How to Extinguish a Lessee's Possessory Interest

Section 363(f) of the Bankruptcy Code authorizes a trustee 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 others things: if applicable non-bankruptcy law permits a sale free and clear; if the sales price exceeds the amount of any 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 over 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. See In re Clark, 266 B.R. 163 (9th Cir. BAP 2001). 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. See In re WBQ Partnership, 189 B.R. 97, 108 (Bankr. E. D. Va. 1995). Pending the bankruptcy court's resolution of any disputes, the non-debtor is entitled to 'adequate protection' of its interest. See 11 U.S.C. ' 363(e). This most commonly takes the form of a replacement lien on the proceeds of the sale.

'Any Interest' Broadly Construed

Section 363(f) has been applied to a wide range of interests, but courts have sometimes struggled to comprehend the precise scope of the term 'interest,' which is defined nowhere in the Bankruptcy Code or its accompanying legislative history. The majority construes the term broadly, rejecting the narrow approach ascribed to by some courts that find section 363(f) to be confined to in rem property interests or only those claims that have already been asserted at the time the property is sold. Compare In re Paris Industries Corp., 132 B.R. 504 (D. Me. 1991) (free and clear sale enabled bankruptcy court to enjoin product liability claims as asserted against purchaser), with Fairchild Aircraft Corp. v. Cambell, 184 B.R. 910, 917-18 (Bankr. W.D. Tex.) ('The sorts of interests impacted by a sale 'free and clear' are in rem interests which have attached to the property. Section 363(f) is not intended to extinguish in personam liabilities'), vacated on other grounds, 220 B.R. 909 (Bankr. W. D. Tex. 1998).

Section 363(f) is problematic if a debtor-lessor seeks to sell property free and clear of the possessory interests of tenants. This is so because another provision in the Bankruptcy Code ' section 365(h)(1) 'specifically protects such interests. Under section 365(h)(1), if the trustee rejects an unexpired lease of real property, the non-debtor lessee has the option to either 1) treat the lease as terminated and pursue its claim for damages in the bankruptcy court; or 2) 'the lessee may retain its rights under such lease ' that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable non-bankruptcy law.' 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). Congress intended that rejection of a lease by a debtor-lessor should not deprive a tenant of its estate for the term for which it bargained. H. R. Rep. No. 95-595, 349-350 (1977); S. Rep. No. 95-989, 60 (1978). Section 365(h) and section 363(f) are seemingly at odds. This was the paradox confronted by the Seventh Circuit in Qualitech Steel.

Qualitech Steel

Shortly after filing for Chapter 11 protection, Qualitech Steel Corporation (Qualitech) sold substantially all of its assets (including a steel mill containing 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,' except for those specifically excepted. Precision was notified of the sale, yet chose not to object. Instead, it negotiated with the ultimate buyer of the property regarding the assumption of its (unrecorded) lease. Those negotiations proved futile, and Precision's lease agreement was deemed rejected in accordance with the terms of Qualitech's plan of reorganization.

Precision commenced litigation seeking a determination that it retained a possessory interest in the warehouse notwithstanding the sale of the property. That action ultimately made its way to the bankruptcy court, which ruled that, based upon 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. It also implicitly rejected the idea that section 365(h)(1) somehow preserved Precision's rights.

Precision appealed to the district court, which reversed. Reasoning that the provisions of section 363(f) and 365(h) are incongruous, the district court held that 'the terms of section 363(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 Court of Appeals, in a case of apparent first impression at the circuit level, reversed. Mindful of its obligation to construe the two statutory provisions in a way that avoids conflict if at all possible, the Seventh Circuit did precisely that. Despite the 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 Supreme Court's observations in other contexts that 'interest' is a broad term, the Court of Appeals concluded that the right a leasehold confers upon the lessee 'readily may be understood as an 'interest' in the property' within the meaning of section 363(f).

It 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 section 363 and 365 contain specific cross-references to other provisions that have a limiting effect on their scope. The court then observed that the plain language of section 365(h)(1) suggests that it is limited in scope. In particular, the Seventh Circuit emphasized, section 365(h)(1) 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). According to the court, a lessee is not without recourse if its leasehold rights are extinguished in this way. Section 363(e) gives it 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.

Analysis

Precision Industries does little to explain why policy considerations underlying section 363(f) (eg, promoting expeditious liquidation of a debtor's assets and maximization of the value of its estate) must necessarily override Congress' intent in section 365(h)(1) to protect the rights of lessors and lessees by preserving expectations in real estate transactions. To conclude that Congress intended to preserve those rights only in cases where the debtor remains in possession of property may be correct, but it is difficult to divine that intention from the statute as written or its legislative history. For this reason, the Seventh Circuit's rationalization of the harmony between section 363(f) and 365(h) is strained.

A number of lower courts have reached the same conclusion as the Seventh Circuit for the same reasons. See, e.g., In re Downtown Athletic Club of New York City, Inc., 2000 WL 744126, at *4 (S.D.N.Y. June 9, 2000); In re Bedford Square Associates, L.P., 247 B.R. 140 (Bankr.E.D. Pa. 2000), appeal dismissed as moot sub. nom. Wal-Mart Real Estate Business Trust v. Bedford Square Associates, LP, 2001 WL 286793, at *8 (E.D. Pa. Mar. 20, 2001). But judging by the number of contrary decisions, the issue is far from resolved. See, e.g., In re Churchill Properties III, Ltd. Partnership, 197 B.R. 283, 288 (Bankr. N.D. Ill. 1996); In re Stable Mews Associates, 35 B.R. 603, 607 (Bankr.S.D.N.Y.1983); In re LHD Realty Corp., 20 B.R. 717, 719 (Bankr. S.D. Ind.1982); see generally 3 Alan N. Resnick & Henry J. Sommer, Collier on Bankruptcy ' 365.10[1], at 365-79 to 365-80 & n. 7 (15th ed. rev. 2003). (Interestingly, the Seventh Circuit was never asked to decide whether the sale free and clear of Precision's unrecorded lease satisfied one of the five conditions of section 363(f). Precision never argued that it did not. The ruling might have been different if it had. Qualitech would have to demonstrate either that a sale free and clear of the leasehold interest was permitted under applicable non-bankruptcy law, or that Precision could be compelled to accept a money satisfaction of its interest.)

The relative paucity of decisions addressing the interaction of sections 363(f) and 365(h) reflects the fact that most disputes regarding a tenant's rights where the underlying property is sold in bankruptcy are settled as part of the sale transaction. The practical realties confronting lessees and their professionals when determining how best to preserve leasehold rights in this instance can only be fully understood with recognition that there are well developed arguments on both sides of the issue.

Mark G. Douglas is the Restructuring Practice Development Facilitator of the New York office of Jones Day, and the Managing Editor of the firm's monthly publication, the Business Restructuring Review.

The ability of a trustee 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 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, based both upon the language of the statute and its underlying purpose. So much so, in fact, that it has even been interpreted to permit sales free and clear of claims (eg, successor liability) and in rem property interests (such as covenants and easements) that are generally inalienable under common law. Broadly applied, section 363(f) also arguably conflicts with certain other provisions of the Bankruptcy Code. How best to resolve this conflict in a way that preserves the integrity of Bankruptcy Code by harmonizing its provisions was the subject of a case of apparent first impression in the Circuit Courts of Appeal. In Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp.), 2003 WL 1918405 (7th Cir. Apr. 23, 2003), the Seventh Circuit ruled that a court order approving the sale of real property under section 363(f) extinguished a tenant's possessory rights in the property despite the protection afforded to non-debtor lessees under section 365(h)(1) of the Bankruptcy Code.

Sales Free and Clear

Section 363(f) of the Bankruptcy Code authorizes a trustee 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 others things: if applicable non-bankruptcy law permits a sale free and clear; if the sales price exceeds the amount of any 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 over 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. See In re Clark, 266 B.R. 163 (9th Cir. BAP 2001). 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. See In re WBQ Partnership, 189 B.R. 97, 108 (Bankr. E. D. Va. 1995). Pending the bankruptcy court's resolution of any disputes, the non-debtor is entitled to 'adequate protection' of its interest. See 11 U.S.C. ' 363(e). This most commonly takes the form of a replacement lien on the proceeds of the sale.

'Any Interest' Broadly Construed

Section 363(f) has been applied to a wide range of interests, but courts have sometimes struggled to comprehend the precise scope of the term 'interest,' which is defined nowhere in the Bankruptcy Code or its accompanying legislative history. The majority construes the term broadly, rejecting the narrow approach ascribed to by some courts that find section 363(f) to be confined to in rem property interests or only those claims that have already been asserted at the time the property is sold. Compare In re Paris Industries Corp., 132 B.R. 504 (D. Me. 1991) (free and clear sale enabled bankruptcy court to enjoin product liability claims as asserted against purchaser), with Fairchild Aircraft Corp. v. Cambell , 184 B.R. 910, 917-18 (Bankr. W.D. Tex.) ('The sorts of interests impacted by a sale 'free and clear' are in rem interests which have attached to the property. Section 363(f) is not intended to extinguish in personam liabilities'), vacated on other grounds , 220 B.R. 909 (Bankr. W. D. Tex. 1998).

Section 363(f) is problematic if a debtor-lessor seeks to sell property free and clear of the possessory interests of tenants. This is so because another provision in the Bankruptcy Code ' section 365(h)(1) 'specifically protects such interests. Under section 365(h)(1), if the trustee rejects an unexpired lease of real property, the non-debtor lessee has the option to either 1) treat the lease as terminated and pursue its claim for damages in the bankruptcy court; or 2) 'the lessee may retain its rights under such lease ' that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable non-bankruptcy law.' 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). Congress intended that rejection of a lease by a debtor-lessor should not deprive a tenant of its estate for the term for which it bargained. H. R. Rep. No. 95-595, 349-350 (1977); S. Rep. No. 95-989, 60 (1978). Section 365(h) and section 363(f) are seemingly at odds. This was the paradox confronted by the Seventh Circuit in Qualitech Steel.

Qualitech Steel

Shortly after filing for Chapter 11 protection, Qualitech Steel Corporation (Qualitech) sold substantially all of its assets (including a steel mill containing 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,' except for those specifically excepted. Precision was notified of the sale, yet chose not to object. Instead, it negotiated with the ultimate buyer of the property regarding the assumption of its (unrecorded) lease. Those negotiations proved futile, and Precision's lease agreement was deemed rejected in accordance with the terms of Qualitech's plan of reorganization.

Precision commenced litigation seeking a determination that it retained a possessory interest in the warehouse notwithstanding the sale of the property. That action ultimately made its way to the bankruptcy court, which ruled that, based upon 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. It also implicitly rejected the idea that section 365(h)(1) somehow preserved Precision's rights.

Precision appealed to the district court, which reversed. Reasoning that the provisions of section 363(f) and 365(h) are incongruous, the district court held that 'the terms of section 363(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 Court of Appeals, in a case of apparent first impression at the circuit level, reversed. Mindful of its obligation to construe the two statutory provisions in a way that avoids conflict if at all possible, the Seventh Circuit did precisely that. Despite the 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 Supreme Court's observations in other contexts that 'interest' is a broad term, the Court of Appeals concluded that the right a leasehold confers upon the lessee 'readily may be understood as an 'interest' in the property' within the meaning of section 363(f).

It 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 section 363 and 365 contain specific cross-references to other provisions that have a limiting effect on their scope. The court then observed that the plain language of section 365(h)(1) suggests that it is limited in scope. In particular, the Seventh Circuit emphasized, section 365(h)(1) 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). According to the court, a lessee is not without recourse if its leasehold rights are extinguished in this way. Section 363(e) gives it 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.

Analysis

Precision Industries does little to explain why policy considerations underlying section 363(f) (eg, promoting expeditious liquidation of a debtor's assets and maximization of the value of its estate) must necessarily override Congress' intent in section 365(h)(1) to protect the rights of lessors and lessees by preserving expectations in real estate transactions. To conclude that Congress intended to preserve those rights only in cases where the debtor remains in possession of property may be correct, but it is difficult to divine that intention from the statute as written or its legislative history. For this reason, the Seventh Circuit's rationalization of the harmony between section 363(f) and 365(h) is strained.

A number of lower courts have reached the same conclusion as the Seventh Circuit for the same reasons. See, e.g., In re Downtown Athletic Club of New York City, Inc., 2000 WL 744126, at *4 (S.D.N.Y. June 9, 2000); In re Bedford Square Associates, L.P., 247 B.R. 140 (Bankr.E.D. Pa. 2000), appeal dismissed as moot sub. nom. Wal-Mart Real Estate Business Trust v. Bedford Square Associates, LP, 2001 WL 286793, at *8 (E.D. Pa. Mar. 20, 2001). But judging by the number of contrary decisions, the issue is far from resolved. See, e.g., In re Churchill Properties III, Ltd. Partnership, 197 B.R. 283, 288 (Bankr. N.D. Ill. 1996); In re Stable Mews Associates, 35 B.R. 603, 607 (Bankr.S.D.N.Y.1983); In re LHD Realty Corp., 20 B.R. 717, 719 (Bankr. S.D. Ind.1982); see generally 3 Alan N. Resnick & Henry J. Sommer, Collier on Bankruptcy ' 365.10[1], at 365-79 to 365-80 & n. 7 (15th ed. rev. 2003). (Interestingly, the Seventh Circuit was never asked to decide whether the sale free and clear of Precision's unrecorded lease satisfied one of the five conditions of section 363(f). Precision never argued that it did not. The ruling might have been different if it had. Qualitech would have to demonstrate either that a sale free and clear of the leasehold interest was permitted under applicable non-bankruptcy law, or that Precision could be compelled to accept a money satisfaction of its interest.)

The relative paucity of decisions addressing the interaction of sections 363(f) and 365(h) reflects the fact that most disputes regarding a tenant's rights where the underlying property is sold in bankruptcy are settled as part of the sale transaction. The practical realties confronting lessees and their professionals when determining how best to preserve leasehold rights in this instance can only be fully understood with recognition that there are well developed arguments on both sides of the issue.

Mark G. Douglas is the Restructuring Practice Development Facilitator of the New York office of Jones Day, and the Managing Editor of the firm's monthly publication, the Business Restructuring Review.