§ 20A.06 Bankruptcy Issues

• Jurisdiction: United States
• Publication year: 2022

§ 20A.06 Bankruptcy Issues¹

[1]—Selective Rejection in a Bankruptcy Proceeding²

One risk that a buyer-landlord faces in connection with a portfolio net lease sale-leaseback transaction is the selective rejection of sites in the event of a bankruptcy of the seller-tenant. As a debtor, the tenant in a bankruptcy proceeding has the ability to assume or reject any unexpired commercial property lease, subject only to a showing by the tenant that the rejection is in the best interests of the debtor's estate.³ Debtors are generally prohibited from assuming only certain terms within any lease and rejecting the rest. However, where there are multiple sites leased by a tenant, the tenant may attempt to reject certain of the sites while assuming others by arguing that the individual sites are subject to individual "severable" leases,⁴ even where there is only one lease demising multiple sites.⁵ A selective rejection by a seller-tenant can have significant negative consequences for a buyer-landlord, and significant positive consequences for a seller-tenant. This is because it allows a seller-tenant to maintain its lease and operations at profitable sites while terminating any lease demising a site that is not sufficiently profitable, which leaves the buyer-landlord with ownership of the sub-optimal sites and no lease in place for any of them.

Bankruptcy courts generally apply the state law that governs any applicable lease or leases to determine severability.⁶ Although the case law in each state varies, most states focus primarily or solely on whether the contracting parties intended that the subject lease be severable at the time the lease was first effective. Courts consider several factors when attempting to determine whether the parties intended individual sites to be severable:

• Whether the sites are demised by and between one landlord and one tenant.⁷

• Whether the lease includes an express statement and related covenants that evidences that the parties intended the lease to be unitary and not severable.⁸ Because intent is the key inquiry in any severability analysis, the parties should assume that a court will always look to see if the lease contains any express statements of intent that the lease is unitary and if there are related covenants that show that the parties will treat the lease as unitary following execution. Although a lease could also contain a statement and covenants evidencing the intent that the sites be severable and not unitary, this author has never seen such provisions. Perhaps that is because if the parties are focused on these issues, the buyer-landlord will almost always require a master lease of the applicable sites and related provisions regarding the "unitary" nature of the lease. If they are not so focused, or the intent is for severability, the parties generally will demise the sites with individual leases.

In addition, if such a provision contains an express waiver of the right to assert that the lease is anything but single, unitary and indivisible, a bankruptcy court might enforce such a waiver, contingent in part on the law that governs the lease.⁹

Here is an example of a unitary lease provision:

SAMPLE FORM OF UNITARY LEASE PROVISION FOR MASTER LEASE:

[___] Unitary Lease. Landlord and Tenant agree that this Lease constitutes a single and indivisible lease as to all of the Properties collectively, and shall not be subject to severance or division unless and to the extent, pursuant to Section [___], Landlord elects to effect a partial assignment of this Lease. In furtherance of the foregoing, and except as may result from the amendment of this Lease to eliminate certain properties and reduce Base Rent in conjunction with the execution of Landlord Assignment Lease Agreements pursuant to the terms of Section [___], Landlord and Tenant each (a) waives any claim or defense based upon the characterization of this Lease as anything other than a master lease of all the Properties and irrevocably waives any claim or defense that asserts that this Lease is anything other than a master lease, (b) covenants and agrees that it will not assert that this Lease is anything but a unitary, unseverable instrument pertaining to the lease of all, but not less than all, of the Properties, (c) stipulates and agrees not to challenge the validity, enforceability or characterization of this Lease of the Properties as a unitary, unseverable instrument pertaining to the lease of all, but not less than all, of the Properties, and (iv) shall support the intent of the parties that this Lease is a unitary, unseverable instrument pertaining to the lease of all, but not less than all, of the Properties, if, and to the extent that, any challenge occurs. To the extent that legal, tax or title insurance requirements in consummating the purchase of the Properties by Landlord or leasing the Properties to Tenant, may require, or may have required, individual purchase price allocations including allocations of values for individual state transfer tax purposes and title insurance coverage amounts or individual rent allocations (including allocations of rents in certain states for tax purposes), Landlord and Tenant agree that such individual allocations are solely to comply with legal, tax or title insurance requirements, and shall not be used or construed, directly or indirectly, to vary the intent of Landlord and Tenant that this Lease constitutes a single and indivisible lease of all the Properties collectively, and is not an aggregation of separate leases.

• Whether other provisions of the lease (or other related documents, such as letters of intent) imply an intent that the leases are severable and not unitary.

Such provisions can include allocations of individual rents for each separate property and allocations of value for each separate property.¹⁰ Certain other provisions of the lease (or other related documents) can imply that a lease is intended to be unitary rather than severable. Such other provisions can include, without limitation, (1) an agreement that that the individual sites are jointly and severally liable for the entire combined rent amount (allowing the buyer-landlord to exercise remedies against all properties upon any default related to any individual property), (2) an agreement that all the properties have the same term and can only be extended as to all properties (and not selectively) (or an outright prohibition on any division of the properties), and (3) expressly providing that rents are not reduced in the event of a casualty or condemnation. Importantly, the parties should assume that a court will look to such provisions even if the parties have utilized a master lease and have set forth an express statement of intent in that master lease.

[2]—Recharacterization in a Bankruptcy Proceeding¹¹

A tenant in bankruptcy will sometimes try to recharacterize a net lease sale-leaseback transaction as a disguised financing so that the "landlord" creditor is treated as a lender for the purposes of the bankruptcy proceeding.¹² As previously noted, a landlord's rights and remedies in the event of a tenant bankruptcy are generally superior to that of a lender's.¹³ Therefore, a recharacterization of a net lease sale-leaseback transaction as a disguised financing can be highly problematic for the creditor-landlord (and beneficial to the debtor-tenant), and can also greatly impact third parties who relied on the characterization of the transaction as a sale-leaseback, such as the buyer-landlord's mortgage lender.

[a]—Impacts of Recharacterization

If a court finds that the subject transaction is a disguised financing rather than a "true" sale and leaseback, the tenant is deemed the owner of the real estate (because the "sale" of the real estate is deemed not to have occurred), the lease will be deemed a security instrument (securing the amount of the "loan" that was disguised as purchase proceeds), and the tenant will have the opportunity to "redeem" or sell the property.¹⁴ This could leave the landlord as a secured creditor at best, and an unsecured creditor at worst.¹⁵ In addition, even if the landlord is deemed a secured creditor, the documents will likely lack provisions typical in secured financings in the applicable jurisdiction, many of which benefit lenders, including with respect to critical issues such as lender remedies upon default.¹⁶

[b]—Factors Considered in a Bankruptcy Recharacterization Analysis

Courts will disregard the characterizations or labels by the parties and the "form" of the transaction and will often employ an "economic realities" analysis to determine whether a lease should be recharacterized as a financing device.¹⁷ In employing this analysis, courts have considered many factors, including the following:

• The intent of the parties (including an intent to structure the transaction to obtain tax benefits).¹⁸

• Whether the

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