Last year was a tough one for Montgomery Ward. Sales were down and the Christmas season was "make or break" for the company. Timing, being everything, was not on its side. The economy, after years of growth, was slowing. Consumers, concerned about the economy, scaled back their Christmas shopping.

The result was a lackluster holiday sales season and the death knell for retailers like Montgomery Ward that were clinging to life. In the end, Montgomery Ward was forced to file for chapter 11 protection in December 2000 and liquidate its holdings. In re Montgomery Ward, D. Del., C.A. No. 00-4667 (2000).

Although Montgomery Ward had inventory and customer lists that were valuable, its greatest assets were real estate holdings, both owned and leased. However, the process of liquidating hundreds of real estate interests would be time-consuming and costly. Montgomery Ward needed to find a way to sell its properties efficiently so as to maximize the proceeds for the benefit of its creditors. To accomplish this, Montgomery Ward proposed that it assign its interest in the properties to a so-called "designated rights bidder"—in other words, a liquidator.

Bankruptcy Judge Raymond Lyons characterized the debtors' motion this way: "[M]y understanding of the deal is that the properties of the debtor...[are] broken up into two categories—fee-owned properties and leasehold interests—and [the liquidator] will be acquiring the right to compel the debtor to sell fee-hold interests to a designated purchaser and the right to compel the debtor to move to assume and assign leasehold interest to assignees designated by [it.]" In exchange, the liquidator would pay Montgomery Ward an up-front fee and share profits from the ultimate disposition of the property. Montgomery Ward was free of the burden of selling off all the properties itself, and it received a large up-front payment and the prospect of additional payments upon sale. Allowing market forces to operate freely, the liquidator, Montgomery Ward and the creditors would all benefit.

Montgomery Ward filed its "designated rights motion" in February 2001. Printed and bound like an issue of Newsweek, the motion ran 58 pages. Buried in the arguments supporting the motion were provisions to assist the "designated rights purchaser" in the efforts to maximize the disposal of the properties. Any terms in the leases, which in Montgomery Ward's estimation infringed on the ability to sell the lease, were deemed "anti-assignment" clauses that the court should invalidate. "Going-dark" provisions were at the forefront.

The speed by which Montgomery Ward sought this relief was extraordinary even by Delaware standards—approximately two weeks from the filing of the motion to a hearing on the merits. Landlords hastily filed opposition papers, objecting on the basis that the relief affected the landlords' "due process rights" and that the court should allow more time for the landlords to respond. By moving so quickly, left unaddressed was the fundamental question of whether such "designation rights sales" are even permitted under the Bankruptcy Code. In the end, the matter was approved without a formal opinion from the court.

Montgomery Ward sought authorization for the sale of "designation rights" under the provisions of §363(b)(1). However, nowhere in the motion was there a discussion of whether the so-called designation rights were property of the estate that could be transferred. Rather, the proposed sale of designation rights contemplated allowing the designated rights purchaser to exercise unique bankruptcy powers under §365 for its own benefit.

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Montgomery Ward's motion simply did not take into consideration the heightened risk of expense and damage to the estate should the designated rights purchaser default.

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The Third Circuit had previously determined that certain types of rights available to trustees and debtors-in-possession are not "assets" that could be sold to a third party even with bankruptcy court approval. In In re Cybergenics Corp., 226 F.2d 237 (3rd Cir. 2000), the court held that state law fraudulent conveyance claims that the debtor was authorized to pursue, pursuant to its strong-arm powers in its capacity as a chapter 11 debtor-in-possession (DIP), were not an asset that belonged to the debtor personally, and therefore could not be sold to a third party as part of a court-approved sale of assets. The court came to the "inescapable conclusion" that the fraudulent transfer claims, which state law provided to Cybergenics' creditors, were never assets of Cybergenics. That conclusion was not altered by the fact that a DIP is empowered to pursue those fraudulent transfer claims for the benefit of all creditors. The avoidance power itself "was likewise not an asset of Cybergenics, just as this authority would not have been a personal asset of a trustee, had one been appointed." Id. at 245. The court held that because the provisions of §365 permitting assumption and assignment of leases were unique bankruptcy powers to be exercised for the benefit of all creditors, those powers do not exist and therefore cannot be assigned outside of the context of a bankruptcy case.

To be sure, there are cases interpreting provisions of the Code that allow for the appointment of a representative of the estate to pursue avoidance powers, for instance, on behalf of the estate. See, e.g., 11 U.S.C. §1123(b)(3)(B). But even the cases interpreting those provisions speak in terms of "representatives" of the estate, not sales of assets. See In the Matter of Texas Gen. Petroleum Corp., 52 F.3d 1330 (5th Cir. 1995); In re Sweetwater, 884 F.2d 1323 (10th Cir. 1989); and In re Churchfield Mgmt. & Inv. Corp., 122 B.R. 76 (Bankr. N.D. Ill. 1990). The Ninth Circuit had permitted the transfer of avoidance powers outside of the context of a chapter 11 reorganization plan, but only "when a creditor [was] pursuing interests common to all creditors." In re P.R.T.C. Inc., 177 F.3d 774, 781 (9th Cir. 1999). In the Montgomery Ward matter, the designated rights purchaser was pursuing assumption and assignment of leasehold interests for its own pecuniary benefit and gain. Indeed, it was not even suggested that the designated rights purchaser was a creditor of the estate.

The only published opinion upon which Montgomery Ward relied for authority to permit the sale of designation rights was In re Ernst Home Center Inc., 209 B.R. 974 (Bankr. W.D. Wash. 1997). However, the Ernst case arose under the Ninth Circuit's more expansive view of the transfer of bankruptcy rights (see, e.g., P.R.T.C., supra). It also suffered from the same analytical deficiencies criticized by the Third Circuit. In Ernst, the bankruptcy court characterized what was sold to the liquidator as "bonus value." This euphemism was used to disguise what was truly being sold to the designated rights purchaser as property of the estate. Ernst, supra, 209 B.R. at 985. Moreover, the court failed to discuss what portion of the "bonus value" was not going to be recaptured for the benefit of creditors of the estate, but solely for the benefit of the designated rights purchaser. Unfortunately, rather than analyze the appropriateness of selling unique bankruptcy powers for a discount to the detriment of creditors of the bankruptcy estate, the court seemed motivated by the expediency and size of the down payment. ("The opportunity should not be rejected, even if it will produce in the end only a small distribution to unsecured creditors." Id. at 980.) This is most likely the reason why much of the court's analysis seemed strained, such as its conclusion that the transaction was a sale of property of the estate because it included a sale of three fee interests. Id. at 985-86.

Even if the Ernst case were the law governing the sale of designation rights in the Montgomery Ward case, the court expressly excluded from its holding those landlords that had continuous operation covenants in their leases. The court stated that it would give "those landlords the opportunity to show that the terms of their leases would, under state law, give them the right to remove Ernst from possession, notwithstanding Ernst's continued payment of all monetary amounts due under the lease." Id. at 982. It is assumed that many of the affected landlords in the Montgomery Ward matter had such provisions. Because the designated rights purchaser was not a creditor of Montgomery Ward's bankruptcy estate, it had no particular motivation to act on behalf of any creditor of the bankruptcy estate, but was principally motivated to maximize its profit. As a result, several aspects of the transaction were adverse to creditors: first, the designation rights were being sold at a deep discount or the designated rights purchaser would have had nothing to do with it; second, some substantial portion of the proceeds from the assignment of leases under §365 of the Bankruptcy Code would not be available for distribution to creditors; and third, landlords whose leases were ultimately rejected would have no claim for damages against the non-debtor party (designated rights purchaser) who caused the damage, but merely an unsecured claim in the bankruptcy estate. Giving a landlord such a doubly discounted source of recovery for damage directly caused by a non-debtor party clearly distorted the balance of the equities created by §365. Furthermore, the failure to return all profits to the estate from the assumption and assignment of leases could not possibly have been in the best interests of creditors.

Montgomery Ward's motion simply did not take into consideration the heightened risk of expense and damage to the estate should the designated rights purchaser default. The value was surrendered merely for the expediency of having a third party cover holding costs and the potential for much higher costs of administration caused by individual objections each time an "end user" assignee was proposed. These are the very reasons why the Third Circuit determined that bankruptcy rights cannot be sold as though they were any other type of asset that exists in the absence of a bankruptcy case.

In the end, the court was not required to produce a written decision on these points because the interested parties resolved their issues with the debtor, leaving the court without a reason to delve more deeply into whether such sales violate the Code. With more debtors turning to similar sales, perhaps we will see another court take this issue on directly and thus decide whether the expedience of this practice trumps the very Code upon which it is based.