Who should profit from dot-gones?

Real Estate Weekly, March 7, 2001 by Natalie Keith

Trinity 's appeal says it owns the right to sublease

Trinity Real Estate is appealing a bankruptcy court judge's legal blow to landlords issued last year, when he ruled against Trinity's efforts to retain profits from the reassignment of a bankrupt dot-com's lease.

Judge Richard Bohanon ruled against a provision included in a lease Trinity signed with Boo.com for space at 435 Hudson St., saying it runs counter to bankruptcy code policies. The provision -- called a "subleasing profit provision" -- would have required Boo.com to give Trinity any profits gained from subleasing the space. Bohanon's ruling was issued Dec. 15 in the U.S. Bankruptcy Court Southern District of New York.

"Equity dictates that the subleasing profit provision in the debtor's lease must be invalidated," Bohanon wrote. "If I were to hold otherwise, the debtor would not be able to realize the full economic value of its primary asset."

The decision was made as part of bankruptcy proceedings involving Boo.com North America Inc., which filed for Chapter 11 bankruptcy in October. Boo.com had been leasing approximately 9,043 SF of space from Trinity. Boo.com had been paying $27.50 per square foot for the space, but in the years since signing the lease, the market rate for the space had risen to about $50 per square foot.

As part of its reorganization strategy, Boo.com planned to reassign the lease to Radical Media, which would pay $350,000 for the lease and the telephone system and another $150,000 for reimbursement of Boo.com's security deposit. The windfall was to be paid to Boo.com's creditors, in the company's efforts to escape from bankruptcy.

"The profit-sharing clause in the lease hinders the debtor's effort to realize the full value of its assets and would result in a diminished distribution to all other creditors. Such an outcome would clearly be contrary to bankruptcy policies which try to balance the interests of all parties involved," Bohanon wrote.

The decision could have an impact on future leasing decisions regarding dot-coms. Office rents have soared over the past few years, making leases, such as the one between Boo.com and Trinity, valuable assets. This has prompted some landlords to include provisions, such as a sublease profit provision, that ensures that the property owner will benefit from the reassignment of an undervalued lease.

When dot-coins file for bankruptcy, however, the lease is often the only substantial asset the company has left and many dot-corns try to reassign it to pay off creditors.

Emanuel Grillo, an attorney with the Manhattan law firm Torys, has represented both landlords and tenants in bankruptcy cases. He said the decision could be particularly important to the retail sector, because when retailers file for bankruptcy, they typically close many stores.

"It's going to make it difficult for landlords to get value from the upside of the lease," Grillo said. "It will be really interesting to see how this case is decided on appeal."

In deciding for Boo.com, Bohanon cited section 365f of the bankruptcy laws, which says a landlord cannot "restrict, condition or prohibit a debtor's right to assign an executory contract or unexpired lease." He cited several cases in which the judge had ruled in favor of a tenant due to section 36Sf.

Grillo said he was surprised that the judge's ruling stemmed from a discussion of which company would reap the profits of the reassigned lease, not whether reassignment was appropriate.

"[The decision] didn't talk about whether or not you can reassign a lease, it talked about diving up the economic benefit," Grillo said.

So far, the executives as Trinity Real Estate seem optimistic about their chances to win the appeal.

"Obviously we think that a lease that had a recapture position should have been an asset of the landlord," said Joseph T. Palombi, executive vice president of the company. "We respect the bankruptcy court's decision, but we don't agree with it. We have an appeal pending with another court and we have filed for a motion for the bankruptcy court not to distribute the proceeds from the sublease until the appeal has been decided."

At the same time, Palombi claims that he has not been discouraged from taking on other high-tech tenants. "Even when there were a lot of dot-corns out there, we decided that we would not lease more than 5% of our portfolio to dot-corn companies," he said. "And we always made it a point to get the lease secured, just in case there was a bankruptcy. So, I don't think our attitude will change at all."