Relating to Real Estate

Two recent decisions by the United States Bankruptcy Court for the Eastern District of Virginia approving lease assignments by Toys “R” Us (TRS) in its Chapter 11 case pending in Virginia highlight the difficulty that landlords have in controlling the assignments of below-market leases by debtors or trustees in bankruptcy cases. In re Toys “R” Us, Inc., et al., No. 17-BK-34665 (Bankr. E.D. Va.).  

In a May 30, 2018 decision, the bankruptcy court approved a sale by TRS of a lease in a shopping center to Burlington Coat Warehouse Corporation for $1,150,000. The sale was opposed by the landlord on the basis that TRS failed to provide adequate assurance of future performance by the assignee as required by §365(b) of the Bankruptcy Code. The lease at issue was entered into in 1996 and did not contain a use restriction or require that it be assigned to a party whose use did not violate another tenant’s use in the shopping center. In 2009, the landlord entered into a lease with an off-price women’s apparel retailer and agreed in that lease that “if it had the capacity to do so,” the landlord would not enter into another lease with an off-price retailer. The landlord’s objection was based on §365(b)(3) of the Bankruptcy Code, which states that in the case of a shopping center the debtor must provide assurance that its assignment will be subject to all lease provisions including a use or exclusivity clause, “will not breach any such provision in any other lease…,” and “will not disrupt any tenant mix or balance in such shopping center.” The court declined to read §365(b)(3) literally and approved the sale of the lease to Burlington primarily because the TRS lease did not include a use restriction or require the tenant to comply with another tenant’s lease.

In the second case, which was decided on May 31, 2018, the same bankruptcy court approved a sale of a TRS lease for $1,300,000 to a furniture retailer even though the TRS lease provided that the space could not be used for the sale of furniture. Unlike the first case, this TRS store was not located in a shopping center, and thus the shopping center protections under §365(b)(3) did not apply. The sale was opposed by the landlord on the basis that the assignment was barred due to the use restriction in the TRS lease.  In overruling the objection, the court relied upon §365(f) of the Code, which provides that a lease may be assigned notwithstanding a provision that permits the landlord to terminate or modify the lease if it is assigned. Citing earlier decisions from other courts, the court read §365(f) broadly to evidence a policy to eliminate restrictions on assignability in order to maximize creditor recoveries. Also, the court found that the landlord failed to prove that it would be harmed by the assignment. The court approved the assignment free and clear of the use restriction.

The court’s decision in the first case was unsurprising in view of the absence of any language in the TRS lease that restricted TRS in its use of the space. Although the court could have applied §365(b)(3) literally in the landlord’s favor, the result of the case was arguably consistent with commercial expectations. The court’s decision in the second case is debatable and ironic in that the result likely would have been different had the TRS store been located in a shopping center. Because it was not, the court did not need to apply §365(b)(3), which provides that an assignment of a shopping center lease may not be approved in violation of a use restriction. However, the court’s reading of §365(f) to support its decision appears to be over expansive. Section 365(f) invalidates lease provisions that permit landlords to bar lease assignments. It is questionable whether it can be stretched to invalidate a bargained for use restriction. Although the court’s interpretation was supported by other bankruptcy court decisions, there are no appellate decisions on this issue.

For questions, please contact Larry Coppel (410) 576-4238.