The Seventh Circuit Court of Appeals, in a unanimous decision written by Judge Posner, recently ruled that a landlord who legally terminates a lease before a tenant files for bankruptcy protection may later be found to have received a preferential or constructive fraudulent transfer, and held liable to the bankruptcy estate for the full value of the lease.
The debtor in the case had owned more than 100 oil change and auto maintenance stores throughout the Midwest. It typically bought a store, sold it to investors and then leased it from the new owners under a long-term contract. When its debts where mounting and bankruptcy was looming, the debtor agreed with one particularly difficult landlord to terminate two leases. The landlord then re-leased the two premises to another tenant.
Creditors sued to avoid the lease terminations and sought the value of the leases as compensation. The bankruptcy court ruled the terminations were not transfers of property, a necessary element of a preference or fraudulent transfer action. Judge Posner held that, because the definition of "transfer" under the Bankruptcy Code was broad and includes " parting with . . . an interest in property", the terminations where, arguably, transfers. The case was remanded to the bankruptcy court for further proceedings. But the outcome there seems pretty foregone, as a constructive fraudulent transfer basically requires a transfer for less than reasonably equivalent value and an inability of a debtor to pay debts as they come due (insolvency).
Judge Posner's decision is at odds with the prior decisions of most bankruptcy courts—which had held that the prepetition termination of a lease is not an avoidable transfer—and the Uniform Fraudulent Transfer Act section 8—which provides that a transfer of a debtor's lease is not voidable if it results from the "termination of a lease upon default by the debtor when the termination is pursuant to the lease and applicable law". Nonetheless, because it is the first appellate decision in this area and is written by an influential, respected judge, it is expected to carry weight with bankruptcy judges throughout the United States.
Before seeking to terminate leases either by agreement or court action, landlords should now weigh the potential risk of a finding of an avoidable transfer under the Bankruptcy Code if the tenant terminated ends up filing for bankruptcy. Depending on the situation, the risk/reward calculation might result in a decision that the risk of a finding of a voidable transfer is still worth the potential rewards of termination. But marginal cases might no longer be worth pursuit.
A copy of a more detailed explanation of the decision by my colleague Audrey Noll can be viewed here.
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