Early Lease Terminations: Understanding and Managing Avoidance Risks

When faced with a financially distressed tenant, an early lease termination agreement can be an effective means for a landlord to resolve the uncertainty created by its tenant’s financial distress and to mitigate potential economic losses. Such agreement typically provides that, in exchange for the tenant making a final payment to the landlord, vacating the leased premises, and surrendering possession, the landlord agrees to an earlier expiration of the lease term and to release the tenant from having any further rent or other payment obligations. Nevertheless, the benefits of an early lease termination agreement should be carefully weighed against the potential downside avoidance risks that could arise if the distressed tenant becomes the subject of a bankruptcy proceeding. As part of determining whether and on what terms to enter into an early lease termination agreement, a landlord should be aware of the theoretical risks that sections 547 and 548 of the Bankruptcy Code present and whether any final payment consideration could become the subject of avoidance claims and litigation in a subsequent bankruptcy case involving the tenant.

Under section 547(b) of the Bankruptcy Code, a bankruptcy court may avoid a “preferential” transfer made: (1) to or for the benefit of a creditor; (2) on account of an antecedent debt owed by the debtor; (3) while the debtor was insolvent; (4) either within 90 days before the filing date of the petition or within one year before the filing date of the petition, if such creditor at the time of such transfer was an insider of the debtor; and (5) that enables such creditor to receive more than it would receive in a hypothetical Chapter 7 liquidation case. Likewise, under section 548(a)(1)(B) of the Bankruptcy Code, a “fraudulent transfer” of any interest of the debtor in property it owns (such as a leasehold interest or cash) that occurs within two years before the filing date of the petition, may be avoided if the debtor received less than reasonably equivalent value in exchange for such transfer, and the debtor was insolvent at the time of the transfer or became insolvent as a result thereof.¹ Although there is limited case law addressing whether and how a prepetition early lease termination agreement can give rise to a potentially viable preferential or fraudulent transfer claim, it is important to be aware of the authority that does exist not only to understand the bankruptcy venues in which such authority is controlling precedent, but also because the relevant fact patterns and judicial findings can be used to develop strategies for minimizing, if not eliminating, such avoidance risks, regardless of bankruptcy venue.

There is little reported case law substantively addressing the assertion of a preference claim for payments received prepetition under an early lease termination agreement. In In Midwest Holding #7, LLC v. Anderson (In re Tanner Family, LLC),² however, the United States Court of Appeals for the Eleventh Circuit (which is controlling precedent on bankruptcy and district courts in Alabama, Florida, and Georgia) considered whether the debtor’s payment of an early lease termination fee in exchange for obtaining a release of any further rent payment obligations following termination of the lease could be avoided as a preference under section 547(b) of the Bankruptcy Code. The central issue before the court was whether the $87,172.50 final payment by the tenant to its landlord constituted a transfer “for or on account of an antecedent debt owed by the debtor before such transfer was made.” 11 U.S.C §547(b). The landlord took the position that the debt incurred by the lease was not “legally collectible” until the first day of the month when rent becomes due, and therefore, the payment it received was not on account of any antecedent debt, while the trustee countered that the tenant’s obligation to pay rent for the entire term of the lease was incurred on the date the parties entered into the lease. In agreeing with the trustee and affirming the rulings of the bankruptcy court and district court,³ the court held that the payment was on account of an antecedent debt because “a debt need not be matured before the date of the transfer in question in order for it to be antecedent to that transfer” and therefore subject to potential avoidance as a preferential transfer.⁴

There are more decisions that have considered whether an otherwise valid termination of a lease constitutes a fraudulent transfer under section 548(a)(1)(B) of the Bankruptcy Code. The only reported decision by a circuit court of appeals comes from the Seventh Circuit (which is controlling precedent on bankruptcy and district courts in Illinois, Indiana, and Wisconsin), which held in Official Committee of Unsecured Creditors of Great Lakes Quick Lube LP v. T.D. Investments I, LLP that a landlord’s termination of allegedly “profitable” leases 52 days before the tenant filed for bankruptcy could be deemed a fraudulent transfer.⁵ In that case, the creditors’ committee sued the landlord under section 548 to recover the value of the leases, and the bankruptcy court for the Eastern District of Wisconsin held that, because the subleases were validly terminated under Wisconsin law prepetition, and thus, could not be assumed, the termination agreement was not avoidable. In reversing the bankruptcy court’s decision, the Court of Appeals found that the lease terminations were fraudulent transfers, emphasizing the distinction between the value of the leases terminated prepetition (to which creditors may be entitled) and the leases themselves (whose otherwise valid termination prepetition could not be unwound through avoidance litigation).⁶ The case was remanded to the bankruptcy court to determine whether the debtor received reasonably equivalent value for the lease termination, and ⁷ the bankruptcy court subsequently found that termination of the lease deprived the debtor of realizing $57,000 if it had continued to operate at the terminated locations.⁸ Based on the expert testimony provided at trial, the bankruptcy court determined such value to be in excess of the net present value the debtor realized from being released under the agreement from making future rent payments, and after deducting approximately $46,000 in rent owed as of the lease termination date, the bankruptcy court ruled that the plaintiff was entitled to judgment of $11,000.⁹

On the other hand, the United States Bankruptcy Court for the Southern District of New York held in Durso Supermarkets v. D’Urso¹⁰ that a lease validly terminated prepetition under state law did not become part of the bankruptcy estate and thus could not be the subject of a fraudulent transfer claim. The court ruled that, for purposes of section 548, federal law determined “what constitutes a transfer and when it is complete”; however, state law defined the nature and limitations of the debtor’s “property interest” in the lease.¹¹ Thus, under New York law, a lease term for more than three years could be considered an interest in real property. The court held that the termination of the lease, due to a prepetition, material default, did not wrongfully deprive the creditors of the estate of rights “to which they would be entitled,” because at the time of termination, Durso Supermarkets (the tenant/future debtor) lost all legal and equitable rights under the lease.¹² The court reasoned that, once the lease was terminated, it failed to become property of the estate and, thus, was not subject to assumption or rejection.¹³ While the court found that the lease termination constituted a transfer, it declined to hold that such transfer could be considered a fraudulent transfer under section 548 because “…[t]o find otherwise would give [the Debtor’s] creditors rights in Mrs. D’Urso’s real property superior to her own.”¹⁴

Given such limited and at points conflicting caselaw, landlords should consider certain key factors in evaluating potential risk and the steps that may be taken in structuring an early lease termination agreement, including:

1. What the likelihood is of the tenant actually filing for bankruptcy.

• Because it is difficult to rely on the 90-day preference period running, the landlord should exercise diligence on its tenants to ensure that any lease termination agreement is executed as soon as financial distress becomes a possibility. 
• All lease termination agreements should document (with supporting financial data) that the tenant is receiving reasonably equivalent value for surrendering the premises and for relief from rent and other obligations, and landlord should consider itemizing all financial obligations such as taxes, repairs, common area maintenance, property insurance, etc.
• To the extent possible, the landlord should convey any concessions or additional consideration it may be given as value that is being given in exchange for the early termination payments.

2. Whether the lease being terminated is above or below market.

• Landlords may want to perform diligence, including by way of a broker’s opinion of value, appraisal, or independently determining, if possible, whether the lease to be terminated is at or above current market rates for similar leased locations.

3. Whether there are existing defaults under the lease agreement that may entitle the landlord to terminate under the express terms of the lease.

• Landlords should seek to terminate the lease in accordance with the lease terms and applicable state law, including by providing all required notice to and complying with, or obtaining the express waiver by, the tenant of any cure periods.

4. Finally, it will be important to determine how the consideration the landlord is receiving under an early termination agreement compares to the amount of a claim for rejection damages that the landlord would be entitled to assert if instead of entering into such agreement, the unexpired lease were to be rejected in bankruptcy and the landlord’s resulting claim for damages made subject to application of the cap set forth in section 502(b)(6) of the Bankruptcy Code.¹⁵

• If the termination payment the tenant is paying to the landlord under the early termination agreement exceeds the amount of its statutorily capped rejection damages that the landlord would have in a hypothetical bankruptcy of the tenant, there is a heightened risk that, if the tenant ends up in bankruptcy, then the consideration received prepetition in excess of the capped limit on rejection damages in bankruptcy may be challenged.

Ultimately, landlords with distressed tenants should consult with real estate and restructuring counsel at the inception of negotiations, and, in any event, before entering into an early lease termination agreement, so that potential preferential and fraudulent transfer risks can be identified and mitigated to the extent feasible under the circumstances. Failure to do so could result in costly litigation and the avoidance of any benefit received pre-bankruptcy.

¹ Additionally, pursuant to subsection 548(a)(1)(A), a claim for “actual” fraud arises where the transfer was made or the obligation incurred with “actual intent to hinder, delay, or defraud” the debtor’s other creditors. Further, pursuant to the “strong-arm” powers of section 544 of the Bankruptcy Code, a debtor-in-possession or its trustee may use applicable state fraudulent conveyance laws, like the Uniform Voidable Transactions Act, provides a longer look-back period than the two years in section 548(a) claims.

² Midwest Holding #7, LLC v. Anderson (In re Tanner Family, LLC), 556 F.3d 1194 (11th Cir. 2009).

³ Anderson v. Midwest Holding #7, LLC (In re Tanner Family, LLC), 2007 LEXIS 3986 (Bankr. N.D. Ga. 2007), and Midwest Holding #7, LLC v. Anderson, 387 B.R. 892 (N.D. Ga. 2008).

⁴ Midwest Holding #7, LLC v. Anderson (In re Tanner Family, LLC), 556 F.3d at 1197.

⁵ Official Committee of Unsecured Creditors of Great Lakes Quick Lube LP v. T.D. Investments I, LLP (Great Lakes II), 816 F.3d 482 (7th Cir. 2016).

⁶ Some courts have determined that section 365(c)(3) does not prohibit a trustee or debtor from assuming an agreement validly terminated prepetition if that termination constitutes an avoidable transfer under §§ 547 or 548. See In re Harvey Company, Inc., 68 B.R. 851, 859 (finding that section 365(c)(3) is inapplicable when the lease was terminated in a constructively fraudulent manner).

⁷ In re Great Lakes Quick Lube Limited Partnership, 2017 WL 2266769 at *5 (Bankr. E.D. Wis. 2017).

⁸ Id.

⁹ Id.

¹⁰ Durso Supermarkets v. D’Urso, 193 B.R. 682 (Bankr. S.D.N.Y. 1996).

¹¹ Id. at 696-97.

¹² Id. at 700.

¹³ In re Egyptian Brothers Donut, Inc., 190 B.R. 26 (Bankr. D.N.J. 1995) (stating that there is a substantial body of case law that supports the position that a pre-petition termination of an agreement constitutes a “transfer,” subjecting the termination to 547 and 548 avoidance, but declining to find that the debtors would be able to avoid the pre-petition termination of the franchise agreements despite their material default and then either assume or reject the agreements during the course of the bankruptcy cases since that would “violate the express language of 365(c)(3).”); In re Haines, 178 B.R. 471 (Bankr. W.D. Mo. 1995) (rejecting the debtor’s attempt to avoid the prepetition termination of its lease as constructively fraudulent under 548(a)(2) on several grounds, but primarily due to the express language of 365(c)(3), finding that allowing a debtor to avoid a pre-petition termination and assume the agreement would violate long-established rules of statutory construction).

¹⁴ See Durso Supermarkets, at 700.

¹⁵ That section provides for allowance of a lessor’s claim for damages following rejection of its lease in bankruptcy provided such claim does not exceed “(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease, following the earlier of (i) the date of the filing of the [bankruptcy] petition; and (ii) the date on which such lessor repossess, or the lessee surrendered, the leased property; plus (B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates”. 11 U.S.C. §502(b)(6).