As many landlords have experienced, when a tenant goes bankrupt, the landlord can often lose the benefits of the lease. In addition to lost rental income, landlords must also face the prospect of losing control over choosing their tenants for the space occupied by a debtor, as an increasing number of debtor-tenants are utilizing the bankruptcy courts and specific provisions under the Bankruptcy Code to assume and assign the unexpired leases to replacement tenants. More often than not, the assignment and assumption of the unexpired lease is approved by the bankruptcy court, over the objections of the landlord, and in violation of the unexpired lease’s “use restriction” clause. A recent decision in a significant case confronting the conflicts between landlords and debtor-tenants has shed new light on the common practice of assumption and assignment of unexpired leases in bankruptcy.

In Trak Auto Corporation v. West Town Center, LLC, the United States Court of Appeals for the Fourth Circuit resolved a conflict between competing provisions of the Bankruptcy Code and provided strong support for a landlord’s enforcement of use restriction clauses in leases. In Trak, the debtor was a retailer of auto parts and accessories which sought to assign its shopping center lease to a third party. The highest bidder for the lease was a discount apparel merchandiser. The debtor did not receive any interest from auto parts retailers, likely because there were several other auto parts stores within miles of the shopping center.

The debtor’s landlord objected to the proposed assignment, claiming that such an assignment would violate the use restriction clause in the lease, which specifically required that the leased space be operated for the retail sale of automobile parts and accessories and such other items as are customarily sold by the tenant at other stores. Over the objection of the landlord, the bankruptcy court approved the assignment of the lease, leaving the landlord with a discount apparel merchandiser it did not want.

The Fourth Circuit reversed that decision, determining the bankruptcy court erred in permitting the debtor to assign its lease to an apparel merchandiser that would not honor the use restriction. The court specifically held that shopping center leases are in a special category, because Congress has made it more difficult for a debtor-tenant to assign such leases in Chapter 11. Moreover, the court found that the landlord successfully negotiated to have the lease space dedicated to the sale of auto parts, and reasoned that courts should not modify the landlord’s original bargain with the debtor.

The Fourth Circuit’s message to retail landlords and debtor-tenants is clear: bankruptcy courts cannot invalidate use restriction clauses merely because another tenant or use may be more valuable, or because the debtor-tenant has not been able to find an assignee interested in occupying the space for the required use under the lease. Courts cannot simply ignore the landlord’s choice of tenant mix in its shopping center, whether or not it is feasible under the current market conditions or even a wise choice by the landlord.

The Fourth Circuit’s decision will likely have persuasive authority and be cited in disputes between landlords and debtor-tenants. Landlords seeking to enforce other common restrictions and obligations that appear in retail leases, such as provisions limiting the closing of a store without the landlord’s consent or the making of alterations, may rely on this case.

In addition, Trak may also undercut the developing market for “designation rights” of leases in large shopping center bankruptcy cases. Those sales, which can involve tenants with multiple shopping center sites, are usually structured as auctions of rights to a number of store locations. When a debtor sells its designation rights, it transfers the exclusive rights to designate which of its unexpired leases will be assumed and assigned, to whom each lease will be assigned, and which leases may be excluded from any assignment. Designation rights are generally valuable only if leases can be assigned without the restrictions that have been negotiated into the leases by landlords.

While the Fourth Circuit’s decision is not a total victory for landlords, it is a strike against those dealing in the sale of designation rights and returns a measure of control to landlords.