Insights

Delaware Bankruptcy Court Denies Debtors the Ability to Assume and Reject Individual Leases Under A Master Lease Agreement

In almost all large chapter 11 cases where a debtor leases significant amounts of real property, the debtor’s ability to assume or reject its unexpired leases plays a significant role in the restructuring of the debtor’s business operations. The ability to assume necessary leases, while at the same time eliminating future obligations under leases that are not essential to the debtor’s reorganization, provides the debtor with significant flexibility when formulating a financial restructuring plan. Generally, bankruptcy courts show great deference to a debtor’s business judgment when the debtor decides to assume or reject an unexpired lease. As such, courts rarely prevent a debtor from assuming or rejecting an unexpired lease, if the debtor has demonstrated a sound business reason for the decision.

As evidenced by a ruling recently handed down by a Delaware bankruptcy court in In re Buffets Holdings, Inc., however, a debtor’s discretion to assume or reject its unexpired leases may not exist in situations where an individual lease is part of a master agreement. Instead, a debtor may need to determine whether to assume or reject the master agreement as a whole, rather than each agreement on an individual basis. This was the result in the Buffets Holdings case, where the debtors eventually rejected two master lease agreements after the bankruptcy court prevented the debtors from assuming or rejecting the individual leases contained under those master agreements. As a result, it is important for a debtor to carefully review its rights and obligations under master agreements when formulating a plan to restructure its business operations.

The Buffets Holdings Decision

The Buffets Holdings debtors operate a large steak-buffet restaurant chain, which includes more than 600 company-operated restaurants. Prior to seeking chapter 11 relief in Delaware in January 2008, the Buffets Holdings debtors participated in a series of financial restructuring transactions that ultimately allowed them to refinance their secured debt and issue a dividend to their shareholders. The financial restructuring included a sale/leaseback transaction that involved 29 of the debtors’ restaurant locations. As part of this sale/leaseback transaction, the debtors entered into certain master lease agreements that governed the debtors’ leases on their individual restaurant locations. After their chapter 11 filing, the Buffets Holdings debtors, in an attempt to streamline their operations, sought to assume and reject certain individual leases without assuming or rejecting the related master lease agreements that governed the individual leases. In response, FP1 LLC and FP2 LLC, the debtors’ landlords under the master lease agreements, filed objections and argued that the debtors could not separate the individual leases from their respective master lease agreements and therefore had to assume or reject the master lease agreements as a whole. After considering the parties’ respective positions, the bankruptcy court agreed with the landlords’ position.

In reaching its decision, the bankruptcy court initially noted that when a debtor attempts to assume an unexpired lease, the debtor must assume the lease in its entirety. Stated otherwise, a debtor cannot retain and enforce portions of a lease that the debtor views as favorable, while rejecting the remaining, unfavorable portions of the lease. In situations where an individual lease contains separate, severable agreements, however, a debtor may determine which individual agreements to assume and which individual agreements to reject. Thus, the Buffets Holdings debtors’ ability to assume or reject their individual leases hinged on whether the bankruptcy court viewed the individual leases as separate agreements, as opposed to mere components of the master lease agreements.

In addressing the question of whether the master lease agreements constituted single integrated contracts, the bankruptcy court, citing numerous other bankruptcy and district court decisions, determined that it must apply state, rather than federal, law. After a brief review of the relevant state law, the Buffets Holdings court determined that the “intent of the parties” governed whether the master lease agreements were single, integrated contracts and that, absent some form of ambiguity in the master lease agreement, the agreement’s plain language provided the best evidence of the debtors’ and the landlords’ intent. The court found that the master lease agreement was not ambiguous, and it therefore focused its analysis on the plain language of the master lease agreement.

In its analysis, the bankruptcy court initially addressed what the debtors and the official committee of unsecured creditors perhaps viewed as their strongest evidence – that the total rent due under the master lease agreements was apportionable to the individual leases contained thereunder. Both the debtors and the creditors’ committee argued that the apportionment of rent was a “critical” factor in demonstrating that the parties intended the individual leases to be severable from the master lease agreements. In support of their argument, the debtors and the creditors’ committee cited to both state and bankruptcy court decisions holding that contracts are divisible when one party’s performance consists of separate and distinct components, and the consideration transferred under the contract is apportionable to the individual components contained within the contract.

The bankruptcy court, while acknowledging that the ability to apportion consideration under a master agreement is a potential factor that a court may consider, decided that the apportionment of rent under the master lease agreements was not a conclusive factor. It reasoned that, standing alone, the apportionment of payments among individual components was not always determinative of whether parties intended to treat a contract as divisible. In reaching this determination, the bankruptcy court cited the Seventh Circuit’s 2006 decision in In re United Airlines, Inc., in which the court of appeals held that an agreement to lease space at an airport and to repay certain bond debt was a single integrated contract, even though the agreement provided for separate payments on account of the lease obligation and the bond debt. The Seventh Circuit’s holding relied on the fact that, despite the apportionment of payments between the lease obligation and the bond debt, the parties to the agreement would not have entered into the agreement if it did not include both the lease and the bond components.

In addition to the payment provisions, the Buffets Holdings debtors and the creditors’ committee also cited to other provisions in the agreements in an attempt to demonstrate that the master agreements were divisible. For example, the debtors and the creditors’ committee cited to several provisions within the master agreements that allowed the underlying mix of individual leases to change under certain, specific circumstances. The bankruptcy court, once again disagreeing with the debtors’ and the committee’s position, found that the fact that the mix of individual leases governed by the master agreements may change under certain circumstances did not indicate that the parties intended the individual leases to be separate agreements under all circumstances.

Similarly, the creditors’ committee cited to other provisions in the master lease agreements that, in the event of a tenant default under an individual lease, permitted the landlords to seek remedies under either the individual lease or the master lease agreements as a whole. Rather than characterize these provisions as evidence that the parties intended to sever the individual leases, however, the Buffets Holdings court decided that it was customary for contracts to allow a party flexibility in choosing what remedies to pursue in the event of default. In support of its conclusion that the parties intended the master lease agreements to constitute single, integrated contracts, the court cited to provisions in the master lease agreements that held individual tenants liable not only for the lease payments under their individual leases but also the aggregate amount of payments under all of the individual leases covered by the master lease agreements. In addition, the master lease agreements required the continued payment of the total rent due thereunder, even in the event of the destruction of one or more of the individual leased locations.

The committee attempted to argue that such provisions constituted “cross-default” provisions that were invalid under relevant bankruptcy law. The bankruptcy court, however, decided that the individual leases were “economically interdependent,” and as a result, the provisions with respect to the payment of the aggregate amounts due under the master lease agreement were valid. Further, because the individual leases were “economically interdependent,” the bankruptcy court concluded that the landlords’ economic interest was in the aggregate package of leases, and thus, allowing the debtors to assume or reject leases on an individual basis would deny the landlords the benefit of their bargain.

Finally, while the Buffets Holdings court based its holding upon the plain language of the master lease agreements, the court also examined the course of prior dealings between the debtors and the landlords. From this examination, the bankruptcy court determined that the negotiations between the parties provided further evidence that the parties intended the master lease agreements to be indivisible. Specifically, the bankruptcy court noted that the landlords insisted on the master lease structure, and the debtors agreed to it to obtain favorable lease terms and to gain treatment of the leases as “operating leases” for accounting purposes. Thus, the Buffets Holdings court decided that even if the master lease agreements had been ambiguous, the course of dealings between the parties indicated their intent to treat the agreements as single, integrated contracts.

The Ramifications of the Buffets Holdings Decision

The flexibility to restructure a debtor’s operations through the assumption or rejection of executory contracts and unexpired leases often is one of the primary benefits a business receives from a chapter 11 filing. As a result, if applied broadly, the Buffets Holdings decision likely will have a significant impact on almost any chapter 11 case in which a debtor is party to master agreements.

The 2005 amendments to section 365(d)(4) of the Bankruptcy Code, which establishes the deadline for a debtor to assume or reject a nonresidential real property lease, already have forced debtors to decide whether to assume or reject their unexpired leases on a significantly expedited basis. As a result of the 2005 amendments, debtors with a large number of real property leases must now perform a significant amount of prepetition planning with respect to the restructuring of their operations prior to the petition date. The level of planning required is even greater, however, for debtors that are party to a significant number of leases subject to a master agreement. In this scenario, a debtor must analyze its leases both individually and on a master lease basis in light of the Buffets Holdings decision.

The Buffets Holdings decision also may limit a debtor’s ability to renegotiate more favorable lease terms with a lessor prior to a bankruptcy. Typically, a debtor may use its ability to assume or reject an unexpired lease within a bankruptcy case as leverage to renegotiate the lease to obtain more favorable terms. This negotiation often occurs as part of an attempted out-of-court restructuring and is most effective in scenarios where it is in the lessor’s economic interests to ensure a continued stream of payments under a lease, even if such payments are in an amount less than originally negotiated. In situations involving a master lease agreement, however, the Buffets Holdings decision may reduce significantly a debtor’s leverage to renegotiate an individual unexpired lease, because the debtor would have to assume or reject the master agreement as a whole. As a result, a landlord may be much less flexible in terms of renegotiating the economic terms of an individual lease that is part of a master agreement.

The Buffets Holdings decision also may have ramifications after a debtor has filed a bankruptcy petition. For example, in the context of a retail chapter 11 case, the ruling may significantly limit a debtor’s ability to shed unprofitable lease locations subject to a master lease agreement through the rejection of individual leases. The impact of the decision is not limited to the retail industry, however, and would have a similar impact on almost any other chapter 11 debtor whose individual leases are part of a master agreement.

In conclusion, the Buffets Holdings opinion could have far-reaching implications for bankruptcy and nonbankruptcy practitioners alike. Nonbankruptcy practitioners and business professionals should take note of the bankruptcy court’s decision when structuring leasing arrangements. How these agreements are structured will have a direct impact on the ability of a company to utilize the benefits of section 365 of the Bankruptcy Code in the event of a future bankruptcy filing. In turn, once a company finds itself in financial distress, restructuring professionals should review all master lease/contract arrangements to determine whether the agreements are severable in light of the Buffets Holdings decision. Further, restructuring professionals should assess the economic impact on the company’s business in the event a bankruptcy court were to follow the Buffets Holdings ruling.

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In re Buffets Holdings, Inc., 387 B.R. 115 (Bankr. D. Del. 2008).

In re United Airlines, Inc., 453 F.3d 463 (7th Cir. 2006).

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