Ever since the 7th Circuit’s decision in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC, 327 F. 3rd 537(7th Cir. 2003), bankruptcy practitioners and lessees have wondered if, in the context of a debtor-in-possession or a trustee sale of real estate free and clear of any interests in the property under Section 363(f), they could protect the lessee’s Section 365(h) right to remain in possession of leased real estate when the lease is rejected. Many shook their heads at the Seventh Circuit’s reasoning and attributed the decision to the lessee’s failure to object to the sale or to seek adequate protection under Section 363(e). Others raised concerns about the possible impact of the case on a licensee’s right to retain intellectual property under Section 365(n) after an intellectual property license has been rejected. Now, from the United States Bankruptcy Court for the District of Massachusetts, Chief Judge Feeney has restored a bit of sanity to this area of bankruptcy practice, that is unless you have a case in the 7th Circuit. Hopefully, her In re Haskell, L. P., 2005 Bankr. LEXIS 251 (Bankr. D. Mass. 2005) decision will be a beacon guiding practitioners and courts that address these issues in the future.

In Precision Industries, Inc. v. Qualitech Steel SBQ, LLC, 327 F. 3rd 537(7th Cir. 2003), the Seventh Circuit held that a lessee of real property from the debtor did not have an interest in the real estate after that real estate had been sold in a bankruptcy court sale free and clear of interests in accordance with Section 363(f). In other words, the lease did not survive the sale and the lessee’s rights under Section 363(h) were likewise lost. The lessee did not object at the time of the bankruptcy court authorized sale and the lease was not specifically rejected until after the sale closed. The lessee did not raise its Section 363(h) right to remain in possession of the leased real estate until after the sale free and clear of interests had closed and the buyer locked the lessee out of the property. The result was that Section 363(f) trumped Section 363(h).

Chief Judge Feeney’s decision was issued in the Chapter 11 case of Haskell L.P. The debtor owned a piece of real estate encumbered by a first mortgage. The debtor also leased a portion of its real estate to a hospital which operated a short term stay facility with 60 parking spaces on the leased property, paid no fixed rent, but paid all operating expenses and real estate taxes. The hospital/lessee also held a right of first refusal to purchase the real estate, with that option secured by a second mortgage. The first mortgagee and the hospital/lessee had entered into a subordination and non-disturbance agreement so that if the first mortgage was ever foreclosed, the first mortgagee would not disturb the hospital/lessee’s ability to occupy the portion of the debtor’s real estate occupied pursuant to the lease.

In the Chapter 11 case, the debtor filed a motion asking the court for authority to sell the real estate by public auction free and clear of all interests including free and clear of the lease. The parties believed that a public auction would net substantial funds, but not enough to pay off the first mortgage let alone leave anything for the hospital/lessee on its second mortgage. The debtor also filed a motion to reject the option secured by the second mortgage. It also filed a liquidating plan with a disclosure statement which contemplated the public auction of the real estate, as well as the rejection of the hospital’s lease. The bankruptcy court took up the motion to sell free and clear because it made no sense to deal with the plan and its accompanying disclosure statement unless the sale was going to go forward.

The hospital/lessee timely objected to the motion to sell the real estate free and clear of its lease, perhaps distinguishing itself by this act alone from the lessee in the Precision Industries, Inc. case. The objection raised the hospital lessee’s prospective Section 365(h) rights to remain in possession of the leased real estate after rejection of the lease. The objection also asserted the hospital/lessee’s right under Section 363(e) to have its lease interest in the real estate and its 363(h) rights adequately protected. No objection was filed to the motion that asked for authority to reject the option to purchase. The debtor stipulated that the hospital lease would be rejected under the liquidating plan and that the value of the real estate was about half what was owed to the first mortgagee.

At the hearing on the Debtor’s motion for authority to sell the real estate, the hospital/lessee presented evidence that a loss of its lease would cause it considerable damages, but that it would be extremely difficult if not impossible to quantify those damages.

The bankruptcy court’s refused to authorize the sale because the debtor could not provide adequate protection to the hospital/lessee. Chief Judge Feeney’s analysis covered the following points:

  1. For purposes of Section 363(f), which allows a sale free and clear of interests if "applicable nonbankruptcy law permits sale of such property free and clear of such interest," the hypothetical ability of a governmental entity to take the leased real estate by eminent domain does not satisfy the statute. Rather than allow the debtor to apply a hypothetical test, the court insisted on an actual test holding that the only "applicable nonbankruptcy law" that should be used to satisfy Section 353(f) is law that a trustee or debtor-in-possession could actually employ.

  2. Sales of the property under Section 363(f) are subject to the Section 363(e) requirement that adequate protection be provided to the holder of an interest in the property being sold. While adequate protection could be provided by allowing the interest to attach to the proceeds of the sale, in the Haskell L.P. case that solution would not work because the proceeds to be realized from the sale were not enough to even satisfy the first mortgage, let alone protect the hospital/lessee. There would simply be no proceeds to which the hospital/ lessee’s interest would attach. In light of the evidence presented that the hospital/lessee would suffer substantial and unquantifiable damages if it lost its lease as well as its Section 365(h) ability to remain in possession of the leased premises after rejection of the lease, no adequate protection had been offered or could be provided.

It is possible that the explanation for the difference between the Haskell decision and the Seventh Circuit decision in Precision Industries, Inc. is nothing more than the product of the lessee having failed to object to the Precision Industries, Inc. sale and to assert its Section 363(e) rights while the lessee did timely object to the sale in the Haskell case and also asserted its rights under Section 363(e) to adequate protection. If that’s the lesson to be learned from comparing the two cases, then the admonition to bankruptcy attorneys for lessee’s that has been voiced after the Precision Industries, Inc. decision was issued would appear accurate, i.e. object early and often when the debtor-in-possession or a trustee attempts to sell real estate subject to a lease where the lessee is in possession.

However, that’s just too simplistic a position in light of the reasoning employed by the Seventh Circuit which held in Precision Industries, Inc. that Section 363(f) rights to sell real estate free and clear trump a lessee’s Section 365(h) rights to remain in possession of the leased real estate after the underlying lease has been rejected. The decision in Haskell attacks that reasoning and makes clear that if a sale is the subject of a timely objection coupled with appropriate evidence, the bankruptcy court should uphold the rights of a tenant under Section 365(h), even before rejection of the underlying lease, over an attempt to trump those rights using Section 363(f).

Of course, Haskell, with a 99 year lease and a not-for-profit hospital as the tenant, presents an extreme case. The only evidence the court mentions regarding adequate protection was evidence presented by the lessee to the effect that its damages should it be unable to continue to occupy the leased premises would be significant and unquantifiable. The only protection offered by the debtor was a second lien on the proceeds of the sale, an admittedly worthless bit of protection since the first mortgagee’s secured claim would eat up all of the sale proceeds. It’s not hard to see why the court viewed the debtor’s offer of adequate protection as hardly adequate at all. However, where the sale free and clear can produce surplus assets available to satisfy unsecured claims, adequate protection of a tenant’s Section 363(h) rights may be possible. Imagine that alternative space is available, the costs of moving a lessee from the leased location to another is not extreme, and the lessee can operate adequately out of alternative space without damage to its business. In these circumstances, an adequate protection arrangement could be worked out or imposed under Section 363(e) by a bankruptcy court which is otherwise satisfied that a sale free and clear makes sense. Creditors committees are going to have to evaluate whether the sale, subject to such adequate protection, provides sufficient benefit to the estate such that it wants to support the sale and courts are going to have to wrestle with the Section 363(f) issues.

  • Other courts that allowed Section 363(f) to trump Section 365(h) rights include:
  1. In re Downtown Athletic Club of N.Y.C., 2000 U.S. Dist LEXIS 7917, *10-14 (S.D.N.Y. 2000) (Tenants without a lease argued that they had a right to get a lease. Real property was sold free and clear of interests and tenants did not object nor assert Section 363(e) right to adequate protection. They later sued in Federal District Court which upheld the sale and declined to follow Taylor).

  2. In re Hill, 307 B.R. 821, 825-826 (Bankr. W.D. Pa. 2004) (Court finds that no lease existed. Follows Precision Industries, Inc. after referring to its analysis as persuasive and exhaustive).
  • Other courts that upheld Section 363(h) rights in the face of Section 363(f) or otherwise:
  1. In re: Churchill Properties III, L.P., 197 BR 283 (Bankr. N.D.Ill. 1996) (Very similar facts to Haskell including a sale of real estate proposed in a plan to be free and clear of any interests including the real estate lease. Holds that Section 365(h), being a specific provision of the Bankruptcy Code, takes precedence over Section 365(f) which is a general provision).

  2. In re: Taylor, 198 BR 142 (Bankr. D. SC 1996) (Follows LHD Realty Corp. and holds that Section 365(f) does not trump Section 365(h));

  3. In re: LHD Realty Corp., 20 BR 717 (Bankruptcy S.D. Ind. 1982) (Analyses the state-law doctrine of commercial impracticability and finds it not available to a debtor. Views Section 365 as the exclusive remedy available to a debtor when dealing with an unexpired lease).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.