United States: Reconciling Section 365(h) Of The Bankruptcy Code With Sections 363(f) And 544(a)

When one thinks of the treatment of a lease in bankruptcy, it is usually 11 U.S.C. § 365 that first comes to mind. Section 365 specifically authorizes the trustee to assume or reject an unexpired lease. If the debtor is the lessor, then the trustee may reject the lease, but the lessee may retain its rights under the lease pursuant to § 365(h), including its right of possession. In that event, the trustee need not perform any affirmative obligations of the lease, and the lessee's remedy is to offset any damages it suffers against the rent.

However, reported cases deal with two less commonly seen procedures—an attempt by the trustee to sell a property free and clear of a lease pursuant to 11 U.S.C. § 363(f), or to avoid a lease pursuant to 11 U.S.C. § 544(a)(3). Those cases include Precision Industries Inc. v. Qualitech Steel SBQ LLC,1 holding that a lease did not survive a sale free and clear of interests pursuant to § 363(f), despite the argument that § 365(h) preserves the lessee's rights.

The Seventh Circuit's decision in Precision Industries was much criticized, in part because some thought it allowed § 363(f) to undercut the protections of § 365(h) without offering a persuasive reason Congress might have intended such a result.2 The decision caused angst among lenders in the business of financing leases and their counsel, who typically relied on the protections of § 365(h). While the initial fears that Precision Industries would kill the lease financing industry subsided, it seems that more than ten years later, the courts have not resolved the question of whether § 365 trumps § 363(f). Most recently, the court in In re Spanish Peaks Holdings II LLC3 allowed a sale free and clear of a lease under § 363(f).4

Section 363

In Precision Industries, the debtor sold real estate free and clear of interests pursuant to 11 U.S.C. § 363(f). Section 363(b) authorizes the sale of property outside the ordinary course of business, after notice and a hearing, and § 363(f) says:

(f) The trustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of an entity other than the estate, only if--

(1) applicable nonbankruptcy law permits sale of such property free and clear of such interest;

(2) such entity consents;

(3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;

(4) such interest is in bona fide dispute; or

(5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.

After the sale in Precision Industries, a dispute arose between the purchaser and a lessee concerning whether the pre-existing lease survived the sale free and clear. The bankruptcy court held it did not. The court said the sale order unambiguously approved the sale free and clear of interests, including the lease, and was not appealed. The court disagreed that the lessee's protections under § 365(h) trumped a sale free and clear under § 363(f). On appeal, the district court ruled that indeed § 365(h) did trump the sale free and clear under § 363(f), and reversed.5 The district court reasoned that the two provisions conflicted, and held that the more specific provisions of § 365(h) pertaining to leases should prevail. The court cited In re Churchill Properties III Ltd. Partnership.6

However, on appeal from the district court decision, the Seventh Circuit found that § 365(h) does not conflict with § 363(f). The provisions simply deal with different things. The court said the protections of § 365(h) apply in a proceeding under § 365 to reject a lease, while § 363(f) applies in a proceeding under § 363 to sell property.7 In dealing with the threshold issue of whether § 363(f) authorizes a sale free and clear of the lease, the court said the lessee did not dispute the buyer's argument that the property could be sold free and clear under applicable nonbankruptcy law because the lease had not been recorded.8 Accordingly, § 363(f)(1) applied, and a sale free and clear of the lease was permitted.

Although the holding that § 363(f) allowed a sale free and clear of a lease initially caused angst among lenders, in reality, § 363(f) adds little to the trustee's powers. In order for § 363(f) to apply, one of the five circumstances listed above must be present. However, those provisions do not generally apply to a lease that has been properly recorded. A purchaser usually takes subject to a recorded lease under state law,9 so § 363(f)(1) would generally not apply to a lease.10 While a lessee may of course consent to the sale free and clear of its lease, a sale free and clear could probably be accomplished without the assistance of § 363(f) in that instance, so § 363(f)(2) adds little to the parties' rights under state law.10 A lease is not generally treated as a lien, so § 363(f)(3) would not apply to a lease.11 While a lease might be subject to a dispute, a court would presumably limit the application of § 363(f)(4) to disputes that challenge the validity of the lease itself and present merit.12 Subsection 363(f)(5), allowing sale free and clear if the interest holder could be compelled to accept a monetary satisfaction, is not likely to apply to a lease13 except where the lease itself includes a buyout provision.14 Thus, the circumstances where § 363(f) would apply to a lease seem rare in a well-documented financial transaction involving a lease. Where it does apply, adequate protection may be required under § 363(e).

Nevertheless, the fact that courts continue to come down on both sides of Precision Industries demonstrates that the matter is not inconsequential. In order to put the issue in the proper perspective, it is useful to consider how courts have handled a similar issue arising under § 544(a)(3) of the Bankruptcy Code.

Section 544

Of course, § 544(a)(3) gives the trustee (or debtor in possession) the rights and powers under state law of a bona fide purchaser of real property from the debtor at the time the bankruptcy is filed, whether or not such a purchaser actually exists. Moreover, the trustee has such rights and powers irrespective of the knowledge of the trustee or any creditor.15 The courts have interpreted the term "knowledge" to mean "actual knowledge" as opposed to "constructive knowledge."16 Thus, while actual knowledge is irrelevant under § 544(a), constructive knowledge may be a defense.

The reason § 544(a)(3) sometimes applies to a real property lease is that some state recording statutes require a lease of real property to be recorded as a condition for enforcement against a bona fide purchaser of the lessor's title. Very often, leases are not recorded. In most bankruptcy cases involving a lease in the context of § 544(a)(3), the issue has been whether the failure to record the lease renders the lessee's rights avoidable by the trustee.

In Webber Lumber & Supply Co. Inc. v. Trucklease Corp. (In re Webber Lumber & Supply Co. Inc.),17 the court held that failure to record a lease rendered the lease avoidable under § 544(a) even though the lessee was actually in possession of the property. The court reasoned that under Massachusetts law, the lessee's possession was not considered "constructive notice" of the lessee's rights, but rather "actual notice." Because actual notice is irrelevant under § 544(a)(3), the lessee's possession did not prevent the trustee from avoiding the unrecorded lease.18 The court also rejected the argument that § 365(h) protected the lessee. The court reasoned that:

The Lessee would have us "reconcile" § 544(a) with § 365(h) and (i) by excluding from the sweep of § 544(a) all lessees and purchasers in possession. But there is no conflict among the statutes. Section 365(h) and (i) prohibit the rejection of the property interest of a lessee or purchaser in possession. These subsections are based upon the proposition that rejection, which merely involves a debtor declining to assume a contractual obligation, should not be used to terminate property interests. Section 544(a), on the other hand, has as its express purpose the avoidance of property interests. The statutes supplement each other rather than conflict. All that was necessary to escape § 544(a) was a recording of the lease or a notice of the lease. The Debtor's agreement not to do so was fatal.

Id., at 79-80.

The importance of Webber Lumber is itssuggestion that the lessee's rights can be separated into two components: (1) contractual rights governed by § 365, and (2) property rights governed by § 544(a). According to Webber Lumber, the statutes do not conflict, but supplement each other. Moreover, while the court in Precision Industries offered only what amounted to a procedural distinction between the statutes it was considering (based on which section the trustee happened to be utilizing), the Webber Lumber court offered a substantive distinction, i.e. whether the lessee's property rights were implicated or merely its contractual rights. While Precision Industries dealt with § 363(f) rather than § 544(a), § 363(f) similarly affects property rights rather than contractual obligations.

The rights of the lessee under § 365(h) do not depend on recording of the lease or possession. Is that evidence of Congressional intent to protect the lessee despite its failure to record or take possession, and despite the protections (or lack thereof) offered by state law? Perhaps it only shows that § 365 was not intended to affect the lessee's property interest in any event, but rather, only the lessee's contractual rights which are independent of its possession or recording. Under that interpretation, § 365(h) merely preserves whatever property rights the lessee has under state law, leaving other sections such as § 544(a) and § 363(f) to determine whether the lessee's property rights may be impaired.

Despite the analogous logic of Webber Lumber, cases discussing § 363(f) have not picked up on the distinction between termination of interests and termination of obligations in analyzing § 363(f) and § 365(h).19 Cases arising under § 363(f) and § 365(h) continue to cite Precision Industries and are often decided on an ad hoc basis, without focus on legal principle.

For example, in a recent case, In re Spanish Peaks Holdings II LLC,20 the court held that a lease did not survive a sale free and clear. Although the court cited Precision Industries and its progeny, it was clear that the court was most concerned about the fact that the lessees were affiliated with the debtor, an issue not confronted in the earlier cases. The court distinguished the prior cases and stated:

After considering the foregoing and given the facts of this case, the Court finds that a case-by-case, fact-intensive, totality of the circumstances, approach, rather than a bright line rule, governs whether § 363(f) or § 365(h) prevails in any given situation.

Id., 2014 Lexis 913, at *50.

The court stated that one of the leases was not recorded and there was a dispute involving the leases, but emphasized that the leases were between affiliated parties at a rent far below market. The court did not explain why affiliation of the parties matters under § 363(f) or § 365(h). Possibly, affiliation of the lessee with the debtor would imply consent to a sale free and clear under § 363(f)(2), particularly if the lessee did not object to the motion to sell free and clear, or possibly the court was simply relying upon its inherent powers to do equity. In any event, the court offered no new legal analysis to reconcile § 363(f) with § 365(h), but the court did conclude that in the case before it, the property was sold free and clear of the lease, despite § 365(h). Moreover, the court's reliance on a "totality of circumstances" approach, if followed by other courts, promises that this issue will continue to arise in future cases.

Conclusion

The bifurcation of a lease into contractual and property interest components does not resolve all questions about the treatment of leases in bankruptcy, but it may help to clarify the relationship between § 365(h), § 544(a), and § 363(f). Assuming that courts ultimately conclude that a lessee's property interest is protected under § 365(h), but that it may still be subject to avoidance under § 544(a) or sale free and clear under § 363(f), there still remains to be determined the circumstances under which § 544(a) and § 363(f) operate. The issues under § 544(a) are likely to center on whether the rights of the lessee are perfected against those of a bona fide purchaser under state law by virtue of recording or possession. A broader inquiry may be appropriate under § 363(f), but even so, the courts are not likely to permit the sale of a property free and clear of a lease in the context of a well-documented and properly perfected financial transaction involving a lease. The cautious lessee and lender will insist upon recording the lease, rather than relying exclusively on possession, but most lenders and title insurance companies already require some record notice of the lease in such a transaction. Thus, the manner in which these issues are ultimately resolved by the courts should not cause much loss of sleep in the finance industry.


Footnotes

1 327 F.3d 537 (7th Cir. 2003).

2 See e.g., Michael St. Patrick Baxter, "Section 363 Sales Free and Clear of Interests: Why the Seventh Circuit Erred in Precision Industries v. Qualitech Steel," 59 Bus. Lawyer 475 (Feb. 2004); Robert M. Zinman, "Precision in Statutory Drafting: The Qaulitech Quagmire and the Sad History of § 365(h) of the Bankruptcy Code," 38 J. Marshall L. Rev. 97 (Fall 2004).

3 2014 Lexis 913 (Bankr. D. Mont. 2014).

4 See also, In re R.J. Dooley Realty Inc., 2010 WL 2076959 (Bankr.S.D.N.Y. 2010), and In re MMH Automotive Group LLC, 385 B.R. 347 (Bankr.S.D.Fla. 2008), where the courts allowed property to be sold free and clear of leases, and In re Samaritan Alliance LLC, 2007 WL 4162918 (Bankr.E.D.Ky. 2007) and In re Zota Petroleums LLC, 482 B.R. 154 (Bankr.E.D.Va. 2012), where courts denied sales free and clear, holding that § 365 trumps § 363(f).

5 See Precision Industries Inc. v. Qualitech Steel SBQ LLC, 2001 Lexis 8328, 2001 WL 699881 (S.D.Ind. 2001), rev'd 327 F.3d 537 (7th Cir. 2003).

6 197 B.R. 283 (Bankr.N.D.Ill. 1996) (holding that § 363(f) does not override § 365(h)).

7 See also In re R.J. Dooley Realty Inc., 2010 WL 2076959, *6 (Bankr.S.D.N.Y. 2010) ("§ 365 describes what happens when a trustee assumes or rejects...an unexpired lease... § 363 concerns the use or sale of property. These are different issues in bankruptcy...").

8 See 327 F.3d at 546, fn. 3. Although the issue was not discussed by Precision Industries, one suspects that the unrecorded lessee would have been protected if it had been in possession of the property and the law of the applicable jurisdiction protected a lessee in possession from the rights of a bona fide purchaser without recording. Note that by contrast, § 365(h) does not require that the lease be recorded for the lessee's rights to survive or that the lessee be in possession—only that the term of the lease has commenced.

9 But see, In re Bedford Square Associates L.P., 247 B.R. 140, 145 (Bankr.E.D.Pa. 2000) (failure to record lease enabled sale free and clear under § 363(f) because, "Although the Debtor has not commenced a § 544(a)(3) action to avoid the Lease provision at issue, the fact that it could in all probability do so successfully is sufficient to establish that a 'bona fide dispute' regarding the enforceability of this Lease provision for the purposes of § 363(f)(4) exists").

10 The district court opinion said the purchaser's argument was that a property could be sold free and clear of an unrecorded lease in a foreclosure sale. See Precision Indus. v. Qualitech Steel SBQ, LLC, 2001 Lexis 8328, 2001 WL 699881, at *10 (S.D. Ind. 2001). It is not clear whether the existence of a prior mortgage played a role in the decision. In many jurisdictions, a bona fide purchaser takes free of an unrecorded lease irrespective whether it purchases at a foreclosure sale. On the other hand, even an unrecorded lease may be enforceable against a bona fide purchaser in some jurisdictions, if the lessee was in possession of the property. The focus on foreclosure sales leads one to ask whether the existence of a prior mortgage might bring a subordinate lease within § 363(f)(1) even if it is recorded. The idea that § 363(f)(1) applies because the property could be sold free of the lease in a foreclosure sale seems wrong, at first, because a § 363(f) sale is not a foreclosure sale. However, the court in In re R.J. Dooley Realty Inc., 2010 WL 2076959, *6 (Bankr.S.D.N.Y. 2010), approved a sale free and clear on that grounds. The mortgagee requested a sale free and clear, and its successor exercised a credit bid. At least in that context, the result seems appropriate. A mortgagee should not be compelled to accept less than it could obtain in a foreclosure, but unless the junior leases can be eliminated, the proceeds from a § 363 sale would be reduced by the trustee's inability to deliver clear title. Moreover, the mortgagee's right to credit bid would be impaired because it would be bidding on title subject to the leases. A sale free and clear may therefore be needed to protect the mortgagee's rights in that instance.

11 In re Taylor, 198 B.R. 142, 160 (Bankr.D.S.C. 1996) ("leases do not amount to liens under South Carolina law for purposes of § 363(f)(3)").

12 See In re Patriot Place Ltd., 486 B.R. 773, 815 (Bankr.W.D.Tex. 2013) (§ 363(f) did not authorize sale free and clear of lease because "[I]t is not possible for the Court to now conclude that there is a 'bona fide dispute' under § 363(f)(4) as to the validity of 3LM's leasehold interest on an objective basis... 3LM has cured and can promptly cure any defaults in the Shopping Center Lease..."). But see Bedford Square, fn. 9, supra (failure to record lease created dispute under § 544(a)(3) regarding enforceability of lease).

13 See In re Patriot Place Ltd., 486 B.R. 773, 815 (Bankr.W.D.Tex. 2013) (lessee could not be compelled to accept money satisfaction). See also In re Haskell L.P., 321 B.R. 1 (Bankr.D.Mass. 2005) (eminent domain power did not compel lessee to accept money satisfaction under § 363(f)(5)).

14 See e.g., In re MMH Automotive Group LLC, 385 B.R. 347 (Bankr.S.D.Fla. 2008) (buyout provision allowed sale free and clear upon payment to lessee of $60,000).

15 11 U.S.C. §544(a) says in relevant part:

(a) The trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by--

*****

(3) a bona fide purchaser of real property, other than fixtures, from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists.

16 Varon v. Trimble, Marshall & Goldman, P.C. (In re Euro-Swiss International Corp.), 33 B.R. 872 (Bankr.S.D.N.Y. 1983). Constructive knowledge is presumed by law irrespective of the person's actual knowledge.

17 134 B.R. 76 (Bankr.D.Mass. 1991).

18 Later cases that allowed avoidance under § 544(a) despite the lessee's possession include In re University Towers Owners' Corp., 266 B.R. 36 (Bankr.D.Conn. 2001), and In re Watts Contractors Inc., 360 B.R. 489, 492 (Bankr.E.D.Va. 2007) (also rejecting application of § 365, and stating "While the defendant is correct that § 365 offers the exclusive mechanism for rejecting leases, this presupposes that the rejected lease is in fact valid and not void. Section 544 (a) enables the trustee to avoid transfers that would be void under general property transfer rules as applied by the state."). By contrast, Euro-Swiss International, supra, fn. 16, held that possession constitutes constructive notice under New York law. These cases hinge upon whether possession is actual or constructive notice under state law, but that distinction is fuzzy. For example, the court in University Towers said that while Connecticut courts refer to possession as constructive notice, in reality possession constitutesactual notice in Connecticut because it is effective only if the purchaser actually knows of facts that would put a prudent man on inquiry that another party may have possession. See University Towers, at 266 B.R. 40. The court allowed the trustee to avoid the lease under § 544(a) even though the lessee's rights would be protected by its possession under Connecticut law. Thus, federal law may play a role in determining whether possession constitutes actual or constructive notice. By contrast, in Euro-Swiss International, the court seemed to accept the New York courts' characterization of possession as constructive notice, even though from the court's discussion of New York law, it appears similar to that of Connecticut. The distinction is still fuzzier in some states that require that possession be "open and notorious," which implies that while notice of possession is required, the purchaser may be charged with such notice using an objective standard. The line is blurred even more by cases holding that constructive possession is sufficient. See e.g., Lee Road Partners Ltd. v. F.W. Woolworth Co. (In re Lee Road Partners Ltd.), 169 B.R. 507 (E.D.N.Y. 1994) (although the lessee/sublessor was not in actual possession of subleased property, it had constructive possession under a prior version of § 365(h) that had been interpreted to require possession). These cases suggest the lessee need not even have actual possession in some instances to be protected under state law.

19 But see In re Kong, 162 B.R. 86, 95 (Bankr.E.D.N.Y. 1993) (dealing with § 365(h), but not § 363(f), and stating, "A lease is part contract and part conveyance... It creates an estate in the subject property, which vests in the lessee... Where the debtor is the lessor... rejection of that lease only results in the termination of the covenants that require future performance by the debtor... Rejection does not divest the lessee of its estate." (citations omitted)).

20 2014 Lexis 913 (Bankr. D. Mont. 2014).

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