Can a debtor seeking debtor-in-possession (“DIP”) financing under Section 364 of the Bankruptcy Code grant a lender a lien on a leasehold interest in the face of an express anti-hypothecation provision in the underlying lease? There are no cases directly on point, and the DIP financing order entered in The Great Atlantic & Pacific Tea Company (“A&P”) Chapter 11 case leaves this interesting issue unresolved. 

The proposed DIP financing order in A&P sought to provide the DIP lender with a lien on all of the Debtors’ “interests in leaseholds”, and specifically sought to invalidate any anti-hypothecation provisions in the Debtors’ leases (along with more general anti-assignment provisions) with respect to the granting of such liens. A number of landlords objected (including landlords represented by Kelley Drye & Warren). 

Section 365 of the Bankruptcy Code permits the assumption and assignment of leases and executory contracts, notwithstanding (in most cases) any anti-assignment provisions in such agreements. The rights of the non-debtor party are protected by provisions which require the curing of monetary defaults and adequate assurance of future performance. Typically the collateral package for a DIP financing will include any proceeds of a lease assignment. None of the landlords in A&P questioned that an economic benefit realized by the Debtors’ estates following the assumption or assignment of any lease under Section 365 of the Bankruptcy Code could be pledged to the DIP lender. However, the landlords objected to the granting of liens directly on the Debtors’ rights under the leases themselves. 

The difference between a lien on the proceeds of a lease assignment and a lien on the leasehold interest itself may seem somewhat arcane, but the distinction can be crucial. Absent the granting of lien on the leasehold interest, a failed Chapter 11 case usually would result in the landlord regaining the premises. If such a lien were granted, however, then the DIP lender, in the event of a default by the Debtors, could foreclose on the Debtors’ rights under the lease and gain possession of the leasehold premises without having to comply with the burdens and landlord protections of an assumption and assignment under Section 365.           

The Debtors and the DIP lender contended that anti-hypothecation provisions in leases are invalid under Section 365(f) of the Bankruptcy Code. The DIP lender also pointed to cases suggesting that a bankruptcy court, in approving DIP financing under Section 364(c), can grant a lien on assets that are subject to negative pledge covenants.  

The landlords countered that such invalidation, by the express language of Section 365(f), could apply only if such leases were actually assumed under Section 365(b). The landlords further noted that Section 365(b)(3) of the Bankruptcy Code contains provisions specifically intended to protect commercial landlords in connection with the assumption and assignment of shopping center leases, and that the proposed A&P DIP financing order would fly in the face of such protections.  

The DIP lender chose to forego a direct fight on this issue. While most of the Debtors’ leases contained anti-assignment clauses, only a handful had express anti-hypothecation language.   Judge Robert Drain of the U.S. Bankruptcy Court for the Southern District of New York approved the liens on the Debtors’ leasehold interests notwithstanding any general anti-assignment covenants, and the DIP lender agreed to carve out the leases with specific anti-hypothecation language and to take a lien solely on the proceeds of any assignment with respect to such leases. 

The facts did not warrant a full scale battle on this question in A&P. However, the issue remains outstanding, and will undoubtedly be fully joined in some future case.