Legal Briefs

Designation Rights

Selling lease assignments provides an option for bankrupt retailers.

When retail tenants are unable to honor rent payments due to bankruptcy, selling the property's designation rights may provide an alternative option for realizing the leases' value. A designation rights sale involves debtors transferring their right to decide which leases to assume, to whom those leases should be assigned, and the terms for those assignments to a third party. The ability to force lessors to accept lease assignments permits the sale of designation rights in bankruptcy, which otherwise would be prevented by lease anti-assignment provisions.

Lease Assignment

When designation rights sales take place, the third-party purchaser pays an initial sum to the debtor and pays the lease carrying costs until assignment. The proceeds from the assignment then are divided between the purchaser and debtor.

It becomes the purchaser's responsibility to market the leases to potential lessees and bear the related expenses. The debtor agrees to assign the leases as directed by the purchaser during a specified time period. When the purchaser reaches an agreement with an assignee, the debtor must seek bankruptcy court approval to assume the lease and assign it to the assignee on the terms negotiated by the designation rights purchaser. Any leases not assigned at the end of the specified time period usually are rejected by the debtor and the premises are restored to the lessor.

For example, Kimco Funding LLC purchased the designation rights to Montgomery Ward's leases during its bankruptcy case. Kimco paid Montgomery Ward's bankruptcy estate $15 million as well as the first $15.5 million in proceeds from the lease assignments. Kimco received the next $30.5 million in proceeds, two-thirds of the next $24 million was paid to Montgomery Ward, and the additional proceeds were divided equally between the two parties.

As the example illustrates, the sale provides immediate cash flow and relieves debtors from their monetary lease obligations during the designation period. Although debtors surrender some of the value in the leases to purchasers, the guaranteed initial payment reduces the risk of finding qualified assignees and shifts that burden from the debtors' management teams to the designation rights purchasers.

No Restrictions, Higher Price

Lessors often view bankruptcy lease assignments in general, and designation rights sales in particular, as impinging on their rights to control tenant selection and the property. Other lessees in retail centers also may have concerns about the quality of new lessees selected by designation rights purchasers due to their impact on the image of the retail center and their potential for sale of competing lines of merchandise.

Debtors can obtain higher prices in designation rights sales by having restrictions on use, alteration, continuous operation, and further assignment excised from the leases. Bankruptcy courts have authorized assignments in violation of lease restrictions when the purpose of the restriction appeared to be designed to prevent assignment. For example, in Kmart's Chapter 11 case, the bankruptcy court permitted locations to go dark for nine months following a designation rights sale even though the leases required continuous operation. Recent bankruptcy amendments require compliance with continuous operation lease provisions following assumption.

Lease provisions that permit lessors to share in the consideration from lease assignments pose a significant threat to designation rights sales. Often called profit-sharing provisions, their enforcement removes much of the financial incentive for designation rights purchasers. However, courts generally invalidate profit-sharing terms as anti-assignment provisions.

Lessor Preparation

Lessors must be prepared to act promptly following a lessee's bankruptcy filing. The limited time for assumption set by recent bankruptcy amendments gives lessors powerful leverage to prevent designation rights sales. In addition to refusing to consent to an extension of that time period, lessors also should oppose debtors' requests for a 90-day extension for assumption authorized by U.S. Bankruptcy Code Section 365(d) (4) (B). Negotiating with debtors for prompt rejection of leases in return for a lessor's waiver of claims or payment also should be considered.

The terms of designation rights sales must be analyzed carefully. Lessors should oppose any efforts to invalidate lease terms as part of the sale. Other leases in the retail property should be reviewed to ensure that lessors will not be placed in breach of those agreements by the assignments contemplated by the sale. Additionally, if the sale terms provide for debtors to receive only nominal consideration from the lease assignments, lessors may be able to successfully argue the sale constitutes an invalid transfer of Section 365 power to assign leases.

While lessors may be able to save use restrictions and similar lease provisions from being invalidated, they must be prepared for bankruptcy court approval of designation rights sales. A sale in bankruptcy cannot be overturned on appeal unless a stay is obtained for the sale order. Getting a stay pending appeal requires a bond that generally is prohibitively expensive for designation rights sales. Lessors who cannot successfully block a designation rights sale in bankruptcy court usually shift their focus to the debtor and purchaser's efforts to assign the leases.

Lease assignment requires debtors to repay all monetary defaults and to correct all possible non-monetary defaults in order to comply with continuous operation provisions in the leases and to provide adequate assurance of the assignee's future performance of the leases. Adequate assurance includes proving that percentage rent will not decline substantially; that the assignment will not violate use, exclusivity, and similar provisions in either the subject lease or other leases in the center; and that the assignment will not disrupt the center's tenant mix or balance. These factually intensive requirements provide fertile ground for lessors to oppose the assignment of their leases by debtors pursuant to the purchasers' designation.

The large financial incentives for debtors and designation rights purchasers virtually ensure that designation rights sales will continue to be an important alternative plan in commercial retail bankruptcies.

Nicholas A. Franke, JD

Nicholas A. Franke, JD, is a partner at Spencer Fane Britt & Browne LLP in St. Louis. Contact him at (314) 863-7733 or nfranke@spencerfane.com.

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