Vigilance and Planning Are Necessary in Bankruptcy Matters

Not even a year later, Qualitech filed a Chapter 11 petition, and shortly thereafter, all of Qualitech's assets were sold to the debtor's senior pre-petition lenders. The sale order provided that the debtor was to convey its assets to the lenders “free and clear of all liens, claims, encumbrances and interests, except for certain enumerated liens” pursuant to Section 363(f) of the Bankruptcy Code. The lenders in turn assigned their rights to a newly created entity and that entity and Precision disputed who was entitled to the possession of the leased premises.

The court first held that the tenant's interest under a lease is an interest in the property of the debtor and the sale under Section 363 can be made free and clear of that interest. For such a result to follow, however, one of several requirements must be satisfied: 1) applicable nonbankruptcy law must permit the sale of such property free and clear of such interest; or 2) the party whose interest is extinguished must consent; or 3) the interest must be a lien and the price at which such property is to be sold must be greater than the aggregate value of all liens on such property; or 4) the interest must be in dispute; or 5) the holder of the interest must be able to be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest. Since Precision did not assert that none of the requirements were satisfied, the court expressly assumed that “one or more of the statutory criteria were met and that a sale of the property free and clear of Precision's interest as a lessee was permissible.”

Unfortunately, the tenant did not object to the sale and only became active in the proceedings after the sale was held. As a result, we do not know how the case would have been resolved if Precision had filed a timely objection and asserted that the requirements for a sale free and clear of its leasehold interest were not satisfied. As the case stands, Precision's interest was extinguished.

Is that reason for all tenants to fear that their leasehold interest will be extinguished if their landlord goes into bankruptcy and sells the demised premises free and clear of the leasehold interest? Probably not. If tenants are careful to protect their interests and not sleep on their rights, they should not be subject to the loss of their interest.

It must be noted that if the debtor had proceeded under a parallel procedure set out in Section 365(h) to reject the Precision lease rather than selling its assets free and clear of that leasehold interest, a tenant in possession under a rejected lease would be allowed to retain its rights under its lease for the balance of the term, including renewals. A similar protective provision is not found in Section 363, and the court held that the tenant protective provisions of Section 365 cannot be read into Section 363.

How can the tenant obtain the equivalent of those protections? There are at least two ways.

First, the tenant must diligently assert that the requirements for the sale free and clear of the leasehold interest are not met. If it is assumed that the interest is not in dispute and the tenant does not consent to the sale free and clear, neither of those requirements will be satisfied. By its very nature, the lease is not a lien. That leaves the argument that either applicable nonbankruptcy law permits the sale of the property free and clear of the tenant's interest, or the tenant must be subject to being compelled in a legal or equitable proceeding to accept a money satisfaction of its interest.

In certain factual circumstances, such as the foreclosure of a mortgage that is prior to the lease, or the execution sale on a judgment that is prior to the lease, or the sale of real estate taxes and resultant tax deed, or the condemnation of the property, the property may be sold free and clear of the tenant's interest. Those laws, however, are not “applicable” to the sale of the property in bankruptcy free and clear of the lease. See e.g. In re Pintlar Corporation, 187 B.R. 680 (Bky. Ct. D.Idaho 1995); In re Manning, 37 B.R. 755 (Bky. Ct. D. Col. 1984). While the phrase “applicable nonbankruptcy law” includes both federal and state law, Patterson v. Shumate, 504 U.S. 753, 112 S.Ct. 2242 (1992), in the case at hand, no circumstances applied to bring any such nonbankruptcy law into play. The bankruptcy court simply used its statutory power to sell the assets free of all interests.

The last of the five alternate requirements involves the situation where the party holding the interest to be divested could be compelled in a legal or equitable proceeding to accept a money satisfaction of such interest. This leg of the requirements for a sale free and clear has been used primarily where the property is burdened by liens in an aggregate amount that is too large to be paid out of the sale proceeds. In such event, one such equitable proceeding may be the pending bankruptcy in which the cram down powers are used to require the lien holder to accept less than the full amount of its secured debt from the sale proceeds. In re Grand Slam U.S.A., Inc., 178 B.R. 460 (E. Dist. Mich. 1995); In re Weyland, 63 B.R. 854 (Bky. Ct. E. Dist. Wisc. 1986); In re Hunt Energy Co., Inc., 48 B.R. 472 (Bky. Ct. N. Dist. Ohio 1985).

Where the interest is a right in real estate, such as a right under a declaration of restrictions, this section should not apply. Gouveia v. Tazbir, 37 F.3d 295 (7th Cir.1994). See also In re 523 East Fifth Street Housing Preservation Development Fund Corporation, 79 B.R. 568 (Bky. Ct. S. D. N.Y. 1987). The same result should apply in the context of a tenant's leasehold interest.

Second, the court itself pointed out that there is a mechanism in the Bankruptcy Code to protect the tenant's interest. The tenant could have petitioned the court to prohibit or condition the sale as may be necessary to adequately protect the tenant's leasehold and possessory interest. Section 363(e). Precision did not, however, seek such protection.

While it is facile to say that bad cases make bad law and that this is merely a case that presents a bad result because the tenant did not take timely steps to protect its interest, that may well be the best explanation of this case. Tenants must be vigilant to protect their interests and prevent the leasehold estate from being terminated as a result of a sale free and clear in bankruptcy. Tenants should not disregard those “routine” notices that they get from the bankruptcy court. To do so may bring about dramatically adverse consequences.

It should also be pointed that not all under-market leases are in jeopardy of being extinguished at the whim of the landlord. Resort to bankruptcy is not available to all landlords. They must be experiencing financial difficulties and make a good faith bankruptcy filing. Even those landlords who qualify may not wish to enter the bankruptcy arena and loose control over their destiny by becoming subject to the scrutiny of the court.

The other Seventh Circuit case involves a bankrupt tenant and an oversized result. Ha-Lo Industries, Inc. v. Center Point Properties Trust, 342 F.3d 794 (7th Cir. 2003) is a case of bad timing. Ha-Lo, the debtor, had a new custom-designed headquarters building constructed for it. The monthly rent for this high-tech and high-styled building was $660,342.17. Ha-Lo exercised its right to reject this lease and vacated the building on or about Nov. 3, 2001. On Nov. 1, 2001, the debtor paid to the landlord $60,031.17, rent apportioned to 3 of the 30 days of November, claiming that its obligation was only to pay the prorated rent for November. The landlord demanded the balance of the November rent and filed an administrative claim for the amount due.

Section 365(d)(3) of the Code requires the timely performance of all obligations of the debtor under an unexpired lease until the lease is assumed or rejected. The Ha-Lo lease required that rent be paid on the first day of each month. As a result, the debtor was contractually required to pay the entire amount of the rental payment on Nov. 1, and could not prorate that rent for the time in which the tenant was in occupancy before the effective date of the lease rejection.

While the lease had various provisions that allowed the proration of rent under certain specific circumstances, such as the termination of the lease upon the destruction of the premises as a result of a casualty, or the beginning or ending of the term on other than the first or last day of a month, those provisions were not applicable in this instance. Ha-Lo was obligated to pay the whole month's rent, even though it had occupancy for a shorter period until the lease was effectively rejected.

Both of these cases provide the lesson that the parties must be careful and protect their rights. If possible the debtor in the Ha-Lo case could have planned to vacate the premises before or at the end of the prior month and would have saved a large amount of rent. The tenant in the Qualitech case could have been more active in protecting its rights and shaping the result when the landlord's assets were sold free and clear. Both good lessons to learn.

Two recent decisions by the U.S. Court of Appeals for the Seventh Circuit have attracted the attention of leasing lawyers. Both of those cases demonstrate that landlords and tenants alike may be taken by surprise by the operation of the Bankruptcy Code.

The first decision that created quite a stir involved a landlord's bankruptcy. While at first reading the facts and outcome of the case seem devastating to tenants, further analysis proves that the true lesson of the case may simply be that the tenant must vigilantly protect its rights if its landlord is in bankruptcy.

In Precision Industries, Inc. v. Qualitech Steel SBQ, LLC , 327 F.3d 537 (7th Cir. 2003) the court held that the sale of the debtor's assets, including property that was subject to a ground lease, was a sale free and clear of the tenant's interest, thereby extinguishing the tenant's leasehold interest. In this case, Qualitech Steel, the debtor, ground leased land at its steel mill facility to Precision. The tenant then proceeded to construct a warehouse on the leased land as part of an integrated, on-site, supply and services arrangement with Qualitech. The ground lease had a term of 10 years and called for the payment by Precision to Qualitech of an annual rent of $1.

Not even a year later, Qualitech filed a Chapter 11 petition, and shortly thereafter, all of Qualitech's assets were sold to the debtor's senior pre-petition lenders. The sale order provided that the debtor was to convey its assets to the lenders “free and clear of all liens, claims, encumbrances and interests, except for certain enumerated liens” pursuant to Section 363(f) of the Bankruptcy Code. The lenders in turn assigned their rights to a newly created entity and that entity and Precision disputed who was entitled to the possession of the leased premises.

The court first held that the tenant's interest under a lease is an interest in the property of the debtor and the sale under Section 363 can be made free and clear of that interest. For such a result to follow, however, one of several requirements must be satisfied: 1) applicable nonbankruptcy law must permit the sale of such property free and clear of such interest; or 2) the party whose interest is extinguished must consent; or 3) the interest must be a lien and the price at which such property is to be sold must be greater than the aggregate value of all liens on such property; or 4) the interest must be in dispute; or 5) the holder of the interest must be able to be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest. Since Precision did not assert that none of the requirements were satisfied, the court expressly assumed that “one or more of the statutory criteria were met and that a sale of the property free and clear of Precision's interest as a lessee was permissible.”

Unfortunately, the tenant did not object to the sale and only became active in the proceedings after the sale was held. As a result, we do not know how the case would have been resolved if Precision had filed a timely objection and asserted that the requirements for a sale free and clear of its leasehold interest were not satisfied. As the case stands, Precision's interest was extinguished.

Is that reason for all tenants to fear that their leasehold interest will be extinguished if their landlord goes into bankruptcy and sells the demised premises free and clear of the leasehold interest? Probably not. If tenants are careful to protect their interests and not sleep on their rights, they should not be subject to the loss of their interest.

It must be noted that if the debtor had proceeded under a parallel procedure set out in Section 365(h) to reject the Precision lease rather than selling its assets free and clear of that leasehold interest, a tenant in possession under a rejected lease would be allowed to retain its rights under its lease for the balance of the term, including renewals. A similar protective provision is not found in Section 363, and the court held that the tenant protective provisions of Section 365 cannot be read into Section 363.

How can the tenant obtain the equivalent of those protections? There are at least two ways.

First, the tenant must diligently assert that the requirements for the sale free and clear of the leasehold interest are not met. If it is assumed that the interest is not in dispute and the tenant does not consent to the sale free and clear, neither of those requirements will be satisfied. By its very nature, the lease is not a lien. That leaves the argument that either applicable nonbankruptcy law permits the sale of the property free and clear of the tenant's interest, or the tenant must be subject to being compelled in a legal or equitable proceeding to accept a money satisfaction of its interest.

In certain factual circumstances, such as the foreclosure of a mortgage that is prior to the lease, or the execution sale on a judgment that is prior to the lease, or the sale of real estate taxes and resultant tax deed, or the condemnation of the property, the property may be sold free and clear of the tenant's interest. Those laws, however, are not “applicable” to the sale of the property in bankruptcy free and clear of the lease. See e.g. In re Pintlar Corporation, 187 B.R. 680 (Bky. Ct. D.Idaho 1995); In re Manning, 37 B.R. 755 (Bky. Ct. D. Col. 1984). While the phrase “applicable nonbankruptcy law” includes both federal and state law, Patterson v. Shumate , 504 U.S. 753, 112 S.Ct. 2242 (1992), in the case at hand, no circumstances applied to bring any such nonbankruptcy law into play. The bankruptcy court simply used its statutory power to sell the assets free of all interests.

The last of the five alternate requirements involves the situation where the party holding the interest to be divested could be compelled in a legal or equitable proceeding to accept a money satisfaction of such interest. This leg of the requirements for a sale free and clear has been used primarily where the property is burdened by liens in an aggregate amount that is too large to be paid out of the sale proceeds. In such event, one such equitable proceeding may be the pending bankruptcy in which the cram down powers are used to require the lien holder to accept less than the full amount of its secured debt from the sale proceeds. In re Grand Slam U.S.A., Inc., 178 B.R. 460 (E. Dist. Mich. 1995); In re Weyland, 63 B.R. 854 (Bky. Ct. E. Dist. Wisc. 1986); In re Hunt Energy Co., Inc., 48 B.R. 472 (Bky. Ct. N. Dist. Ohio 1985).

Where the interest is a right in real estate, such as a right under a declaration of restrictions, this section should not apply. Gouveia v. Tazbir , 37 F.3d 295 (7th Cir.1994). See also In re 523 East Fifth Street Housing Preservation Development Fund Corporation, 79 B.R. 568 (Bky. Ct. S. D. N.Y. 1987). The same result should apply in the context of a tenant's leasehold interest.

Second, the court itself pointed out that there is a mechanism in the Bankruptcy Code to protect the tenant's interest. The tenant could have petitioned the court to prohibit or condition the sale as may be necessary to adequately protect the tenant's leasehold and possessory interest. Section 363(e). Precision did not, however, seek such protection.

While it is facile to say that bad cases make bad law and that this is merely a case that presents a bad result because the tenant did not take timely steps to protect its interest, that may well be the best explanation of this case. Tenants must be vigilant to protect their interests and prevent the leasehold estate from being terminated as a result of a sale free and clear in bankruptcy. Tenants should not disregard those “routine” notices that they get from the bankruptcy court. To do so may bring about dramatically adverse consequences.

It should also be pointed that not all under-market leases are in jeopardy of being extinguished at the whim of the landlord. Resort to bankruptcy is not available to all landlords. They must be experiencing financial difficulties and make a good faith bankruptcy filing. Even those landlords who qualify may not wish to enter the bankruptcy arena and loose control over their destiny by becoming subject to the scrutiny of the court.

The other Seventh Circuit case involves a bankrupt tenant and an oversized result. Ha-Lo Industries, Inc. v. Center Point Properties Trust , 342 F.3d 794 (7th Cir. 2003) is a case of bad timing. Ha-Lo, the debtor, had a new custom-designed headquarters building constructed for it. The monthly rent for this high-tech and high-styled building was $660,342.17. Ha-Lo exercised its right to reject this lease and vacated the building on or about Nov. 3, 2001. On Nov. 1, 2001, the debtor paid to the landlord $60,031.17, rent apportioned to 3 of the 30 days of November, claiming that its obligation was only to pay the prorated rent for November. The landlord demanded the balance of the November rent and filed an administrative claim for the amount due.

Section 365(d)(3) of the Code requires the timely performance of all obligations of the debtor under an unexpired lease until the lease is assumed or rejected. The Ha-Lo lease required that rent be paid on the first day of each month. As a result, the debtor was contractually required to pay the entire amount of the rental payment on Nov. 1, and could not prorate that rent for the time in which the tenant was in occupancy before the effective date of the lease rejection.

While the lease had various provisions that allowed the proration of rent under certain specific circumstances, such as the termination of the lease upon the destruction of the premises as a result of a casualty, or the beginning or ending of the term on other than the first or last day of a month, those provisions were not applicable in this instance. Ha-Lo was obligated to pay the whole month's rent, even though it had occupancy for a shorter period until the lease was effectively rejected.

Both of these cases provide the lesson that the parties must be careful and protect their rights. If possible the debtor in the Ha-Lo case could have planned to vacate the premises before or at the end of the prior month and would have saved a large amount of rent. The tenant in the Qualitech case could have been more active in protecting its rights and shaping the result when the landlord's assets were sold free and clear. Both good lessons to learn.