Sears, Mall of America and a New Look at Shopping Center Lease Protections

In general, a trustee or debtor in possession may assign a lease if it cures any monetary defaults and provides adequate assurance of future performance by the proposed assignee. If the lease is for space in a shopping center, the lessor enjoys additional protections incorporated into the Bankruptcy Code by the so called shopping center amendments. Two of these provisions were addressed recently in a dispute involving Sears. These were the protections relating to the maintenance of the tenant mix and to the financial condition of the assignee. The crux of the question was what happens when the lease appears to authorize an assignment that the shopping center amendments do not. The answer may surprise you so read on.

Background

Sears was one of the original tenants at the Mall of America and its lease, with extensions, run for 100 years, until 2091. As the district judge noted, “[o]ne wonders whether there will be big box retailing in 2091.” In any event, the Sears lease appears to have many unusual provisions for a big box tenant in a shopping center, likely as a result of the Mall’s desire to lure Sears as an anchor tenant.

Two of the provisions are relevant herein. First, as relevant to the tenant mix provision, the lease required Sears to operate as a retail department store only through 2007. Thereafter, it was allowed to vacate any part of the premises and to sublease some or all of the space without the consent of the landlord. The only condition imposed on an assignment was that the assignee must use the space for any purposes “that are compatible and consistent with (and are not detrimental, injurious or inimical to) the operation of a first-class regional shopping center.” As the court observed, “[the] very broad ‘use restriction’ ... is, of course, virtually meaningless at the Mall of America since [it] includes any legal and non industrial operation that might bring people into Mall of America, for anypurpose.” Thus, “aside from a house prostitution or other criminal  enterprise, this court has had great difficulty imaging any non-industrial use that would not be ‘compatible with and not detrimental’ to [the Mall of America].”

Second, as relevant to the proposed assignee’s financial condition, the lease allowed Sears to assign it provided that the assignee had a net worth or shareholder equity of at least $50 million. Section 365(b)(3)(A), however, requires that the proposed assignee’s financial condition and operating performance shall be similar to the financial condition and operating performance of debtor, here Sears, at the time the lease was entered into.

The Bankruptcy Court’s Ruling

The bankruptcy court approved the assignment. While the proposed assignee was a newly formed entity that intended to market the space to yet unidentified tenants, it held that the tenant mix provision was not violated because the proposed assignee and its intended use did not violate the lease’s use restriction.

As to the proposed assignee’s financial condition, the bankruptcy court concluded that the assignee failed to establish its contention that it had $250 million equity value. That was because the balance sheet on which the assignee relied was marked “draft” and was specifically qualified not to be a basis for any transaction. It went on to conclude that the assignee’s financial condition and operating performance were not similar to that of Sears at the inception of the lease. Yet, the bankruptcy court concluded that “it’s highly likely that the [assignee’s] equity value exceeds $50 million,” which was the test set in the lease for assignments. And because that’s the equity value required by the lease, the bankruptcy court concluded that the financial test was satisfied as well.

The District Court Decision

First, while the court accepted the parties’ stipulation that the Mall of America is a shopping center, the court was not so sure. As the court describes, the mall houses hotels, a miniature golf course, an amusement park, a comedy club, an aquarium, a 2,500 square foot amazing mirror maze, the Crayola Experience which is larger than an NFL football field and a waterpark is under development. Thus, “Mall of America does not look like most ‘shopping centers.’”

Second, the court agreed with the bankruptcy court that the tenant mix provision was not violated. The term tenant mix is not defined in the Bankruptcy Code and the legislative history notes that the shopping center amendments were designed to prevent courts from rewriting the terms of leases to effectuate assignment in bankruptcy. Therefore, the undefined tenant mix term must be interpreted in light of the use restriction contained in the lease. Since the landlord sought adequate assurance of performance in connection with a use restriction which was effectively no restriction at all, the landlord was not entitled to be treated better for assignments in bankruptcy, than outside of bankruptcy: “[Mall of America] is getting the full benefit of what it bargained for back in 1991 insofar as ‘tenant mix’ is concerned. The Bankruptcy Code cannot be read to place the Landlord in a better position that it would have occupied absent the bankruptcy.”

Third, the district court, however, disagreed with the bankruptcy court with respect to the assignee’s financial condition. While the term tenant mix is undefined and thus allows courts more freedom in its application, the Bankruptcy Code is explicit in what is required as the financial condition and operational history of the proposed assignee. Although the Code requires “similar” rather than “identical” financial condition, courts concluded that the test requires proportionally comparable financial health between the assignee and the debtor at lease inception. But here, the assignee failed to satisfy the test as the bankruptcy court concluded that the assignee’s financial condition and operating performance was not similar to that of the 1991 Sears. Next, the bankruptcy court correctly rejected its “proof” as to a $250 million equity value.

But the bankruptcy court’s conclusion that since the assignee met the $50 million equity threshold set by the lease, it met the requirement for having similar financial condition and operating performance to that of Sears in 1991, was rejected by the district court. Regardless of the what the lease provides, it cannot override the specific language of section 365(b)(3)(A). A lease does not “offer a way around a congressionally-mandated standard for providing adequate financial assurance of future lease performance.”

Conclusion

Both courts acknowledged that the financial condition test raised a tough question and one of first impression. They both admitted that they may be wrong. Unfortunately, it is not clear when the case may end up with the Second Circuit since the district court held that the bankruptcy court’s finding that the assignee highly likely has a $50 million equity value was not a factual finding: “’highly likely” doesn’t cut it. Either [the assignee] meets the standard in the Lease … or it does not.”

With the retail downturn expected to be exacerbated by the COVID-19 coronavirus pandemic, a clear guidance on issues critical to assignment of shopping center leases is more important than ever.

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