The Bottom Line

In an opinion dated Feb. 27, 2020, Judge Colleen McMahon of the United States District Court for the Southern District of New York reversed the decision of the bankruptcy court that had granted Sears the right to assign its lease at the renowned Mall of America in Minneapolis, Minnesota. In doing so, Judge McMahon held that a provision in a lease cannot supersede the statutory requirement set forth in §365(b)(3)(A) of the Bankruptcy Code that the financial condition of an assignee of a lease must be “similar to” that of the debtor at the time the debtor became the lessee. See MOAC Mall Holdings LLC v. Transform Holdco LLC (In re Sears Holdings Corp.), 19-09140 (S.D.N.Y. Feb. 27, 2020) (the Opinion).

What Happened?

Background and the Mall of America Lease

The appeal arose in connection with the Chapter 11 reorganization of Sears Holdings Corporation (Sears) and from an order issued by bankruptcy Judge Robert Drain approving the assignment and assumption of the Sears lease at the Mall of America. In 1991, Sears became one of the original tenants of the mall when it entered into its lease with the mall’s owner, MOAC Mall Holdings LLC (MOAC). The terms of the lease, which runs until 2091, are “extraordinarily tenant-favorable,” and contain several provisions “most unusual in a shopping center lease.” See Opinion at 3. In 2007, pursuant to the terms of the lease, Sears’ 15-year obligation (the Major Operating Period) to operate a retail department store in the leased space expired, after which Sears was free to either shut down or operate any alternative type of business in the space. Another provision of the lease permitted Sears to “vacate all or any part … or lease or sublease all or any portion of the building, or assign the Lease” without MOAC retaining any veto power over the assignment. See Opinion at 4. Following the Major Operating Period, if Sears were to cease operating and sublease its premises or assign its lease, it would remain liable under the lease unless its assignee had a net worth of at least $50 million.

The Proposed Assignment

In October 2018, Sears filed for Chapter 11 bankruptcy. Former Sears CEO Eddie Lampert and other former Sears executives formed Transform Leaseco LLC and Transform Holdco LLC (collectively, Transform) to purchase substantially all of Sears’ assets, including “the right to designate certain leases for assignment if approved for assumption and assignment by the Bankruptcy Court.” See Opinion at 8. Sears sought to assign the lease and have it assumed by Transform, which intended to market the space to then-unidentified subtenants. MOAC argued that the proposed assignment would contravene certain provisions in §365 intended to protect the owners and tenants of shopping centers.

Section 365 and the Bankruptcy Court’s Opinion

Section 365(f)(2)(B)of the Bankruptcy Code permits assignment of an unexpired lease of the debtor only if “adequate assurance of future performance by the assignee of such contract or lease is provided, whether or not there has been a default in such contract or lease.” See 11 U.S.C. § 365(f)(2)(B). In addition to §365(f)(2)(B), §365(b)(3) sets forth additional restrictions specifically pertaining to the assignment of a “shopping center” lease in bankruptcy, two of which were at issue in the instant case. Section 365(b)(3)(A) mandates, in the case of an assignment of such a lease, that the financial condition and operating performance of the proposed assignee be similar to that of the debtor “as of the time the debtor became the lessee under the lease.” Section 365(b)(3)(D) states that the assignment or assumption of the lease may not disrupt any “tenant mix or balance” within the shopping center.

In an oral opinion delivered on Aug. 23, 2019, Judge Robert Drain approved Sears’ assumption of the lease and its assignment to Transform, holding that the assignee satisfied the requirements set forth in §365. With respect to §365(f)(2)(B), Judge Drain found that Transform had provided “adequate assurance of future performance” of the lease. Turning to the additional requirements set forth in §365(b), Judge Drain found that §365(b)(3)(D) had to be read in conformity with the underlying lease. Because the lease contained no “tenant mix” requirement, nor any restriction requiring the Sears’ space to operate as a retail department store, Judge Drain held that the assignment to Transform did not violate §365(b)(3)(D).

With respect to §365(b)(3)(A), Transform contended that its current financial condition could be derived from an April 2019 letter disclosing a net worth of $250 million in equity. See Opinion at 8. MOAC’s counsel cast doubt on the accuracy of the document contending that (1) the balance sheet relied on was marked as “DRAFT” and therefore subject to adjustment, and (2) an information table in the document expressly stated it was “not intended to provide the basis for any decision on any transaction.” See Opinion at 12. Based on this, the bankruptcy court was unable to conclude whether Transform had in excess of $250 million in equity.

Nevertheless, Judge Drain found it “highly likely” that Transform’s equity exceeded $50 million. He concentrated on this figure because the governing lease documents relieved Sears of any future obligations under the lease so long as it “subleased or assigned its space to an entity with $50 million in net worth or shareholder equity.” Notwithstanding the plain language of §365(b)(3)(D) that Transform’s financial condition and operating performance be “similar” to that of Sears in 1991, Judge Drain found that §365(b)(3)(A) “requires reference back to the parties’ actual agreement” and must therefore be read in conformity with anything in the lease guaranteeing future performance thereunder. Judge Drain held that the governing agreements confirmed that the lease did not require Sears to “replace itself with a tenant whose financial standing was comparable to that of Sears in 1991 in order to be relieved of liability for performance of the lease.” See Opinion at 14. Accordingly, Judge Drain held that assignment to an entity that had a net worth of $50 million was sufficient under §365(b)(3)(A).

Acknowledging he was “plowing new ground,” Judge Drain stated that if his legal determination and the case law followed were “incorrect,” then the financial condition and operating performance of Transform was not similar to Sears in 1991 and the assignment could not be approved because Transform will have failed to carry its burden of proving financial similarity as required under the statutory provision. Over objection from MOAC, Judge Drain entered a final order authorizing Sears’ assumption of the lease and its assignment to Transform. MOAC appealed.

Judge McMahon’s Opinion

Judge McMahon agreed with the bankruptcy court that Transform had shown adequate assurance of future performance as required under §365(f)(2)(B). She further agreed with Judge Drain that the proposed assignment satisfied §365(b)(3)(D), finding that it would not disrupt the tenant mix at the Mall of America. However, with respect to §365(b)(3)(A), Judge McMahon did not believe the result could be justified and therefore disallowed the proposed assignment.

Section 365(b)(3)(D) Tenant Mix

Upholding the bankruptcy court’s finding that the proposed assignment did not alter the “tenant mix” at the mall, Judge McMahon restated certain findings of fact illustrating that the lease contained no tenant mix restrictions. First, Judge McMahon noted that, other than certain unrelated restrictions that Transform had agreed to abide by, the lease contained no provision limiting tenant mix. Second, upon the expiration of the Major Operating Period, the lease contained no restrictions on what kind of tenants could occupy the space and provided Sears with the right to “go dark” or sublease to a user under no obligation to run a department store. Furthermore, the lease offered MOAC a “right of first refusal” to pay Sears the amount to be paid under a proposed sublease if it did not wish to see any particular new subtenant take over all or a part of the Sears space.

Because the legislative history of the statute provides little guidance on the meaning of “tenant mix,” Judge McMahon found it made “perfect sense” to interpret the phrase, for purposes of §365(b)(3)(D), in light of the lease whose performance is being assured. In deciding the tenant mix question, Judge McMahon concluded that the bankruptcy court had correctly “balanced the rights between the parties, as set forth in the Lease and the REA [and] applie[d] those rights rigorously to decide where the requirement of tenant mix at Mall of America had been met.” See Opinion at 23.

Section 365(b)(3)(A) Assignee’s Financial Condition

Judge McMahon began her analysis of §365(b)(3)(A) by citing to the specific language of the statute. While acknowledging the “impossibility” of locating a tenant that “boasted the precise financial condition and operating performance of Sears back in 1991,” Judge McMahon noted that by using the word “similar,” the statute did not require identity of financial condition and operating performance but rather, at the very least, “proportionally comparable financial health between the assignee and the debtor as of the lease’s inception.” See Opinion at 34. Like Judge Drain, Judge McMahon found that Transform had not demonstrated that its financial condition and operating performance were “similar” to those of Sears in 1991.

However, Judge McMahon disagreed with the bankruptcy court’s adoption of an “alternative standard for determining adequacy of assurance,” effectively rewriting and overriding the “express wishes of the legislature,” and holding that Transform’s $50 million in equity could be substituted for the standard set forth in §365(b)(3)(A). In doing so, the bankruptcy court had gone “far beyond” what any precedent court had ever done. For these reasons, Judge McMahon found that the congressionally mandated standard had not been satisfied and reversed and remanded the matter to the bankruptcy court.

Why This Decision Is Important

In reversing the bankruptcy court’s decision and upholding the “rigorous” adequate assurance standard set forth in §365(b)(3)(A), Judge McMahon held that a provision in a lease relating to the financial condition of an assignee could not be substituted for the statutory provision that the financial condition of an assignee of a shopping center lease must be “similar to” that of the debtor at the time the debtor became the lessee. Judge McMahon’s opinion also sided with a growing body of authority holding that the term “tenant mix,” as used in §365(b)(3)(D), should be interpreted in light of the lease whose performance is being assured.

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