Opinion
Case No. 01-72167-DHA, Chapter 11
January 9, 2002
MEMORANDUM OPINION AND ORDER
This matter comes before the Court on Plaintiffs Motion for an Order Under Section 365 (a) of the Bankruptcy Code and Federal Rule of Bankruptcy Procedure 6006 Authorizing and Approving the Assumption of a Certain Nonresidential Real Property Lease ("Motion to Assume") and Ramco-Gershenson, Inc.'s Objection to Debtor's Motion for an Order Under Section 365 (a) Authorizing the Assumption of the Lease for Store No. 611 and to Deem the Crofton Lease Rejected ("Objection"). This is a core proceeding over which this Court has jurisdiction under 28 U.S.C. § 157 (b)(2) and 1334 (b). Venue is proper pursuant to 28 U.S.C. § 1408 and 1409.
FINDINGS OF FACT
Trak Auto Corporation ("debtor") filed a voluntary petition under Chapter 11 of Title 11 of the United States Code on July 5, 2001. Debtor remains in possession and control of its auto parts supply business and assets pursuant to 11 U.S.C. § 1107. Debtor has retail locations in eastern Virginia, the District of Columbia, Maryland, Illinois, Wisconsin, and Pennsylvania. Distribution centers for debtor are located in Illinois and Maryland, and debtor has offices in Michigan and Maryland. When this petition was filed, debtor operated approximately 196 retail locations in the referenced states. Since the filing, debtor has decided to liquidate its "Chicago Market" stores and to focus its reorganization efforts on the "Metro Market" which encompasses the metropolitan District of Columbia area, Maryland and Virginia.
Ramco-Gershenson ("Ramco") is the managing agent for the landlord of debtor's Store #611, located in Crofton, Maryland. Debtor currently occupies approximately 6,400 square feet of the 30,000 square feet of retail space it leases in Store #611. Approximately forty years remain on this lease, consisting of a series of five year options. of the 30,000 square feet in Store #611 for which debtor is obligated to pay rent to Ramco's principal, almost 24,000 square feet of retail space remains unoccupied. Debtor seeks to retain all 30,000 square feet by its motion with hopes of subletting its unoccupied space and does not plan to expand the size of this particular store.
Debtor did not assume this lease before the § 365 (d)(4) assumption deadline but filed a motion to assume the lease on September 27, 2001, which gives rise to this controversy. Although debtor's motion to assume was not heard before the expiration of the § 365 (d)(4) deadline on October 4, 2001, this Court has already issued an opinion regarding other landlords' sites, where we found that such a motion need not be heard before the assumption deadline passes, but need only be filed before such a deadline has expired. In re Trak Auto Corp., No. 01-72167 (Bankr. E.D. Va. Dec. 17, 2001). We find that as to Ramco, the same rule applies. Debtor's Motion to Assume and Ramco's Objection were heard by this Court on November 5, 2001.
CONCLUSIONS OF LAW
Under § 365 of the Code, "the trustee, subject to the court's approval, may assume or reject any executory contract or unexpired lease of the debtor." 11 U.S.C. § 365 (a). The issue for this Court is whether debtor's proposed assumption of the lease complies with § 365.
The traditional test courts use to evaluate a debtor's decision to assume an unexpired lease is that of business judgment. N.L.R.B. v. Bildisco and Bildisco, 465 U.S. 513 (1984). In other words, the Court must examine the contract that is to be assumed or rejected and analyze the debtor's exercise of its business judgment to determine if the proposed assumption or rejection is in the best interests of the estate. See In re Gateway Apparel, Inc., 210 B.R. 567, 570 (Bankr. E.D. Mo. 1997). While this review of debtor's proposal is highly deferential to debtor's wishes, the Court must also consider all of the circumstances surrounding any particular lease assumption or rejection. This analysis, as the Court in In re Gateway Apparel, Inc., stated:
As stated by the Fourth Circuit, the rule is that "courts should defer to — should not interfere with — decisions of corporate directors on matters entrusted to their business judgment except upon a finding of bad faith or gross abuse of their `business discretion.'" Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1047 (4th Cir. 1985). Further, the Court noted that the business judgment standard "requires that the decision be accepted by courts unless it is shown that the bankrupt's decision was one taken in bad faith or gross abuse of the bankrupt's retained business discretion." Id.
must include a consideration of the effects that assumption would have on the debtor; the implications for the lessor; the benefit or detriment to unsecured creditors; and the significance of the lease to the debtor's reorganization.
Id. Another Court in this District has placed particular emphasis on evaluating the impact a lease assumption may have on the unsecured creditors. See In re Washington Capital Aviation Leasing, 156 B.R. 167, 172 (Bankr. E.D. Va. 1993) ("[I]n deciding whether or not to allow a debtor to assume a lease the court must not only consider the impact on the other party to the lease but also potential detriment to unsecured creditors who would be subordinated to the payment of damages resulting from any postassumption breaches.") Judge Tice, in In re Washington Capital Aviation Leasing, termed the review of the impact on unsecured creditors as "part and parcel of the traditional business judgment test" that is used in evaluating debtor's motion to assume or reject an unexpired lease. Id.
Some courts, however, review only debtor's business judgment and whether debtor's assumption or rejection will benefit the estate without considering the impact of the assumption or rejection on any other constituencies. See, e.g., in re Wheeling-Pittsburgh Steel Corp. V. West Penn Power Co. (In re Wheeling-Pittsburgh Steel Corp.), 72 B.R. 845, 847 (Bankr. W.D. Pa. 1987) ("The burden that rejection may visit upon other entities is not a material fact to be considered by the court under the business judgment test."). To the contrary, this Court believes the better reasoned view is to evaluate debtor's business judgment by considering the impact of debtor's decision on a variety of parties as well as the impact on debtor's estate; i.e. a judicial review of the totality of the circumstances surrounding the debtor's proposal relative to a particular lease.
The weight the other parties and interests receive as part of a court's evaluation of debtor's business judgment has taken a variety of forms. See, e.g., In re Washington Capital Aviation Leasing, 156 B.R. at 172; Chi-Feng Huang v. Pierce (In re Chi-Feng Huang,), 23 B.R. 798, 801 (B.A.P. 9th Cir. 1982) ("The primary issue is whether rejection would benefit the general unsecured creditors. This may involve a balancing of the interests."); Sundial Asphalt Co., Inc. v. V P.C. Investors Corp. (In re Sundial Asphalt Co., Inc.), 147 B.R. 72, 81-82 (E.D.N.Y. 1992) ("The `business judgment' test as envisioned by the Second Circuit . . . leaves room for the court to consider as a factor in approving the rejection of a contract for the sale of real property the rights of vendees and other affected parties."); In re Patterson, 199 B.R. 59, 61 (E.D. Pa. 1990) ("[T]he bankruptcy court is clearly entitled to consider the benefit to the estate in general."); In re Valley View Shopping Ctr., L.P., 260 B.R. 10, 39 (Bankr. D. Kan. 2001) (The determination of whether debtor may assume a lease "must include a consideration of the effects that assumption would have on the debtor; the implications for the lessor; the benefit or detriment to unsecured creditors; and the significance of the lease to the debtor's reorganization."); In re Gateway Apparel, Inc., 210 B.R. 567, 570 (Bankr. E.D. Mo. 1997) (same); In re Huff, 81 B.R. 531, 538 (Bankr. D. Minn. 1988) (citing the balancing test of In re Chi-Feng Huang); In re Meehan, 46 B.R. 96, 101 (Bankr. E.D.N.Y. 1985) ("[T]he `business judgment' test . . . leaves room for the court to consider as a factor . . . the rights of vendees and other affected parties."); and In re Air Vermont, Inc., 40 B.R. 61, 63 (Bankr. D. Vt. 1984) ("The Court in reviewing the `business judgment' as to acceptance or rejection, must further consider the substantive agreement; the subject matter of the agreement and its necessity to the debtor; and, the implications of such acceptance or rejection.").
Even though the impact of debtor's business judgment in whether to assume or reject a lease is felt to the greatest extent by the unsecured creditors, this Court finds that several factors must be examined in determining whether debtor is exercising sound business judgment. Thus, we adopt the four primary factors used to review debtor's business judgment as set forth in In re Gateway Apparel, Inc., 210 B.R. 567 and In re Valley View Shopping Center, L.P., 260 B.R. at 39: (1) the effect of debtor's proposed assumption or rejection upon debtor's estate; (2) how the lessor is impacted by the assumption or rejection of its lease; (3) whether any benefit or harm to the unsecured creditors arises from the assumption or rejection of the subject lease; and (4) the significance of the lease to debtor's overall reorganization efforts.
Ultimately, this Court finds that it is not in the best interests of the debtor's estate to assume the lease for Store #611. While the Director of Real Estate for debtor testified that the assumption of this lease could benefit the estate (Transcript of Proceedings ("Tr.") at 21), this Court finds that debtor's testimony was highly speculative and the risk to unsecured creditors of a large administrative rent claim outweighs the extremely marginal profit which this store location brings into debtor's automotive parts enterprise.
Debtor's evidence shows that if this lease is assumed and debtor is responsible for the full rent payments on the site (all 30,000 square feet), the profit of Store #611 drops to approximately $775 per month. Transcript of Proceedings ("Tr.") at 13. This same profit level would be achieved on this store until the build-out of the remaining 24,000 square feet of space is completed for a new subtenant, a process that may take at least eleven months. Tr. at 24. This Court notes that this small profit level does not even account for the cost of construction to make the space suitable for the sublessee — a cost that will likely be borne by debtor. Further, if debtor's sublessee defaults on its rental obligations, debtor would ultimately be responsible for that default and all future rents for the entire space, eliminating debtor's profit on this store.
A. Effect Upon Debtor's Estate
In examining the impact on debtor's estate of the continued operation of the Crofton site, this Court must rely on the evidence adduced at the hearing on this matter. This process is one which is necessarily factually driven and site specific.
When debtor filed its motion to assume the Ramco lease, it had a "firm offer" to sublet the remaining 24,000 square feet of space left in its leased site. Debtor's Motion to Assume ¶ 8. However, at the hearing on this motion, debtor's witness testified that its "firm offer" never materialized into a binding commitment by the proposed sublessee. Tr. at 15 ("To my knowledge, the deal [for the sublease of the remaining space] just never transpired. I don't know for what reason."). Further, debtor's witness testified to a number of remaining options it was pursuing for the subletting of the extra space in Store #611. Tr. at 14-15. of those subleasing options which debtor's witness explained during the hearing on the matter, Ramco's witness testified that the landlord would not approve any of the proposals that debtor's leasing representative set forth on the record. Tr. at 44. Without the landlord's permission for the construction required to sublease the space, debtor would be in violation of its lease terms, which this Court cannot condone or authorize. See Exhibit A of Ramco-Gershenson at 44 (lease agreement with landlord assumed by debtor) (hereinafter "Lease"). Thus, faced with no permissible sublessee ready and willing to occupy the remaining 24,000 square feet of debtor's space, it could not possibly be in the best interests of the estate to approve the assumption of this lease when the store has such tenuous profit levels absent a sublessee.
Another indicator of the impact of the lease assumption on debtor's estate is the lack of certainty of debtor's plans for the site and how those items that remain uncertain may harm debtor's estate. Wholly speculative plans by the debtor where the risk of harm lands on debtor's estate will not be approved by this Court.
In this case, Debtor's testimony regarding the other tenants it had been negotiating with for this extra space are also indicative of how speculative debtor's plans are at this stage of its reorganization. While this Court must give due deference to debtor's business judgment, this Court may not approve the assumption of a lease premised on hypothetical tenants and subleasing arrangements. See In re Huff 81 B.R. at 538 (In rejecting debtor's business judgment, Court noted that debtor has "produced such sparse evidence to support [its business judgment] that it is clear they are only speculating. . . ."). Debtor's witness stated on the record "[r]ight now we're speculating what could possibly happen with this space." Tr. at 39 (emphasis added). Such speculation cannot possibly be said to comprise sound business judgment for a debtor struggling to reorganize its business.
At the time of the hearing, debtor had failed to pay the lease obligations at most of its store locations. Debtor had also not paid its real estate tax and common area maintenance (CAM) obligations at most of the locations. A review of debtor's operating reports indicates that this debtor has been and continues to be financially strapped. Debtor hopes its operations will become profitable by closing down its "Chicago Market" locations and focusing in on the "Metro Market" locations which would include the site at issue in this proceeding. Debtor's defaults on payments at this location and several others are evidence of debtor's precarious financial position. This Court will not approve the assumption of a lease where the impact on debtor's estate ultimately may be devastating.
Although debtor's plans to close its "Chicago Market" are not speculative because this Court has approved the retention of an asset liquidator for that region, debtor's plans to return its "Metro Market" to profitability are positively not certain. While absolute certainty is not required of debtor's plans, some additional evidence, possibly in the form of economic forecasts, may have aided debtor in seeking this Court's approval of its motion in this instance.
Another negative impact on debtor's estate would arise from the assumption of the Ramco lease in the form of high build-out costs for a sublessee. Debtor's witness testified that many of the parties with which it had discussed subleasing required debtor to absorb the costs of making the remaining 24,000 square feet suitable for its sublessee's needs. Tr. at 24-26 This would include building walls, adding utility service to the site, and many other costs peculiar to a specific subtenant. Tr. at 24-26. Not only has Ramco indicated that some of the construction may be a violation of debtor's lease, Tr. at 47, but debtor would have to fund this construction with new loans. An increase in debtor's debt load does not benefit the debtor's bankruptcy estate; rather, it serves to further burden the debtor.
From the evidence produced at the hearing on this matter, debtor has not shown that the assumption of the Ramco lease will benefit its bankruptcy estate.
B. Impact on the Lessor
Little evidence was introduced at the hearing on this matter regarding the impact the lease assumption or rejection will have upon Ramco or its principal. The witness for Ramco stated that, of the proposed subleases mentioned during the hearing and the information it had regarding those proposals, it would not approve any of the subletting arrangements being pursued by debtor. Tr. at 44. Ramco's witness testified that a much higher rental rate may be achieved if the lease is rejected. Tr. at 55. However, such a consideration is not sufficient to overturn debtor's assumption of the lease as Ramco would be bound by the terms of its bargain if the lease were assumed. Thus, this Court is unable to establish with any certainty the true impact on the lessor if this lease is assumed versus rejected. Ramco would be negatively impacted by the assumption of this lease its the debtor continues to default in paying the rent due. The debtor cannot offer adequate assurance of future performance under the lease.
C. Impact on the Unsecured Creditors
Another factor that this Court must consider is the impact of debtor's assumption of this lease on its unsecured creditors. Should debtor assume this lease, it would be liable for the build-out costs and the entire monthly rental obligation at this site regardless of whether it occupies the whole space or another occupies a portion of the space with the debtor. See Lease at 17-18. The same holds true even if debtor enters into a sublease arrangement with another entity that has the landlord's approval for the associated build-out. Lease at 17-18. Should any sublessee default on its rental obligations, debtor would then be left paying the bill for the entire space. Such arrearages could quickly amount to a large administrative rent claim by this landlord on debtor's estate. Given debtor's monthly rental and CAM charges, a year of rent at this location is approximately $120,800. Exhibit B of Ramco-Gershenson. The administrative rent claim would thus reduce the recovery obtained by the unsecured creditors. The risk of this large expense to be borne by the unsecured creditors is too high for this Court to approve debtor's proposal to assume the lease for Store #611.
D. Importance of this Location to the Success of Debtor's Overall Reorganization
Neither debtor or Ramco presented evidence regarding the significance of Store #611 to the success of debtor's reorganization. Debtor claims the store will be profitable if the lease is assumed, yet this site's profitability levels will only increase if it can find a suitable subtenant. See Tr. at 10, 13. As stated above, debtor's speculative propositions of finding a sublessee are not the basis of sound business judgment and cannot be the foundation on which this Court would find that this store is necessary to debtor's reorganization efforts. Without a sublessee, this store generates such marginal profit as to be of little value to debtor's estate. Store #611 does not enhance debtor's estate and debtor has many other locations in the "Metro Market" where it can focus its reorganization efforts that presumably are much more profitable than this site. This Court simply lacks any evidence by which it can determine the relative value of this store to the debtor's reporganization plans to operate in the "Metro Market".
CONCLUSION
Debtor has stated that its business judgment calls for it to assume the Ramco lease. However, debtor has not provided sufficient evidence to show that Store #611 would in fact benefit debtor's estate such that assumption of the Ramco lease can be deemed by this Court as the exercise of sound business judgment. From the evidence debtor did provide for this Court, we find that it would not be a sound exercise of business judgment for debtor to assume the Ramco lease. Therefore, the debtor's Motion to Assume the Ramco lease is hereby DENIED and the Ramco Objection is SUSTAINED.
IT IS SO ORDERED.