argument.[34]
Next, the Supreme Court found that it only treats provisions as jurisdictional if there is clear Congressional intent.[35] Bankruptcy Code Section 363(m) does not satisfy the “clear-statement rule” as it does not address jurisdiction of other courts.[36] Additionally, the provision includes a proviso that makes 363(m) inapplicable if the sale is to a bad faith purchaser or lessee, if the transaction is stayed pending appeal, or if the appellate court does something other than reverse or modify the sale or lease authorization.[37] The Supreme Court concluded that the provision is more akin to a statutory limitation that provides good faith purchasers protection upon appellate review.[38]
The Recent District Court Decision
Following the Supreme Court’s 363(m) jurisdictional ruling, the Court of Appeals the District Court decision vacating the assumption and assignment of the Lease to Transform.[39] As a result, before the District Court was the appropriate remedy available to Sears or MOAC in light of the fact that the Lease had not been assumed and assigned. [40]
Transform and Sears argued that the District Court should dismiss the appeal as moot and end the case on the grounds that there is no remedy available to MOAC.[41] Transform argued that the only means of remedy available under the Code is to unwind transfers in an avoidance action pursuant to Bankruptcy Code Section 549 ‑ which MOAC cannot bring because the two year statute of limitations expired and any right to bring an avoidance action belonged to Sears and the Trustee under the terms of the Sears bankruptcy plan.[42] Additionally, it argued that MOAC is estopped from challenging the assignment because MOAC accepted a cure payment from Transform, which was due only upon assumption of the Lease.[43] In the alternative, Transform and Sears argued that the Lease should return to the estate because Sears satisfied its obligations under Bankruptcy Code Section 365(d)(4) when it announced its decision to assume the Lease on April 19, 2019.[44]
Sears also argued that it was not liable for damages because the Sears plan of reorganization contained a broad exculpation clause and MOAC did not suffer an injury resulting in money damages.[45] Finally, Sears and Transform posited that the District Court should otherwise put the parties back in the position they were in on August 23, 2019, when the Bankruptcy Court “erroneously” approved the assignment to Transform.[46]
On the other hand, MOAC argued that despite the arguments to the contrary, the case is not moot for lack of remedy.[47] Sears never properly assumed the Lease and the deadline under Bankruptcy Code Section 365 has passed; therefore, the Lease must be returned to MOAC.[48] Alternatively, MOAC argued that it was entitled to damages from Transform or Sears equal to the value of the Lease.[49]
First, the District Court denied Sears and Transform’s arguments that MOAC was precluded from attacking the Bankruptcy Court judgment because it accepted the cure payment.[50] Specifically, it found that MOAC accepted a payment of common charges and taxes on the property, along with other repairs, and this payment did not constitute an acceptance of a benefit or a judgment.[51] Rather, the payment was made pursuant to a stipulation intended to preserve all parties’ rights pending appeal.[52] Additionally, the District Court found that Transform forfeited its rights to make any arguments that MOAC’s receipt of this payment constituted acceptance when it did not raise the issue earlier on in the appeals process.[53]
Second, the District Court found Transform’s waiver of protections under 363(m) was valid.[54] “[T]he fact that there was no stay pending appeal does not insulate [Transform]’s title, or prevent MOAC from arguing that it should be divested of that title now that the Transfer Order has been overturned.”[55] Where the purchaser at a judicial sale was a party to the judicial proceedings leading up to the sale – as Transform was here – it is charged with notice of any defects in the proceedings, and its title will be defeated if the order authorizing the sale is reversed on any ground.”[56] Accordingly, the Court ruled that Transform’s argument that a sale in bankruptcy can only be undone via an avoidance action is no longer a viable argument.
The District Court held that Transform was divested of its title per the vacatur of the order authorizing the assignment.[57]
The District Court was then left with one more question: What Happens To The Lease?
The District Court first had to decide whether it was possible for Sears to assume the Lease long after the deadline in Bankruptcy Code Section 365(d)(4) had passed.[58] Bankruptcy Code Section 365(d)(4) provides that parties have 120 days after the petition date to assume or reject a lease, otherwise the lease will be deemed rejected.[59] MOAC maintained that it was not possible to grant Sears an opportunity to assume the lease because the deadline to do so passed (August 31, 2019).[60] Sears, in response, argued that the Lease was not subject to Bankruptcy Code Section 365(d)(4), as it was not a “true lease” in economic terms, but more akin to property ownership.[61]
In doing so, Sears relied on a Second Circuit decision, Int’l Trade Admin v. Rensselaer Polytechnic Inst. (“RPI”), 936 F.2d 744 (2d Cir. 1991). There, the lease was favorable to the tenant in similar ways identical to Sears: it ran for a term of 99 years with a base rent of just under $1000 per year, which was similarly prepaid, and the tenant also paid additional rent in the form of expenses.[62] Three years after the debtor in RPI filed for bankruptcy, the trustee requested an extension of time to assume or reject the lease, which was denied. On appeal, the landlord argued that the lease had terminated as a matter of law; the bank that had loaned money to the debtor, which was secured by the debtor’s interest in the lease, argued that it was not a “true lease” given the economic realities of its terms.[63] The Second Circuit agreed with the bank, highlighting the 99-year term and the prepayment of the rent as out of the ordinary for a normal landlord-tenant relationship.[64] Further, the Second Circuit noted that leases of nonresidential real property do not include situations where a lessor is acting as a seller or a lender.[65] Accordingly, the court found that it would have been inequitable to allow RPI to recapture the lease given the tenant’s prepayment.[66]
Turning to the Lease at hand, the District Court found that the Second Circuit’s ruling in RPI was dispositive, and required a finding that the Lease was not a true lease and therefore not subject tot 365(d)(4).[67] The scope of the terms of the Lease were nearly identical to the terms in the Lease in RPI, and it similarly would be inequitable to allow MOAC to retain the Lease.[68] “Just as in RPI, Sears had both constructed the store at its own expense and it prepaid the lease; the landlord received ‘the substance of its bargained for consideration.’”[69]
MOAC was not without protections, as it still was protected from assignment to an entity that did not satisfy the provisions of 365(b)(3)(A).[70] Further, the deadline under 365(d)(4) was passed to protect landlords to ensure they were not “left endlessly in the dark about whether their leases will be assumed or rejected. “MOAC was never in the dark about Sears’ intentions with respect to the Mall of America Lease, nor could it have been. That Lease – itself a unicorn – was a uniquely valuable estate asset; only a moron would have thought that Sears was not going find some way to monetize it, and MOAC and its counsel are anything but.”[71]
The District Court found that no “legitimate bankruptcy purpose” would be served by ordering the trustee to forfeit the Lease.[72] The Lease belonged to the estate.[73]
Finally, the Court ruled that MOAC is not entitled to monetary damages from Transform because Transform was deprived of the Lease, which gave MOAC the relief to which the Code entitles it against Transform.[74] As to Sears, MOAC could not recover damages from Sears or the estate as the exculpation provisions contained in the plan had preclusive effect, barring parties from pursuing claims or collecting from the estate in contravention of the plan.[75]
The District Court noted that MOAC received all it bargained for back in 1991: “It has been protected against the assignment of the Lease to a party that is ineligible under the Code. Although that assignment was vacated, all defaults under the Lease were cured years ago and any compensation due under the Lease has been paid while this case has wended its way up through the courts and back again. None of that money needs to be paid back in light of the vacatur of the assignment.”[76]
Takeaways
- The requirements of Bankruptcy Code Section 365(d)(4) will be strictly enforced and cannot be modified by contract. The District Court squarely rejected the Bankruptcy Court’s reliance on the Lease to define the contours of section 365(b)(3).[77]
- When litigating whether an executory contract, lease, or license can be assumed, assumed and assigned, or rejected, if it is not first established (by agreement or judicial determination) that the contract, lease or license is in fact an executory contract subject to assumption, assumption and assignment or rejection, party litigants may find themselves like Sears and MOAC litigating the assumption, assumption and assignment or rejection issue based upon a false premise.[78] In short, if all legal issues and objections are not raised at the outset, the piecemeal litigation that may ensue may be lengthy, costly and wholly unsatisfactory.
- If litigation is pending at the time of plan confirmation and the plan contains an exculpation provision, if the pending litigation is not carved-out of the exculpation provision, the counterparty to the debtor may be foreclosed of certain remedies.[79]
- While the Bankruptcy Code sets out detail substantive and procedural provisions for altering debtor-creditor rights, holding parties to the benefit of their bargain and not permitting a windfall remains an animating principle.[80]
[1] In re Sears Holdings Corp. (“Sears IV”), No. 19 CIV. 09140 (CM), 2024 WL 1971813, at *1 (S.D.N.Y. May 3, 2024).
[2] In re Sears Holdings Corp. (“Sears I”), 613 B.R. 51, 56 (S.D.N.Y.), order vacated on reh’g, MOAC Mall Holdings LLC v. Transform Holdco LLC (In re Sears Holding Corp.) (“Sears II”), 616 B.R. 615 (S.D.N.Y. 2020), vacated and remanded, MOAC Mall Holdings LLC v. Transform Holdco LLC (In re Sears Holding Corp.) (“Sears 2nd Cir. II”), No. 20-1846-BK, 2023 WL 7294833 (2d Cir. Nov. 6, 2023).
[3] Id.
[4] Id. at 56-7.
[5] Sears IV, at *1.
[6] Id.
[7] Id.
[8] See In re Sears Holdings Corp., et al., Case No 18-23538 (RDD) (Bankr. S.D.N.Y. 2018).
[9] Case No 18-23538, Docket No. 1730.
[10] Sears I, 613 B.R. at 59.
[11] Id.
[12] Id.
[13] Case No 18-23538, Docket No. 2199.
[14] MOAC Mall Holdings LLC v. Transform Holdco LLC (In re Sears Holding Corp.) (“Sears 2nd Cir. I”), 2021 WL 5986997 at *4 (2d Cir. Dec. 17, 2021).
[15] Id.
[16] Bankruptcy Code Section 365(b)(3) imposes additional restrictions on the assignment of a “shopping center lease.” It provides that adequate assurance of future performance of a lease of real property in a shopping center includes adequate assurance:
(A) of the source of rent and other consideration due under such lease, and in the case of an assignment, that the financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time the debtor became the lessee under the lease;
(B) that any percentage rent due under such lease will not decline substantially;
(C) that assumption or assignment of such lease is subject to all the provisions thereof, including (but not limited to) provisions such as a radius, location, use, or exclusivity provision, and will not breach any such provision contained in any other lease, financing agreement, or master agreement relating to such shopping center; and
(D) that assumption or assignment of such lease will not disrupt any tenant mix or balance in such shopping center.
[17] Sears I,at 60-1.
[18] Id.
[19] Id. at 62.
[20] Id. at 62-3
[21] Id. at 75-6.
[22] Sears IV, at *5.
[23] Case No 18-23538, Docket No. 5074.
[24] Sears I, at 68.
[25] Id.
[26] Sears I, at 74.
[27] Id.
[28] See Sears II.
[29] Bankruptcy Code Section 363(m) provides “The reversal or modification on appeal of an authorization under subsection (b) or (c) of this section of a sale or lease of property does not affect the validity of a sale or lease under such authorization to an entity that purchased or leased such property in good faith, whether or not such entity knew of the pendency of the appeal, unless such authorization and such sale or lease were stayed pending appeal.” 11 U.S.C. § 364.
[30] Sears II.
[31] Id.
[32] Sears 2nd Cir. I.
[33] Id.
[34] Transform Holdco, 143 S. Ct. 927, 935 (2023).
[35] Id. at 936.
[36] Id. at 937.
[37] Id.
[38] Id.
[39]Sears 2nd Cir. II, at *1.
[40] Sears IV, at *7.
[41] Id. at *8.
[42] Id.
[43] Id.
[44] Id.
[45] Id. at *9.
[46] Id.
[47] Id.
[48] Id.
[49] Id.
[50] Id.
[51] Id.
[52] Id. at *10.
[53] Id.
[54] Id.
[55] Id. at *11.
[56] Id.
[57] Id.
[58] Id at *19.
[59] 11 U.S.C. § 365(d)(4).
[60] Id at *16.
[61] Id.
[62] RPI, 936 F.2d at 746.
[63] Id. at 748.
[64] Id. at 748-50.
[65] Id. at 750.
[66] Id. at 751.
[67] Sears IV, at *17.
[68] Id.
[69] Id.
[70] Id. at *18.
[71] Id.
[72] Id. at *22.
[73] Id.
[74] Id.
[75] Id.
[76] Id. at *24.
[77] Judge Drain’s approach was to treat the adequate protection requirements of Bankruptcy Code Section 365 as the ceiling, which would have left open the possibility for parties to negotiate and substitute their own adequate protection requirements in a lease; however, Judge McMahon’s ruling in Sears I makes it clear that these requirements are the floor.
[78] The District Court ruled that only a “true lease” is subject to Bankruptcy Code Section 365(d)(4). RPI and Sears IV provide (likely non-exhaustive) guidelines for what is not a true lease: a lease or a landlord-tenant relationship in which there is a lengthy term, a prepayment of significantly below-market rent, and the development of a property at the lessee’s expense. These elements give rise to a finding that a landlord was acting as a seller or lender and there is no “true lease.” As discussed, MOAC received everything it had bargained for when it negotiated the tenant-friendly Lease. Sears in turn invested a significant amount of its own funds to develop the premises. The District Court’s decision recognized and enforced the practical realities of this relationship.
In this case, this finding meant that the Lease was never automatically terminated by virtue of the 365(d)(4) deadline expiring before Sears assumed the Lease, and therefore the Lease remained with the estate.
[79] Sears IV, at *22-3.
[80] Id. at 14.