Fifth Circuit Holds Debtor’s Alleged Bad Faith Dealings Do Not Negate Business Judgment Deference on Lease Rejection

Background

This case arises out of a dispute between J.C. Penney Properties, Inc., as predecessor in interest to J.C. Penney Corporation, Inc. (“JCP Properties”), and Klairmont Korners, LLC (“Klairmont”) regarding a ground lease and related sublease for commercial real estate (respectively, the “Lease” and the “Sublease”). JCP Properties acted as a pass-through entity between the landowner (the “Landlord”), who leased the property to JCP Properties, and Klairmont, who subleased the property from JCP Properties. This pass-through arrangement provided no value to JCP Properties as the amounts payable by Klairmont to JCP Properties were identical to the amounts payable by JCP Properties to the Landlord.²

On May 15, 2020, JCP Properties and certain affiliates in the J.C. Penney corporate family (collectively, “JCP” or the “Debtors”), filed a petition for relief under chapter 11 in the United States Bankruptcy Court for the Southern District of Texas (the “Bankruptcy Court”).³ Following a marketing process, the Bankruptcy Court authorized JCP’s entry into an Asset Purchase Agreement (the “APA”) with a buyer (the “Buyer”), pursuant to which the Buyer would purchase substantially all of JCP’s assets as a going concern.⁴ In addition, under the APA, the Buyer had the right to make the final decision as to which leases JCP would assume and which leases JCP would reject through the bankruptcy process.

Initially, JCP proposed to assign the Lease to Klairmont for $1 million, and Klairmont countered with $100,000. Following JCP’s rejection of Klairmont’s counteroffer, JCP engaged a real estate agent who told Klairmont that JCP had received a higher offer, though no other offers were on the table at that time, thereby causing Klairmont to increase its offer to $1.25 million. Thereafter, the real estate agent brokered a partnership between an investor and the Landlord, which collectively offered to pay JCP $1.7 million to reject the Lease (after which, the investor and Landlord planned to sell the property). After hearing they had been outbid, Klairmont attempted to raise its offer to $2 million, and later $3 million (though “[a]ny Klairmont offer would require [JCP/Buyer] to remain in a middleman position, risking Klairmont’s default down the road (as many as 50 more years)”).⁵ However, the Buyer instructed JCP to accept the investor and Landlord’s offer.  Abiding by the terms of the APA, JCP followed the Buyer’s instructions and filed a motion to reject the Lease.

The Bankruptcy Court granted JCP’s motion to reject the Lease,⁶ which Klairmont appealed.⁷ The United States District Court for the Southern District of Texas affirmed the rejection, finding that notwithstanding Klairmont’s $3 million offer, JCP exercised sound business judgment in deciding to comply with the Buyer’s instruction to accept $1.7 million and reject the Lease given the “competing concerns, which involved much more than the $3 million Klairmont offered” in light of the fact that “the amount of money being offered was inconsequential to JCP” because “proceeds from the deal would benefit” the Buyer and given that rejection was “part of the entire Chapter 11 Plan and sale of all the assets as a going concern.”⁸ Thereafter, Klairmont filed the instant appeal to the Fifth Circuit.⁹ On appeal, and relying on non-Fifth Circuit authority, Klairmont argued that JCP’s decision to reject the Lease should not be given deference under the business judgment standard because JCP showed “bad faith, whim, or caprice” in its negotiations with Klairmont.

Fifth Circuit’s Opinion

The Fifth Circuit began by rejecting Klairmont’s interpretation of the business judgment standard and laying out the deferential standard by which courts are to review a debtor’s decision to assume or reject executory contracts and unexpired leases under section 365 of the Bankruptcy Code. Under the deferential business judgment standard in the Fifth Circuit, “as long as assumption of a lease appears to enhance a debtor’s estate, a bankruptcy court should only withhold approval when the debtor’s judgment is clearly erroneous, too speculative, or contrary to the provisions of the Bankruptcy Code.”¹⁰ Acknowledging that a decision to reject may harm other parties’ interests, the Fifth Circuit emphasized that “[t]he correct inquiry under the business judgment standard is whether the debtor’s decision regarding executory contracts benefits the debtor, not whether the decision harms third parties.” The Fifth Circuit recognized that bad faith dealing on the part of JCP’s real estate agent put Klairmont at a disadvantage when negotiating for assignment of the Lease;¹¹ however, such bad faith does not overcome the deference afforded to JCP’s decision to reject the Lease¹² under the business judgment standard.

In dicta, the Fifth Circuit noted that even under the test from another circuit that Klairmont proposed the Fifth Circuit adopt, the outcome would not change, because those courts also focus on the “benefit to the debtor, not bad faith affecting third parties.” Specifically, and contrary to Klairmont’s argument, the cases on which Klairmont relies frame the issue as “whether the decision of the debtor that rejection will be advantageous is so manifestly unreasonable that it could not be based on sound business judgment, but only on bad faith, or whim or caprice.”¹³

Key Takeaways

In the Fifth Circuit, a debtor properly exercises its business judgment to reject an executory contract or unexpired lease so long as the debtor’s decision to reject enhances the bankruptcy estate and is not clearly erroneous, speculative, or otherwise contrary to the Bankruptcy Code.  Any adverse effect on the interests of other parties, whether caused by bad faith dealings or otherwise, will not render such decision improper under the deferential business judgment standard.

1 In re J.C. Penney Direct Mktg. Servs., L.L.C., 22-40371, 2022 WL 5240654 (5th Cir. Oct. 6, 2022).  The Fifth Circuit issued its mandate affirming the District Court on October 28, 2022.

2 Klairmont Korners, LLC, No. 2:21-CV-00139, 2022 WL 2136902, at *2 (S.D. Tex. June 10, 2022).

3 J.C. Penney Direct Mktg. Servs., 2022 WL 5240654, at *1.

4 Klairmont Korners, 2022 WL 2136902, at *2.

5 Id. at *6.  JCP anticipated a fight between the Landlord and Klairmont over adequate assurance if it accepted Klairmont’s offer but “did not want to be in the position of providing adequate assurance that the [Sublease] would continue to be paid and it did not have any assets earmarked to fund litigation over the matter.”  Id. at *4.  And the Buyer “had no interest in buying trouble.”  Id.

6 The District Court states that JCP originally “sought rejection of both the [Lease] and [Sublease]” (id. at *6); however, JCP originally only sought rejection of the Lease, which it argued would result in termination of the Sublease by virtue of JCP losing its rights under the Lease.  See Debtor’s Motion for Entry of an Order (I) Approving Rejection of Ground Lease, (II) Terminating Sub-Ground Lease, and (III) Granting Related Relief, In re J.C. Penney Company, Inc., No. 20-20182 (Bankr. S.D. Tex. Mar. 9, 2021), No. 2732.  The District Court correctly states that “the request for relief on the [Sublease] was withdrawn (with the chips to fall where they may).”  Klairmont Korners, 2022 WL 2136902, at *6.  The issue of Klairmont’s rights, if any, as sublessee under section 365(h) of the Bankruptcy Code are not addressed by the District Court’s order or the Fifth Circuit’s opinion, and the Bankruptcy Court previously reserved that issue for another day.  See Order Approving Rejection of Ground Lease at 2, In re J.C. Penney Direct Mktg. Servs., L.L.C., No. 20-20184 (Bankr. S.D. Tex. July 7, 2021), No. 13.

⁷ J.C. Penney Direct Mktg. Servs., 2022 WL 5240654, at *1.

⁸ Klairmont Korners, 2022 WL 2136902, at *15.

⁹ J.C. Penney Direct Mktg. Servs., 2022 WL 5240654, at *1.

¹⁰ Id. at *2 (quoting Richmond Leasing Co. v. Cap. Bank, N.A., 762 F.2d 1303, 1308−09 (5th Cir. 1985)) (internal quotations omitted).

¹¹ Id. at *3 (“There is no dispute in this case that the real estate agent lied to Klairmont and impeded its dealings with the debtor.”).

¹²  Note that the Fifth Circuit’s opinion referenced rejection of the Sublease as being at issue (id. at *1 (“Following negotiations, and at the direction of the company purchasing its assets, JCP chose to reject its sublease to Klairmont, a decision generally afforded deference under the business judgment rule.”) (emphasis added)); however, as stated by the District Court, it was, in fact, the Lease that was rejected, not the Sublease.  See supra n. 6.  This distinction is not important to the Fifth Circuit’s general opinion regarding the rejection standard under section 365(a) of the Bankruptcy Code, which would apply to any unexpired lease of the Debtors.

¹³ Id. at *2 (citing Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043, 1047 (4th Cir. 1985)) (emphasis added) (internal quotation omitted).