Third Circuit Finds That Prepetition Option Termination Is Not Transfer

Under Section 101(54) of the bankruptcy code, any means of disposing with an interest in property is considered a transfer, and therefore, under certain circumstances, may be avoided as a preference or fraudulent transfer. In a recent unpublished opinion, the Third Circuit recently addressed the scope of the provision and held that prepetition option termination did not give rise to a transfer.

Background

The central question in In re Pazzo Pazzo was what is a transfer. Transfers are defined broadly in the Bankruptcy Code to include the creation of liens, retaining title as a security interest, foreclosing an equity of redemption, and any means of disposing or parting with property or an interest in property. At first blush, it appears that a termination of a property right would constitute a disposition of an interest in property and thus a transfer. The Pazzo Pazzo Court, however, found that the termination of a property interest was not a transfer, and that it was instead akin to the Debtors "fail[ing] to pursue a business opportunity."

In a nutshell, Pazzo was a lessee under a ten-year lease which included an option to purchase. The option was required to be exercised prior to expiration of the lease’s term, or within 30 days of its termination by the landlord.

Pazzo essentially abandoned the premises and the landlord sent it at least four notices of termination, including that its option would terminate within 30 days of lease termination. The response was a complete radio silence. Pazzo simply failed to respond. In its bankruptcy case, however, Pazzo sought to avoid the termination of the lease and the option as fraudulent transfers. Both the bankruptcy and the district courts ruled that no transfer took place.

Third Circuit Approach in Pazzo Pazzo

As to the lease termination, the Third Circuit affirmed the lower courts’ rulings that, under New Jersey state law, Pazzo abandoned the property. The Court did not analyze whether Pazzo’s abandonment of the lease constituted a transfer.

As to the option, the Third Circuit analyzed whether its termination constituted a transfer and ruled that it did not. The Court noted that the district court was correct in holding that the option was a future contingent interest that is protected under the Bankruptcy Code. Nevertheless, the failure to convert the future contingent interest into actual ownership does not constitute disposing or parting with the protected interest. This is because, the debtor did not transfer any rights or interests; rather, they failed to pursue a business opportunity by allowing the option to expire.

What Do Other Cases Say?

The general approach to issues like this under the Bankruptcy Code has been to consider the pre-petition termination of an executory contract to be a transfer, even in the Third Circuit. See In re EBC I, Inc., 380 B.R. 348 (Bankr. D. Del. 2008) (analyzing a pre-petition termination of a marketing services agreement for a possible fraudulent transfer). There has been some uncertainty, however, concerning lease terminations, particularly where the termination is non-collusive. In 1993, the Third Circuit affirmed a case in which the New Jersey Bankruptcy Court found that a prepetition termination of a dealership agreement was not a transfer since expired rights are the equivalent of no rights, falling outside of the § 101(54) definition of transfer. In re Coast Cities Truck Sales, Inc. 147 B.R. 674, 678 (D.N.J. 1992), aff'd Coast Cities Truck Sales, Inc. v. Navistar Int'l Transp. Co., 5 F.3d 1488 (3d Cir. 1993).

Other courts, even more recently, have found that lease terminations are, in fact, transfers. In re Great Lakes Quick Lube LP, 816 F.3d 482 (7th Cir. 2016); see also In re White, 559 B.R. 787 (Bankr. N.D. Ga. 2016); In re Durso Supermarkets, Inc. (finding that, where the debtor did not cure a default and a contract terminated pre-petition, such a termination of the lease would constitute a transfer as there was a parting of an interest in property).

What’s Next?

Pazzo Pazzo feels somewhat unsatisfactory. It does not analyze whether the termination of the lease constituted a transfer; describing it as an abandonment does not really address whether it is or is not a transfer. Similarly, referring to the option expiration as a failure to pursue a business opportunity, leaves the analysis incomplete. While the expiration did not result in a transfer to a third-party, the debtor did part with the interest that the option represented. The uncertainty surrounding this issue results in unnecessary litigation and incurrence of legal costs by both debtors and creditors that likely could be put to better uses.

The Third Circuit opinion is available here.

J.J. Moser, admission pending, co-authored this OnPoint.