United States: Eroding The Majority Rule: Another Circuit Concludes That Lease Can Be Extinguished In Free-And-Clear Bankruptcy Sale

The ability of a trustee or chapter 11 debtor-in-possession ("DIP") to sell bankruptcy estate assets "free and clear" of competing interests in the property has long been recognized as one of the most important advantages of a bankruptcy filing as a vehicle for restructuring a debtor's balance sheet and generating value. Still, section 363(f) of the Bankruptcy Code, which delineates the circumstances under which an asset can be sold free and clear of "any interest in such property," has generated a fair amount of controversy. This is so in part because the statute itself does not define "interest."

Although generally acknowledged to encompass liens and security interests, section 363(f)'s scope would appear to be much broader, taking into account both the language of the provision and its underlying purpose. Broadly applied, however, section 363(f) arguably conflicts with certain other provisions of the Bankruptcy Code.

One of those provisions is section 365(h)(1). Section 365(h)(1) provides that, if the trustee or DIP rejects an unexpired real property lease under which the debtor is the lessor, the nondebtor lessee (and any permitted successor or assign, pursuant to subsection (h)(1)(D)) has the option of retaining its rights under the lease for the balance of the lease term. Courts disagree as to whether the rights of a lessee or sublessee under section 365(h)(1) are effectively extinguished if the leased real property is sold free and clear of any "interest" under section 363(f). Until this year, only one court of appeals had weighed in on this question. In Precision Industries, Inc. v. Qualitech Steel SBQ, 327 F.3d 537 (7th Cir. 2003), the Seventh Circuit articulated what has become the minority position on this issue, holding that a real property lease can be extinguished in a free-and-clear sale of the property under section 363(f). However, more recently, in Pinnacle Rest. at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holding II, LLC), 2017 BL 241737 (9th Cir. July 13, 2017), the Ninth Circuit also adopted this position, indicating that the majority rule may be eroding.

Free-and-Clear Sales

Section 363(f) of the Bankruptcy Code authorizes a trustee or DIP to sell property "free and clear of any interest in such property of an entity other than the estate" under any one of five specified conditions. These include, among other things, if applicable nonbankruptcy law permits a sale free and clear, if the sale price exceeds the aggregate value of all liens encumbering the property, or if the interest is in bona fide dispute.

A bankruptcy court's power to order sales free and clear of competing interests without the consent of the party asserting the interest has been recognized for more than a century. See Ray v. Norseworthy, 90 U.S. 128, 131–32 (1875); Van Huffel v. Harkelrode, 284 U.S. 225, 227 (1931). It promotes the expeditious liquidation of estate assets by avoiding delay attendant to sorting out disputes concerning the validity and extent of competing interests, which can later be resolved in a centralized forum. It also facilitates the estate's realization of the maximum value possible from an asset. A prospective buyer would discount its offer significantly if it faced the prospect of protracted litigation to obtain clear title to an asset.

Section 363(e) of the Bankruptcy Code provides that, upon the request of an entity which has an "interest" in property proposed to be sold by the trustee or DIP, the court "shall prohibit or condition" the sale "as is necessary to provide adequate protection of such interest." Section 361 provides that "adequate protection may be provided" by periodic cash payments to protect against any decrease in value of the interest; an additional or replacement lien (if the interest is a lien); or other relief, such as an administrative expense claim, "as will result in the realization by such entity of the indubitable equivalent of such entity's interest in such property."

"Any Interest" Broadly Construed

Section 363(f) has been applied to a wide range of interests. Courts, however, have sometimes struggled to comprehend the precise scope of the term "interest," which is not defined in the Bankruptcy Code or its accompanying legislative history. Most courts reject the narrow approach adopted by courts that find section 363(f) to be confined to in rem property interests or only those claims which have already been asserted at the time the property is sold. Instead, the majority have construed the term broadly to encompass other obligations that may flow from ownership of property, including, for example, successor liability claims. See, e.g., Indiana State Police Pension Trust v. Chrysler LLC (In re Chrysler LLC), 576 F.3d 108 (2d Cir. 2009), cert. granted and judgment vacated on other grounds, 558 U.S. 1087 (2009); In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003); UMWA 1992 Benefit Plan v. Leckie Smokeless Coal Co. (In re Leckie Smokeless Coal Co.), 99 F.3d 573 (4th Cir. 1996); In re PBBPC, Inc., 484 B.R. 860 (B.A.P. 1st Cir. 2013); In re ARSN Liquidating Corp., 2017 BL 17185 (Bankr. D.N.H. Jan. 20, 2017). But see Elliott v. Gen. Motors LLC (In re Motors Liquidation Co.), 829 F.3d 135 (2d Cir. 2016) (agreeing that successor liability claims can be "interests" when they flow from a debtor's ownership of transferred assets, but ruling that certain claims were not barred because they had not yet arisen at the time a section 363(f) sale closed and that certain other claimants received inadequate notice of the sale); Olson v. Frederico (In re Grumman Olson Indus., Inc.), 445 B.R. 243 (Bankr. S.D.N.Y. 2011) (a section 363 sale order cannot exonerate purchasers from successor liability claims by claimants who, at the time of the sale, had not yet been injured and had no contact or relationship with the debtor or its products).

The scope of section 363(f) becomes an issue if a debtor-lessor seeks to sell property free and clear of the possessory interests of tenants or subtenants. This is so because section 365(h)(1) specifically protects such interests. As noted previously, section 365(h)(1) provides that, if the trustee or DIP rejects an unexpired real property lease under which the debtor is the lessor, the nondebtor lessee (and any permitted successor or assign) has the option either: (i) to treat the lease as terminated and file a claim for breach; or (ii) to retain its rights under the lease for the balance of the lease term (including any renewal or extension periods). Section 365(h)(2) provides similar protections to the purchaser of a debtor's timeshare interest.

In enacting section 365(h)(1), lawmakers sought to "codify a delicate balance between the rights of a debtor-lessor and the rights of its tenants" by preserving the parties' expectations in a real estate transaction. In re Lee Road Partners, Ltd., 155 B.R. 55, 60 (Bankr. E.D.N.Y. 1993). The provision's legislative history indicates that lawmakers intended that rejection of a lease by a debtor-lessor should not deprive the tenant of its estate for the term for which it bargained. See H.R. Rep. No. 95-595, 349–50 (1977); S. Rep. No. 95-989, 60 (1978).

Qualitech Steel

In 2003, the apparent conflict between sections 363(f) and 365(h)(1) was considered as a matter of first impression in the circuit courts of appeal in Qualitech Steel. In that case, a chapter 11 debtor sold substantially all of its assets (including a steel mill with a warehouse leased to Precision Industries, Inc. ("Precision") for 10 years) to the mortgagee of the property. The order approving the sale provided that the assets were to be conveyed "free and clear of all liens, claims, encumbrances, and interests," other than those specifically excepted. The Precision lease, which was unrecorded, was not among the exceptions. Precision was notified of the sale but chose not to object. Instead, it negotiated with the ultimate buyer of the property regarding the assumption of its lease. Those negotiations proved futile, and Precision's lease agreement was deemed rejected in accordance with the terms of the debtor's chapter 11 plan.

Precision commenced litigation seeking a determination that it retained a possessory interest in the warehouse notwithstanding the sale of the property. The bankruptcy court ruled that, under the terms of both section 363(f) and the sale order, the new owner had obtained title to the property free and clear of Precision's leasehold interest. According to the court, that interest clearly qualified as "any interest" under the statute and was unequivocally "extinguished" by the terms of the sale order. The court also implicitly rejected the idea that section 365(h) somehow preserved Precision's rights.

Precision appealed to the district court, which reversed. Reasoning that sections 363(f) and 365(h) are incongruous, the district court held that "the terms of section 365(h) prevail over those of section 363(f) as applied to the rights of lessees." It concluded that the more specific terms of section 365(h) must override the more general scope of section 363(f), observing that "[t]here is no statutory basis for allowing the debtor-lessor to terminate the lessee's position by selling the property out from under the lessee, and thus limiting a lessee's post-rejection rights solely to cases where the debtor-lessor remains in possession of its property." The new owner of the property appealed to the Seventh Circuit.

The Seventh Circuit reversed. The court was mindful of its obligation to construe the two statutory provisions in a way that avoids conflict if at all possible. Despite the Bankruptcy Code's silence on the exact meaning of "any interest," the court emphasized, the term itself is sufficiently comprehensive to encompass a broad range of competing rights. Given the U.S. Supreme Court's observations in other contexts that "interest" is a broad term, the Seventh Circuit concluded that the right conferred by a leasehold upon the lessee "readily may be understood as an 'interest' in the property" within the meaning of section 363(f).

The Seventh Circuit faulted the district court's reliance upon an apparent contradiction between the two provisions as a basis for reversing the bankruptcy court. First, the Seventh Circuit noted, the provisions themselves do not suggest that one supersedes or limits the other, whereas other subsections of both sections 363 and 365 contain specific cross-references to other provisions which have a limiting effect on their scope. The court then observed that the plain language of section 365(h) suggests that it is limited in scope. In particular, section 365(h) expressly applies only to situations where the trustee rejects a lease but retains possession of the property. By contrast, if the trustee does not reject the lease but sells the underlying property under section 363(f), the sale will be free and clear of the tenant's possessory interest (provided it meets one of the five conditions in section 363(f)).

According to the Seventh Circuit, a lessee is not without recourse if its leasehold rights are extinguished in this way. Section 363(e) gives the lessee the right to demand adequate protection of its interest in the property. This would most likely take the form of compensation for the value of its forfeited leasehold interest.

A number of lower courts have reached the same conclusion as the Seventh Circuit for some or all of the same reasons. See, e.g., In re Downtown Athletic Club of New York City, Inc., 2000 WL 744126 (S.D.N.Y. June 9, 2000); In re Spanish Peaks Holdings II, LLC, 2014 BL 64226 (Bankr. D. Mont. Mar. 10, 2014), aff'd, 2015 BL 191603 (D. Mont. June 16, 2015), aff'd, 2017 BL 241737 (9th Cir. July 13, 2017); South Motor Co. v. Carter-Pritchett-Hodges, Inc. (In re MMH Automotive Group, LLC), 385 B.R. 347 (Bankr. S.D. Fla. 2008).

Other courts have ruled to the contrary, reasoning that section 363(f) and section 365(h) conflict when they overlap, but that the more specific section 365(h) trumps section 363(f), and the legislative history of the former clearly indicates that lawmakers intended to protect a tenant's estate when the landlord files for bankruptcy. See, e.g., Dishi & Sons v. Bay Condos LLC, 510 B.R. 696 (S.D.N.Y. 2014); In re Zota Petroleums, LLC, 482 B.R. 154 (Bankr. E.D. Va. 2012); In re Samaritan Alliance, LLC, 2007 BL 156456 (Bankr. E.D. Ky. Nov. 21, 2007); In re Haskell, L.P., 321 B.R. 1 (Bankr. D. Mass. 2005); In re Churchill Properties III, Ltd. Partnership, 197 B.R. 283 (Bankr. N.D. Ill. 1996). Despite the Seventh Circuit's contrary approach, those courts represent the majority view on this issue.

Spanish Peaks

Spanish Peaks was a resort in Big Sky, Montana, owned by Spanish Peaks Holdings, LLC ("SPH"), an entity controlled by James J. Dolan, Jr., and Timothy L. Blixseth. The resort properties were financed by a $130 million secured loan that was ultimately assigned to CH SP Acquisitions ("CH SP").

In 2006, SPH leased restaurant space at the resort under a below-market lease that was later assigned to The Pinnacle Restaurant at Big Sky ("Pinnacle"), an SPH affiliate. SPH entered into another commercial lease in 2009 with Montana Opticom, LLC ("Opticom"), also an affiliate. Neither lease contained a subordination or nondisturbance clause protecting the tenant from foreclosure on the underlying property by the mortgagee of the properties.

SPH and two affiliates filed chapter 7 petitions in October 2011 in the District of Delaware, but venue of the cases was transferred to the District of Montana. The chapter 7 trustee proposed to sell the resort properties free and clear of all liens, claims, encumbrances, and interests, with certain exceptions, under section 363(f). Pinnacle and Opticom objected, claiming they were entitled to retain possession of the leased premises under section 365(h).

The bankruptcy court approved an auction sale of the resort properties in 2013 to CH SP for $26.1 million but expressly provided in its order that the sale was subject to any rights of lessees under section 365(h), which would be determined later. The trustee then filed a motion to reject the Pinnacle and Opticom leases, while CH SP separately sought a determination that the property was sold free and clear of the leases. At no time before or after the sale did Pinnacle and Opticom request adequate protection of their leasehold interests under section 363(e) or provide any evidence that they would suffer economic harm if their interests were terminated.

After finding, among other things, that the Pinnacle lease was well below market, that the Opticom lease was unrecorded, and that the validity of both leases was subject to bona fide dispute, the bankruptcy court held that the sale was free and clear of the leases. The district court affirmed on appeal. It reasoned that the sale extinguished the leases because the foreclosure of the property's mortgage would, under Montana law, terminate any leasehold interests junior to the mortgage.

The Ninth Circuit's Ruling

A three-judge panel of the Ninth Circuit affirmed.

According to the court, on the basis of a "proper understanding of the concept of 'rejection,' " sections 363(f) and 365(h) can "easily" be read to give effect to each while preserving their sense and purpose. Although a sale free and clear of a lease may be an effective rejection of the lease "in some everyday sense," the court wrote, "it is not the same thing as the 'rejection' contemplated by section 365," which requires an "affirmative declaration by the trustee that the estate will not take on the obligations of a lease or contract made by the debtor."

The Pinnacle and Opticom leases were not formally rejected by the trustee, and the leases were not deemed rejected under section 365(d)(1) or 365(d)(4)(A) because of the trustee's failure to act within a prescribed period. Thus, the Ninth Circuit panel concluded, section 365(h) was not implicated.

Citing the reasoning in Qualitech Steel with approval, the Ninth Circuit panel explained that section 363(e) makes mandatory the adequate protection of an interest to be terminated in a free-and-clear sale if requested by the holder of the interest. It further noted that the district court in Dishi & Sons concluded that adequate protection could take the form of a lessee's continued possession of its leasehold interest. The broad definition of "adequate protection," the Ninth Circuit panel wrote, "makes it a powerful check on potential abuses of free-and-clear sales."

Next, the court emphasized that section 363(f) authorizes free-and-clear sales only under certain circumstances. Although the bankruptcy court did not specify which alternative subsection of the provision applied to the sale of the resort properties, the Ninth Circuit panel focused on subsection (f)(1), which authorizes a free-and-clear sale if "applicable nonbankruptcy law permits sale of such property free and clear of such interest."

Under Montana law, the court explained, a foreclosure sale to satisfy a mortgage terminates a subsequent lease on the mortgaged property. According to the court, "SPH's bankruptcy proceeded, practically speaking, like a foreclosure sale . . . [and] had SPH not declared bankruptcy, we can confidently say that there would have been an actual foreclosure sale," which would have terminated the Pinnacle and Opticom leases.

The Ninth Circuit panel acknowledged that the court in Dishi & Sons held that section 363(f)(1) refers not to foreclosure sales, but to situations where an asset owner may sell an asset free and clear of an interest under nonbankruptcy law. The panel also acknowledged that debtors often seek bankruptcy protection "for the very purpose" of avoiding foreclosure. Still, the Ninth Circuit panel found it significant that section 365(h) recognizes appurtenant rights conferred by a lease "to the extent that such rights are enforceable under applicable nonbankruptcy law." Disagreeing with Dishi & Sons, the Ninth Circuit wrote that "[w]e see no reason to exclude the law governing foreclosure sales from the analogous language in section 363(f)(1)."

Finally, the Ninth Circuit panel explained that its analysis "highlights a limitation inherent in the 'majority' approach"—namely, although section 365(h) embodies lawmakers' intent to protect lessees, "that intent is not absolute" and coexists with competing purposes, such as the goal of maximizing creditor recovery. According to the court, its reading of sections 363(f) and 365(h) most nearly balances those competing purposes in the way Congress intended.

Outlook

With Spanish Peaks and Qualitech Steel, two circuits have now ruled that a leasehold interest may be extinguished in a free-and-clear sale of property under section 363(f). Therefore, the majority approach on this important issue appears to be losing ground. The rulings may be a welcome development for landlords intent upon selling property in bankruptcy unburdened by leasehold interests, and anything but welcome news for lessees, but the resulting uncertainty is not a positive development for either group.

Absent judicial resolution of the issue at the highest level or legislative clarification, landlords and tenants should be mindful of the approach adopted by the courts in their jurisdictions. Tenants in a minority approach jurisdiction that face the prospect of a free-and-clear sale should demand adequate protection (including the possibility of continued possession) of their leasehold interests at the earliest opportunity.

Finally, Spanish Peaks was an unusual case. Because the lessees failed to demand adequate protection of their leasehold interests under section 363(e), the Ninth Circuit panel never addressed what form of adequate protection would have been appropriate under the circumstances, including the retention of possession. Moreover, because the leases were disputed, the sale could also have been approved under section 363(f)(3), which permits a free-and-clear sale if "such interest is in bona fide dispute."

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Mark G. Douglas
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