VOLUNTARY AGREEMENT TO TERMINATE LEASE CAN BE A FRAUDULENT TRANSFER
On March 11, 2016 the Seventh Circuit Court of Appeals in In re Great Lakes Quick Lube LP considered whether a voluntary agreement to terminate two profitable leases could be avoided as a fraudulent transfer. T.D. Investments I, LP (“Landlord”) had leased two profitable oil-change stores to Great Lakes Quick Lube; in addition, affiliates of Landlord had leased three unprofitable stores to Great Lakes. Fifty-two (52) days before declaring bankruptcy Great Lakes negotiated the termination of all five leases.
In Chapter 11 the creditor’s committee alleged that the two profitable leases were worth approximately $400,000. The committee alleged that the termination of the two profitable leases was constructively fraudulent as the debtor received less than what it transferred. The bankruptcy judge ruled that a lease termination is not a “transfer” under the fraudulent transfer laws of 11 USC §548.
At trial Great Lakes’ principal testified that he terminated the leases because the landlord was demanding and inflexible, insisting upon prompt payment on the rent. Judge Posner stated:
"It seems unlikely that Great Lakes terminated leases on two profitable stores just because the landlord was being difficult and making threats. But if Great Lakes knew it was going down the tubes it would have no compelling reason to cling to the leases since if it did they would become assets of the estate in bankruptcy and thus property of Great Lake's creditors; and either way the leases would have no value to Great Lakes. Conceivably, therefore, even slight irritation with Theisen might have led Great Lakes to terminate them."
The Landlord argued that the leases were abandoned rather than ‘transferred.’ Judge Posner quickly disposed of this argument, noting that the Bankruptcy Code defines transfer broadly to include "each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing or parting with “(i) property; or (ii) an interest in property." 11 USC §101(54)(D). The court ruled that a leasehold interest in real property is in fact an "interest in property" under 11 USC §101(54), and that the debtor parted with that interest by transferring it to T.D. Investments.
The most interesting part of the decision relates to an apparent statutory conflict. By way of background it is important to note that 11 U.S.C. §550 gives bankruptcy trustees and debtors-in-possession two possible remedies when avoiding a fraudulent transfer - - a) to recover “the property transferred,” or b) to recover “the value of such property.” In this case the creditors’ committee was only seeking to recover the value of the two leases, not the leases themselves.
The statutory conflict relates to 11 USC §365(c)(3), which provides that a trustee (or debtor-in-possession) may not assume or assign any unexpired lease if the lease was terminated prior to bankruptcy. By allowing a lease termination to be avoided as a fraudulent transfer, one can imagine a scenario where under §550 the lease itself was recovered and then subsequently assumed or assigned by the trustee or debtor-in-possession; this would be in direct contravention of 11 U.S.C. §365(c)(3).
Judge Posner ruled that §365(c) merely prohibits a trustee from assuming or assigning a lease which would interfere with the occupancy of new tenants. This did not contradict the complaint at issue because the creditors in this case did not want to assume or assign the leases. Rather the creditors were only seeking to recover the value of the leases (not the leases themselves). §365(c)(3) "is therefore inapplicable." In order to avoid a statutory conflict Judge Posner essentially truncated the recovery options in 11 U.S.C. §550(a), limiting the recovery to the value of the leases at issue.
This decision does not cite to any authority for the proposition that a lease termination is a transfer of an interest in property. Judge Posner thought this to be so obvious that an extensive legal analysis was simply unnecessary. In fact, this issue has been widely discussed for over 25 years. See "Avoidance of Lease Terminations as Fraudulent Transfers" 43 Bus. Law. 807 (May, 1988) by Robert E. Goodman, Jr. And see "Lease Terminations as Fraudulent Conveyances" ALI-ABA course of study November 15-17, 2001.
The lesson of this case is that virtually any exchange of value with an entity which is or is about to become insolvent can be attacked as a fraudulent transfer. Structuring an agreement so that there is at least a plausible argument that there was a reasonably equivalent exchange of value is highly beneficial. In this case, the fact that five leases (two profitable and three unprofitable) were terminated simultaneously may prove to be beneficial in the continuing litigation, as being relieved of liability on the unprofitable leases will perhaps be the “reasonably equivalent value” necessary to offset the loss of the profitable leases. While this case did not focus on the three unprofitable leases, this issue will undoubtedly take center stage on remand.