The Bankruptcy Court for the District of Delaware Holds That Debtors Must Assume or Reject Master Leases as a Whole
In re Buffets Holdings, Inc., No. 08-10141 (Bankr. D. Del. May 16, 2008) (Judge Mary F. Walrath)
The Bankruptcy Court held that Master Leases were integrated and could not be separately assumed and assigned or rejected based on the terms of the Master Leases and the parties’ course of conduct.
Debtors sought approval to assume and assign select non-residential real property leases that were bundled together into master leases. Prior to their bankruptcy filing, the Debtors had entered into a sale/leaseback transaction for twenty-nine restaurants where they owned the building but not the land on which the building stood. The Debtors sold the buildings and assigned their ground leases to FP1 LLC and FP2 LLC (collectively, “FP”). The Debtors then subleased the grounds and buildings back from FP under four master leases (the “Master Leases”). Debtors received approximately $35 million for this transaction. Subsequently, Debtors stopped operating restaurants at three locations under two of the Master Leases and wanted to reject or assume and assign individual leases within the Master Leases. FP opposed Debtors’ motion arguing that the Master Leases were integrated agreements that could not be severed.
The Bankruptcy Court began its analysis by first noting that generally, a debtor has the right to assume or reject an unexpired non-residential real property lease. However, if a debtor decides to assume a lease, it must assume all terms of the lease and thus, accept both favorable and unfavorable terms. The Court also noted that the courts will not enforce lease provisions that are solely designed to inhibit the assignment of the lease and thus, cross-default provisions are suspect. Further, merely structuring multiple leases into one lease document does not mean that it is indivisible. Whether contracts are severable is a question of state law. In this case, the parties agreed that Illinois law governed. Under Illinois law, the intent of the parties determined whether the agreements were severable.
The two Master Leases applicable to this dispute encompassed twenty-one properties. Both Master Leases had two tenants and each underlying lease covered a separate restaurant. Each of the restaurants was operated independently and, pursuant to the lease terms, had to provide separate financial reports to FP. Total rent was wired in one lump sum to FP, but the Master Leases reflected allocation of rent to each underlying restaurant.
In support of their argument that the leases were severable, the Debtors first asserted that the apportionment of rent to each of the underlying restaurants demonstrated that the Master Leases were severable. The Court, however, disagreed with this argument. Instead the Bankruptcy Court noted that apportionment of rent was only one factor to consider when determining the parties’ intent. The Debtors also argued that (i) FP’s ability to divide and consolidate individual leases and create new Master Leases; (ii) FP’s right to sell the underlying property resulting in the severance of that property from the Master Lease; (iii) the Debtors’ right to substitute another property in the Master Lease if one property is condemned; and (iv) the Debtors’ ability to substitute or assign individual leases with FP’s consent all demonstrated the parties’ intent that the Master Leases were severable. FP countered contending that all of these provisions either required its consent or were exercisable only by FP and thus, showed that the leases were integrated. The Bankruptcy Court agreed with FP, concluding that allowing severability in only limited circumstances actually demonstrated that the parties intended to create an integrated agreement.
The Debtors next argued that the conduct of the parties proved the leases were severable. Prior to filing the bankruptcy petition, Debtors negotiated with FP to substitute a lease for an underperforming restaurant with a better performing one. FP agreed to the substitution. FP asserted that rather than proving that the leases were divisible, the fact that Debtors sought its permission showed that Debtors did not have the power under the Master Leases to sever individual leases. The Bankruptcy Court agreed with FP’s analysis on this point, noting that if the leases were severable, it was unlikely that Debtors would have negotiated to substitute a lease.
FP also pointed to provisions in the Master Leases to support its theory that the Master Leases were integrated. First, each individual tenant was liable for the total rent. Second, the total rent due was not reduced if one or more properties were destroyed or unable to be used. Third, after the Master Leases expired, they could only be extended if all of the ground leases under the respective Master Leases were extended. Finally, if there was a default on an individual lease, FP could treat it as a default of the entire Master Lease. The Debtors argued that these provisions were simply cross-default provisions and therefore, unenforceable. The Bankruptcy Court reasoned that if the leases were severable, it was more likely that the Master Leases would have limited FP to exercising remedies on default to only the defaulting properties rather than to all of the properties under the Master Lease. The Court therefore held that the individual leases consolidated into the two Master Leases were economically interdependent, and to allow severability would be to destroy the fundamental nature of FP’s bargain.
The Debtors offered cases holding that a master lease for separate properties was severable. The Bankruptcy Court distinguished these cases noting that none of them involved a debtor who, after entering into a lease, bundled them in order to monetize them. The Court reasoned that many of the cases cited by the Debtors involved the original landlord and it was reasonable in those cases to hold that the landlords viewed each lease as a separate contract. However, the Court differentiated this case because the Debtors entered into the sale/leaseback agreement in which the leases were bundled to restrict the exercise of rights by individual tenants in exchange for $35 million. Thus, the Court concluded the parties’ intent that the Master Leases were integrated was clear from the face of the agreements.
The Bankruptcy Court further concluded that it was also clear from the parties’ negotiations that the use of a Master Lease, with its joint and several liability between the tenants, was a key element of the agreement. The Debtors had wanted separate leases, but testimony demonstrated that FP would not enter the deal without structuring it as master leases. The Debtors argued that this testimony could not be used to prove a self-serving proposition. However, the Bankruptcy Court noted that FP’s testimony was convincing because there was no reason for FP to enter into separate lease transactions because FP was not the original lessor.
Debtors finally contended that rather than representing one integrated agreement, the leases were only bundled to allow FP to securitize them. Because this purpose was never accomplished, the Debtors argued that the consolidated structure of the deal should be overlooked. The Bankruptcy Court disagreed and concluded that the leases were consolidated to permit Debtors to monetize the leases and to limit FP’s risk of not being repaid. FP analyzed the bargain based on the average of the terms of the leases and the total rent paid under the Master Lease, and such risk analysis was part of basis for the parties’ bargain.
Thus, the Debtors were not permitted to assume and assign or reject individual leases. Rather, the Debtors had to assume or reject each of the Master Leases as a whole.
The order entered in connection with this opinion has been appealed.
