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
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.
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.