• Appeal of Assumption and Assignment Order Rendered Moot Absent a Stay Pending Appeal
  • June 1, 2005
  • Law Firm: Weil, Gotshal & Manges LLP - New York Office
  • In Weingarten Nostat, Inc. v. Service Merchandise Co., the United States Court of Appeals for the Sixth Circuit held that where a chapter 11 debtor sells lease designation rights to a third party and later assumes and assigns a lease to an assignee designated by that third party, the assignment is part-and-parcel of the original "sale" and subject to the bankruptcy "mootness" provision found in section 363(m) of the Bankruptcy Code. In this case, the Sixth Circuit concluded that since section 363(m) of the Bankruptcy Code applied, the appeal must be dismissed as moot where a stay of the sale at issue pending appeal was not obtained.

    Sections 363(m) and 365 of the Bankruptcy Code

    Section 363(m) of the Bankruptcy Code is often referred to as the "statutory" or "bankruptcy" mootness provision. Section 363(m) provides that an appeal from an order authorizing the sale or lease of a debtor's property will not affect the validity of the sale or lease to an entity that purchased or leased the property in good faith, unless a stay of the sale is obtained pending appeal. This provision provides protection to good faith purchasers by shielding these purchasers from litigation. Moreover, this protection benefits the estate because the reliability of bankruptcy sales should encourage entities to participate in bankruptcy sales and ultimately increases the value of assets sold in bankruptcy.

    Section 365 of the Bankruptcy Code governs the assumption and assignment of executory contracts and unexpired leases. Pursuant to section 365, a debtor may assume and assign an unexpired lease of real property but an assignee of a shopping center lease is required to provide a landlord with adequate assurances of future performance under the lease. Section 365 has no provision analogous to section 363(m) to protect good-faith lease assignees.

    There is a split in the circuits as to whether section 363(m) of the Bankruptcy Code creates a per se rule mooting appeals of orders authorizing sales transactions consummated pursuant to section 363 absent a stay of the sale at issue. A majority of circuit courts, including the United States Courts of Appeal for the First Circuit, Second Circuit, Fifth Circuit, Ninth Circuit (with one exception), Eleventh Circuit and D.C. Circuit follow the per se rule, automatically mooting appeals absent a stay of the sale or lease. The United States Court of Appeals for the Third Circuit, however, has held that the failure to obtain a stay pending appeal is not necessarily dispositive so long as a remedy can be fashioned that does not disturb the validity of the sale itself. Prior to the Weingarten case, the Sixth Circuit had not addressed the issue. Under the facts in Weingarten, however, the Sixth Circuit did not adopt a per se rule because the governing facts of the case required dismissal of the appeal.

    Background

    In March 1999, Service Merchandise Company, Inc. ("Service Merchandise") filed for chapter 11 protection. In connection with the liquidation of its assets, Service Merchandise sold the rights to designate an assignee for most of its real property and retail leases to KLA/SM LLC ("KLA") for approximately $116.4 million. One of the affected leases was Service Merchandise's shopping center lease in the Argyle Village Square Shopping Center in Jacksonville, Florida.

    Weingarten Nostat, Inc. ("Weingarten") was the owner of the Argyle Village Square Shopping Center. Weingarten's predecessor-in-interest had entered into the lease with Service Merchandise, which was set to expire in 2010, with a series of five-year options that could extend the lease through the year 2040. The lease contained only loose restrictions on assignment, sublease and use.

    Years later, Weingarten entered into a lease with Jo-Ann's, Etc. for a store in the same Argyle Village shopping center. The lease to Jo-Ann's, Etc. contained a provision that gave Jo-Ann's, Etc. the option of reducing its rent by one-third or terminating the lease if another store selling arts and crafts similar to those sold by Jo-Ann's, Etc. moved into the shopping center.

    Ultimately, KLA designated JLPK LLC ("JLPK") as the assignee of Service Merchandise's lease. JLPK had agreed to pay KLA $300,000 for designating it as the assignee of the Argyle Village lease, with the intention of simultaneously subleasing the property to Bed Bath & Beyond and Michaels Stores, Inc. ("Michaels"). Pursuant to its agreement with KLA, Service Merchandise notified Weingarten of the proposed assumption of the lease, the assignment to JLPK, and the simultaneous subleases to Bed Bath & Beyond and Michaels. Recognizing that Michaels (a store that also sells crafts) competes with Jo-Ann's, Etc., Weingarten objected to the assumption and assignment of the Service Merchandise lease and claimed that Michaels failed to provide Weingarten with adequate assurance of future performance under the lease.

    Weingarten argued that Service Merchandise could not meet the heightened requirements of section 365(b)(3) of the Bankruptcy Code, the provision requiring the assignee of a shopping center lease to provide the landlord with specific assurances of future performance under the lease, because: (i) JLPK's operating history and financial performance were not similar to the debtor's at the time the lease was originally consummated; (ii) the proposed assignment and sublease breached the lease with Jo-Ann's, Etc., and (iii) the proposed assignment and sublease would disrupt the tenant mix or balance of the shopping center. Although the bankruptcy court originally agreed with Weingarten and rejected the assignment and sublease transaction, the bankruptcy court ultimately approved the assumption and assignment of the lease to JLPK after JLPK offered a limited guarantee of one year's base rent.

    Although Weingarten sought a stay of the bankruptcy court's order pending appeal, his efforts were denied by the district court and Sixth Circuit. In denying the motion for a stay pending appeal, the district court found that Weingarten failed to show a likelihood of success on the merits. The Sixth Circuit then denied Weingarten's motion for an emergency stay of the bankruptcy court order on similar grounds.

    In the meantime, Service Merchandise assumed and assigned its Argyle Village Lease to JLPK, who then subleased the property to Michaels. Upon taking possession of the premises, Michaels invested money in reconfiguring the space and celebrated a grand opening of the store.

    Weingarten subsequently filed a motion for reconsideration of the district court's decision to deny the stay pending appeal which was denied by the district court. Weingarten also appealed the district court's order affirming the assumption and assignment of the lease. Service Merchandise moved to dismiss the appeals as moot under section 363(m) of the Bankruptcy Code.

    The Sixth Circuit's Decision

    The Sixth Circuit determined that Weingarten's appeal of the bankruptcy court's order approving the assumption and assignment of the Argyle Center lease was rendered moot by operation of section 363(m) of the Bankruptcy Code. In reaching its decision, the Sixth Circuit found that "the relief sought by Weingarten would have disturbed the validity of the A4363 sale and assignment" and thus, Weingarten's failure to obtain a stay pending appeal required a dismissal of the appeal.

    The Sixth Circuit noted the express purpose of section 363(m), to encourage participation in bankruptcy sales and increase the value of a debtor's assets by protecting good faith purchasers from modification by an appeals court of the bargain struck with the debtor. It also noted the more general consideration that an appeal must be dismissed as moot when, by virtue of intervening events, the court of appeals cannot fashion effective relief. The court concluded that "[t]he absence of a stay requires dismissal in this case under A4363(m), notwithstanding the fact that A4363(m) applies only to a sale or lease of property under A4363, and does not explicitly extend to lease assignments under 11 U.S.C. A4365, which governs executory contracts and leases in bankruptcy."

    Although the court concluded that section 363 of the Bankruptcy Code does not explicitly extend to lease assignments, the court reasoned that the assignment of a lease, which is property of the estate, for valuable consideration, is a "sale" of property to which the mootness provision of section 363 applies. The court found the underlying transaction in question was the "sale" of Service Merchandise's designation rights to KLA. The subsequent designation of an assignee by KLA was simply an act in furtherance of the original sale transaction. The Sixth Circuit reasoned that although the transaction involved two steps, the assignment of the lease to JLPK was part of a single transaction for which a stay pending appeal is required to prevent the dismissal of an appeal as moot.

    Weingarten advanced a further argument, that the court, before dismissing an appeal as moot, must determine the validity of the assignment. The Sixth Circuit rejected this argument because Weingarten did not challenge Service Merchandise's ability to assign the lease, only the proposed adequate assurances. According to the court, accepting "Weingarten's argument would rob A4363(m) mootness of its force" and the merits of Weingarten's appeal were resolved when the stay motions were denied.

    Conclusion

    The decision in Weingarten, which extends the protections of section 363(m) of the Bankruptcy Code to the assignment of a lease agreement, stands as a strong reminder to creditors or landlords that in order to survive a motion to dismiss an appeal of an order approving the assignment of a lease (which constitutes a "sale"), a stay of the sale order pending appeal must be obtained. Otherwise, the appeal, in a majority of jurisdictions, will be rendered "statutorily" moot by section 363(m) of the Bankruptcy Code.