The Bankruptcy Code generally provides a debtor with the opportunity to assume (accept and continue performing) or reject (breach and cease performing) certain contracts, including unexpired leases. The Bankruptcy Code also includes the ability for a debtor to assign leases that it has assumed. However, assignment is subject to several restrictions. Specifically, the debtor must provide “adequate assurance of future performance by the assignee” under Bankruptcy Code section 365(f)(2)(B). This adequate assurance can be of paramount importance to landlords, who are taking on a new tenant. The amorphous standard of section 365(f)(2)(B) is supplemented by four additional requirements set forth in section 365(b)(3), which are applicable only to shopping center leases. Certain of these heightened requirements have not been the subject of extensive litigation and therefore remain generally untested. Recently, in a February 27, 2020 decision, the District Court for the Southern District of New York considered two of these requirements in connection with the bankruptcy cases of Sears Holding Co. (“Sears”) and provided valuable guidance with respect to their application.
The District Court analyzed sections 365(b)(3)(A) and (D) of the Bankruptcy Code. Section 365(b)(3)(D) requires that “assumption or assignment of [a shopping center] lease will not disrupt any tenant mix or balance in such shopping center”, while section 365(b)(3)(A) requires that “the financial condition and operating performance of the proposed assignee…shall be similar to the financial condition and operating performance of the debtor…as of the time the debtor became the lessee under the lease.”
The District Court concluded that in regard to section 365(b)(3)(D), the Bankruptcy Code does not define the term “tenant mix” or provide any timeframe within which it should be considered. Thus, a court may look to the lease in question to consider the parties’ bargain. In Sears, the lease did not contain any “use” or “tenant mix” restrictions, and the District Court held that the mall owner could not prevent assignment on this basis.
The District Court, however, concluded that the adequate assurance requirements of section 365(b)(3)(A) could not be met by simply meeting the financial condition and operating performance requirements of an assignee set forth in the applicable lease. Instead, the District Court found that the Bankruptcy Code specifically states that the assignee must have a “similar” financial profile as the previous leaseholder and provides a time within which to consider that financial condition – at the inception of the lease. Significantly, this Bankruptcy Code provision is to be interpreted as a requirement irrespective of any language in the lease. So holding comports with preserving the parties’ bargain and would only subject a landlord to a new tenant that was similar to the one it originally contracted with. In Sears, the District Court held that the proposed assignment of the Mall of America lease could not be approved unless it was demonstrated that the assignee had a financial standing similar to that of Sears when Sears had first leased the space in 1991.
Takeaways
There are several data points to take from the District Court’s recent decision. First, this decision makes clear that a debtor’s ability to assume and assign a lease is not a given, particularly with respect to shopping center leases. Not only does a debtor need to provide the baseline adequate assurance of future performance, as required by section 365(f)(2)(B), but must meet each of the heightened standards of section 365(b)(3). The most significant legal determination, however, is that section 365(b)(3)(A) is an independent adequate assurance standard set by Congress which, in contrast to the requirement of section 365(b)(3)(D), is not limited to the terms of the lease in question.
Second, it is important for parties to make an initial determination that a lease is indeed a “shopping center” lease. The parties in Sears stipulated to that finding. Despite this, the District Court noted in a footnote that this was not an easy question given the makeup of Mall of America’s tenants. The District Court stated that while the mall shares some of the commonly understood characteristics of a shopping center, it does not look like most. With the disruption that has occurred in the traditional retail environment, this observation may be true of many malls. Struggling to maintain tenants has forced operators to look outside of the traditional paradigm. Thus, the parties should always ask the threshold question of whether a lease constitutes a “shopping center” lease.
The District Court’s decision, however, may not be the last word on this matter. On March 12, 2020, the assignees of the Sears lease filed a motion for a rehearing on the decision. S&K will continue to monitor this situation and provide any relevant updates.
