Lease Profit-Sharing Provision Unenforceable Condition to Assignment in Bankruptcy

In Antone Corp. v. Haggen Holdings, LLC (In re Haggen Holdings, LLC), 2017 WL 3730527 (D. Del. Aug. 30, 2017), the U.S. District Court for the District of Delaware considered whether, as part of a bankruptcy asset sale, a chapter 11 debtor could assume and assign a nonresidential real property lease without giving effect to a clause in the lease requiring the debtor to share 50 percent of any net profits realized upon assignment. The district court ruled that, in approving the sale, the bankruptcy court did not err in holding that the profit-sharing provision was unenforceable under section 365(f)(1) of the Bankruptcy Code because it conditioned assignment of the lease.

Section 365(f)(1) and Profit-Sharing Provisions

Under section 365(f)(1), with certain exceptions, a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") may assign an executory contract or an unexpired lease notwithstanding a provision in the contract or lease or in applicable law that "prohibits, restricts, or conditions" assignment. The purpose of the provision is to maximize the value of a debtor’s assets for the benefit of the estate and creditors. See Angelone v. Great Atlantic & Pacific Tea Co., Inc. (In re Great Atlantic & Pacific Tea Co., Inc.), 2016 WL 6084012, *4 (S.D.N.Y. Oct. 17, 2016) (affirming an order invalidating a profit-sharing clause in an assigned lease and stating that section 365(f) is a "powerful tool for advanc[ing] one of the Code’s central purposes, the maximization of the value of the bankruptcy estate for the benefit of creditors") (internal quotation marks and citations omitted).

In addition, section 365(f)(3) of the Bankruptcy Code invalidates any provision in an executory contract or unexpired lease assigned by the trustee or DIP that "terminates or modifies, or permits a party other than the debtor to terminate or modify, such contract or lease or a right or obligation under such contract or lease on account of an assignment."

To be unenforceable under section 365(f)(1), a challenged provision does not have to directly prohibit assignment—indirect interference is sufficient. For example, many courts have held that a provision in a lease obligating the lessee to share with the landlord any profits realized from assignment is an unenforceable condition which limits "the debtor’s ability to realize the full value of its leasehold interest" by requiring payment to one creditor and diminishing distributions to all other creditors. In re Jamesway Corp., 201 B.R. 73, 78 (Bankr. S.D.N.Y. 1996); accord In re Standor Jewelers West, Inc., 129 B.R. 200 (B.A.P. 9th Cir. 1991); Great Atlantic, 2016 WL 6084012, at *6.

In Haggen Holdings, the Delaware district court considered whether the bankruptcy court below erred in approving the assumption and assignment of a lease without enforcing a profit-sharing provision.

Haggen Holdings

Prior to filing for chapter 11 protection in September 2015 in the District of Delaware, Haggen Holdings, LLC, and its affiliates (collectively, the "Debtors") owned and operated 164 grocery stores and a pharmacy. In October 2015, the Debtors sought court approval of bidding and notice procedures to govern the sale of various stores, as well as the assumption and assignment of certain related executory contracts and unexpired leases, including a 1993 nonresidential real property lease (the "Lease") between one of the Debtors and Antone Corporation ("Antone"). The Lease provided that "[i]n the event Tenant assigns this Lease . . . , Tenant shall deliver to Landlord fifty percent (50%) of any ‘net profits’ . . . within thirty (30) days of Tenant’s receipt thereof pursuant to such assignment."

After the Debtors filed a notice identifying Good Food Holdings (Bristol Farms) as the successful bidder for the store subject to the Lease, Antone objected to the sale and the assignment, contending that the Lease could not be assigned without enforcing the profit-sharing provision.

The Debtors argued that the profit-sharing provision in the Lease was unenforceable as an anti-assignment provision prohibited by section 365(f)(1). Antone countered that the profit-sharing provision at issue was distinguishable from similar provisions invalidated in other cases. According to Antone, the provision was a bargained-for term given in exchange for below-market rent, and it should therefore be enforced by the bankruptcy court.

The bankruptcy court overruled Antone’s objection, concluding that the profit-sharing provision was unenforceable under section 365(f)(1). In approving the sale and the related assumption and assignment of the Lease, the court wrote that enforcing the profit-sharing provision "would defeat the purpose of section 365(f)(1), which is to . . . enable the Debtor to realize the full value of its assets." Antone appealed the ruling.

The District Court’s Ruling

On appeal, Antone argued that the bankruptcy court erred by not analyzing the facts and circumstances of the case, including evidence of the bargained-for exchange of below-market rent and the profit-sharing provision. According to Antone, the profit-sharing provision was "economically interdependent" with the below-market rent provision and thus should have been enforced. The Debtors countered that the bankruptcy court correctly found that a profit-sharing provision, like the one in the Lease, is a de facto anti-assignment provision which is unenforceable under section 365(f)(1) on the basis of the plain language of the statute and the clear weight of authority.

The district court began its analysis by stating that de facto anti-assignment provisions include provisions which require payment of some portion of the proceeds or profit realized upon assignment, like the provision in the Lease. The court found that the provision at issue conditioned assignment because it required the Debtors to pay Antone 50 percent of net profits received if the Debtors assigned the Lease, which would result in a diminished distribution to all other creditors. The court ruled that, as a matter of law, the profit-sharing provision in the Lease was unenforceable under section 365(f)(1).

The district court noted that other courts considering this issue have similarly refused to enforce profit-sharing provisions as anti-assignment provisions and that Antone failed to cite any decisions to the contrary. It rejected Antone’s argument that this case is factually distinguishable from other cases invalidating profit-sharing provisions under section 365(f)(1).

The court also concluded that Antone mistakenly relied on cases involving the enforceability of rights of first refusal and cross-default provisions. The court explained that, unlike a profit-sharing provision, which extracts value from the estate, a right of first refusal could benefit the estate by creating a bidding war between potential purchasers. Moreover, the court noted, cases involving cross-default provisions are inapposite because they deal with provisions in one or more economically interdependent contracts, as distinguished from different provisions in a single contract.

In so ruling, the district court agreed with the reasoning in Great Atlantic, where the district court affirmed a ruling invalidating a profit-sharing provision under section 365(f)(1) as a matter of law. In Great Atlantic, the court rejected the landlord’s argument that the profit-sharing provision should be enforced due to the parties’ bargained-for exchange in resolving litigation over the debtor’s prior defaults. The district court concluded that: (i) the landlord’s interest had to yield to the policy interest of maximizing the value of the estate for the benefit of all creditors; and (ii) the bankruptcy court was not required to balance the equities, given the unenforceability of the profit-sharing provision as a matter of law.

Outlook

Haggen Holdings is consistent with other rulings on the application of section 365(f)(1). The purpose of assumption and assignment of executory contracts and unexpired leases—maximization of value for the benefit of the bankruptcy estate and creditors—is a fundamental bankruptcy policy. Section 365(f)(1) accordingly is read broadly to render unenforceable a wide range of contract provisions that prohibit, restrict, or condition assignment.

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