Selling the family jewel real estate holding is something that companies are confronting in these cash-starved times – and sale-leaseback transactions are a vehicle of choice.  Giants like the New York Times Co., HSBC, and AIG, tottering under the combined weight of their balance sheets and the economic downturn, look to these to “liberate” the value of prime property otherwise trapped on their balance sheets.  Related structures have been used – to great consternation – in deals ranging from Private Equity buyouts to restaurant franchises.  With claims ranging from fraudulent conveyance to “pump-and-dump” to Mafia-tinged RICO allegations, these transactions don’t always prove legally pure – something to be considered by all those now considering them during our credit doldrums.

A little review may be in order: Sale-leasebacks are transactions where a company sells an asset, often real estate, and leases it back for a defined period, which allows the firm to cash in any equity in property and can also guarantee an investor a stable long-term income.  However, these transactions can be quite risky from a legal perspective, with issues posed by both aspects of the transaction – the sale and the lease.  These transactions raise issues from lack of consideration, to fraudulent conveyance, to misrepresentation.

A sale-leaseback can greatly compound the legal intricacies involved in rejecting leases during bankruptcy, which Buffet Holdings found out (more about that below).  Also, if a sale-leaseback is executed without consideration or at unreasonably high rental rate, concerns arise about possible fraudulent conveyance and misrepresentation, which are issues that have arisen at Mervyns and in an alleged pump and dump scam involving Marcus & Millichap.

Transfer of real estate on which the overarching business depends can greatly complicate a company’s real estate operations, as the new real estate owner has its own interests and can prove quite ornery.  Consider the situation of Buffet Holdings, the owner of Ryan’s and Hometown Buffets.  Prior to its 2008 bankruptcy filing, Buffet Holdings entered into a sale-leaseback involving 26 of its restaurants. The company sold the buildings and assigned their ground leases to new entities, subleased the grounds and buildings back from the same entities under four master leases, and received $35 million in consideration. After the company filed for bankruptcy, it ceased operations at three locations and attempted to reject the individual leases for those three locations, while assuming the other the 26 leases covered by the master leases. The real estate holding entities objected and argued that the debtor could not just pick and choose the parts of the master leases that it wanted. The federal bankruptcy court in Delaware found that individual leases contained in the master leases were economically interdependent and therefore inseparable.  The debtor could only assume or reject each of the master leases in its entirety. The ruling was a tough lesson for Buffets, but a valuable one for other companies considering sale-leasebacks.

This sort of issue is raised in spades in the context of bankruptcy.  Difficult questions come up as to motivations for the transaction, the identity of the new owner, consideration and fraudulent conveyance, among others.  Take, for example, Mervyn’s, which sued its landlord and private equity (PE) owners in September 2008, following its bankruptcy. The suit centered on an (arguably) unfair sale-leaseback structure that split the business into a retail company and a property company…and transferred the real estate assets from the retailer directly to the PE fund. The suit claims that during the $1.25 billion buyout, the PE investors, led by Cerberus, essentially placed the retailer’s valuable real estate and below-market leases into new entities – without giving Mervyn’s any consideration.  The new entities allegedly started to charge Mervyn’s such an extraordinary amount of rent that it resulted in the company’s bankruptcy and made the sale-leaseback amount to a fraudulent conveyance. With sale-leasebacks representing a major funding conduit for many leveraged buyouts (LBO) during the PE boom, we may see more litigation around sale-leaseback.

In shades of the Mervyn’s issues, franchise-industry sale-leasebacks have given rise to allegations of more run of the mill forms of fraud. Eclectic Properties East, LLC v. Marcus & Millichap (M&M) claims that the commercial real estate giant and other named defendants run a $70 million pump and dump operation centering on sale-leasebacks. The suit alleges that the defendants bought Jiffy Lube and Church's Chicken franchises and the real estate on which the business were located and then sold the business to a subsidiary of M&M.  The new franchises would then lease locations back at allegedly stratospheric rental rates, running the business into the ground, and finally M&M would foist the over-valued properties on unsuspecting investors before the franchise went bankrupt.  Investors allege that the scam violated provisions of Racketeer Influenced and Corrupt Organizations Act (RICO) and amounted to negligent misrepresentation, fraudulent concealment, unjust enrichment and imposition of a constructive trust, money had and received, and violated various other California state statutes.

These are significant allegations, in part because the suit calls into question the propriety of a commercial real estate giant like M&M.  For example, consider DineEquity’s (The parent company of Applebee’s and IHOP) 2008 sale-leaseback, which sold 181 restaurant locations for nearly $300 million dollars.  This sale, oriented toward debt-reduction, enabled the restaurateur to reduce its debt by $303 million.  This clash of interests may leave some to wonder how these allegations (which are worse still if the allegations prove accurate) will ultimately impact the market for franchise sale-leasebacks.

With traditional capital markets still closed for business to all but the most financially sound companies, sale-leasebacks could prove to be an important funding conduit in the coming months. However, these transactions need to be structured carefully, transparently, and correctly, especially if bankruptcy is looming. As recent litigation has shown, sale-leasebacks bundle together assets in a way that makes it nearly impossible for a debtor to exit certain leases. Other times, they may actually cause insolvency, which can lead to issues around fraudulent conveyance or fraudulent misrepresentation if the property was sold as an investment. This is important because many more companies might be considering sale-leaseback structures because of the credit crisis.

Published: March 26, 2009