In In re Pazzo Pazzo, Inc., Judge John K. Sherwood of the United States Bankruptcy Court for the District of New Jersey (Newark) held that the pre-petition termination of a buyback option pursuant to the terms of a real estate lease which contained the option did not constitute a fraudulent transfer under §548 of the U.S. Bankruptcy Code. While this may sound like common sense, the decision actually required the bankruptcy court to do some analysis and reconcile what appeared to be several contrary decisions.
Pazzo involved a restaurant operator – Pazzo Pazzo, Inc. (Pazzo), and the former owner of the premises, Berley Associates, Ltd. (Berley), who both filed Chapter 11 in the hopes of reviving a restaurant lease and the former owner’s option to buy back the restaurant premises. Speedwell Ventures (Speedwell) was the assignee of the entity that purchased the property from Berley and leased it to Pazzo. The lease contained an option allowing Berley to repurchase the property. Following Pazzo’s default, Speedwell sent a written termination of the option. Speedwell then sold the property to a third party subject to the option and commenced an adversary proceeding to declare the lease terminated and that the termination of the option pre-petition was proper.
In defending the lawsuit, Berley filed a counterclaim against Speedwell and crossclaim against the purchaser alleging that the termination of the purchase option was a fraudulent conveyance voidable under §548 of the U.S. Bankruptcy Code. Under §548, a trustee (or debtor in possession, in this case) can avoid a transfer of a debtor’s property that occurred within two years of the petition date if the debtor (1) did not receive “reasonably equivalent value” for the property transferred and (2) was insolvent at the time of the transfer or rendered insolvent by the transfer. Berley argued that the value of the options at the time of its termination was more than $1 million, that it received no consideration for the termination and that the termination rendered it insolvent. The prior and current owners countered by claiming that the termination of a contract by operation of law is not a “transfer” of property for fraudulent conveyance purposes.
In ruling that the termination of the option was not a “transfer” for fraudulent conveyance purposes, Judge Sherwood clarified a split among the courts (including bankruptcy courts in New Jersey) that a “pre-petition termination of a contract pursuant to its terms and consequent cessation of a debtor’s rights under a contract does not constitute a transfer for fraudulent conveyance purposes.” In making this ruling the bankruptcy court determined that “[p]ossession of expired rights is the equivalent of no rights. When a termination is pursuant to the terms of the contract there is no transfer.” In addition, the court also acknowledged the significance of contract rights in the real estate marketplace and the uncertainty which would ensue if contract rights properly terminated could be unwoven.
Bankruptcy can be a powerful tool for debtors, and while it provides some ability to alter the rights of parties to a contract, it does have its limits. And as noted above, sometimes what seems like common sense may not be the case.