<b><i>In the Spotlight:</i></b> Does a Tenant's Right of Possession Trump a Sale Under Section 363?

The interplay between ” 363(f) and 365(h) of the Bankruptcy Code continues to plague various courts. This article explores several recent decisions evaluating whether a tenant's rights under ' 365(h) survive a sale of the debtor's assets free and clear of all liens, claims, and encumbrances pursuant to section 363(f). In many cases, the issue boils down to the language of ' 363(f), which permits a sale “free and clear of any interest in such property of an entity other than the estate ' .” Courts have grappled with the question of whether the phrase “any interest” in the context of a real property sale includes not only fee interests, security interests and other ownership interests, but also a tenant's possessory right under ' 365(h). Some courts have construed the broad language of “any interest” to encompass leasehold interests and thus have determined that ' 363(f) trumps ' 365(h), permitting debtors and trustees to sell real property free and clear of leasehold interests. Other courts have reached different conclusions.

In the Courts

In the lone circuit court decision that has dealt with the issue, Precision Industries, Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003), the U.S. Court of Appeals for the Seventh Circuit determined that there was no conflict, holding that ” 365(h) and 363(f) “apply to distinct sets of circumstances.” Id. at 547. The Qualitech court reconciled the alleged conflict by stating that the terms of ' 363(f) apply when a trustee or a debtor-in-possession seeks to sell property of which it is a lessor, whereas ' 365(h) only deals with the assumption or rejection of unexpired leases of real property. By contrast, the district court in Dishi & Sons v. Bay Condos LLC, 510 B.R. 696 (S.D.N.Y. 2014), recently reconciled these apparently conflicting Bankruptcy Code sections differently. The district court affirmed the bankruptcy court's order, which authorized a sale of real property pursuant to ' 363(f), but also permitted the existing tenant to remain in possession of the premises under ' 365(h) after the purchase (i.e., the sale was not free and clear of the lease).

Dishi & Sons

Dishi & Sons marks a clear repudiation of the Qualitech rationale, reading these two statutory provisions in harmony. In addition, its decision construes the apparent conflicting Bankruptcy Code provisions in a way that provides both with meaning in all situations and does not render ' 365(h) nugatory in the context of a free-and-clear sale under ' 363(f).

In addition, the legislative history of ' 365(h) evidences a clear congressional intent to protect lessees when a lessor files for bankruptcy. See, e.g., In re Zota Petroleums, LLC, 482 B.R. 154, 161-162 (Bankr. E.D.Va. 2012). Conversely, many courts have concluded that these two provisions are indeed irreconcilable and that because ' 365(h) is more specific, it trumps ' 363(f) and provides the “exclusive remedy available to the debtor in an executory lease situation.” In re LDH Realty Corp., 20 B.R. 717, 719 (Bankr. S.D. Ind. 1982). The decision in Dishi & Sons clearly holds the promise of a more rational interpretation of these provisions because the decision to reject a lease is merely a decision not to obligate the estate to continue in an unprofitable agreement, as opposed to terminating the lease. Thus, ' 365(h) provides the lessee with rights to continue in possession as long as it continues to honor its obligations under the lease.

The Revel Casino Bankruptcy Decision

More recently, a decision in the Revel Casino bankruptcy proceedings reflects a possible change in course away from the Qualitech rationale by another court of appeals. The bankruptcy court approved the sale of the defunct Revel Casino property in Atlantic City, NJ, free and clear of all liens, claims and encumbrances, including possessory rights of tenants under ' 365(h). See In re Revel AC, Inc.,'525 B.R. 12, 22 (D.N.J. 2015).

The district court in Revel dealt with an emergency application for a stay of the sale order by, among other parties, a group of appellants that were lessees of portions of the Revel casino facility and accompanying properties, which the district court referred to as the “365(h) Appellants.” Following Qualitech, the district court held that the 365(h) Appellants had failed to demonstrate a strong likelihood of success on the merits and denied their request for a stay of the sale order. Id. at 30-31, 35. The 365(h) Appellants then sought an emergency stay of the sale order from the U.S. Court of Appeal for the Third Circuit, which reversed the district court's decision. In re Revel AC, Inc., 2015 U.S. App. LEXIS 1936 (3d Cir. Feb. 6, 2015). It remanded the matter for a stay as to one particular appellant, maintaining a stay of the sale order in effect “until the District Court enters a stay order in conformity herewith.” Id.

On remand, the district court granted a stay of the specific provision of the sale order foreclosing certain parties' rights under ' 365(h) to a larger group of appellants, noting that “the Court cannot ignore the inescapable conclusion that the Court of Appeals' order, regardless of the specific underlying rationale, significantly called into question ' and indeed reversed in part ' this Court's January 21, 2015 decision.” In re Revel AC, Inc., 2015 U.S. Dist. LEXIS 15816, *10 (D.N.J. Feb. 10, 2015). Thus, it would appear that the Third Circuit may be telegraphing that ' 363(f) does not trump lessees' rights under ' 365(h) in a sale.

Adequate Protection of'a Tenant's Interest

In addition, as noted by the court in Dishi & Sons, even in the free-and-clear sale context, ' 363(e) entitles a tenant to adequate protection of its interest. The Dishi & Sons court noted that if the lessee's lease were rejected, and its claim simply treated as a general unsecured prepetition claim, in many sales under ' 363(f), it would not receive any compensation from the proceeds of its sale and that “adequate protection can be achieved only through continued possession of the leased premises.” Id. at 712 (citation omitted).

The Qualitech court similarly noted that in a sale under ' 363(f), where the real estate is sold free and clear of the tenant's possessory rights, a tenant has the right to request adequate protection of its interest under ' 363(e) and “the bankruptcy court is obligated to ensure that their interests are adequately protected.” However, the court did not address what form of adequate protection should or could be provided because the tenant in that case did not object to the sale or seek protection under ' 363(e). 327 F.3d at 548.

Conclusion

The decisions in Dishi & Sons and Revel seem to portend that the rationale and decision in Qualitech may not be the last word on the interplay between ” 363(f) and 365(h), and that the rationale and result espoused by the Dishi & Sons court is more persuasive. Thus, purchasers of real estate assets and potentially their secured lenders need to be concerned that tenants of leased real estate sold free and clear under ' 363(f) may nevertheless remain entitled to exercise their rights under 365(h) and remain in possession of the leased property.

Bruce Buechler is a member of Lowenstein Sandler LLP's Bankruptcy, Financial Reorganization & Creditors' Rights Department, located in Roseland, NJ. Mr. Buechler can be reached at [email protected]. The views expressed in this article are the personal views of the author, and do not reflect the views of Lowenstein Sandler or any of its clients.

The interplay between ” 363(f) and 365(h) of the Bankruptcy Code continues to plague various courts. This article explores several recent decisions evaluating whether a tenant's rights under ' 365(h) survive a sale of the debtor's assets free and clear of all liens, claims, and encumbrances pursuant to section 363(f). In many cases, the issue boils down to the language of ' 363(f), which permits a sale “free and clear of any interest in such property of an entity other than the estate ' .” Courts have grappled with the question of whether the phrase “any interest” in the context of a real property sale includes not only fee interests, security interests and other ownership interests, but also a tenant's possessory right under ' 365(h). Some courts have construed the broad language of “any interest” to encompass leasehold interests and thus have determined that ' 363(f) trumps ' 365(h), permitting debtors and trustees to sell real property free and clear of leasehold interests. Other courts have reached different conclusions.

In the Courts

In the lone circuit court decision that has dealt with the issue, Precision Industries, Inc. v. Qualitech Steel SBQ, LLC , 327 F.3d 537 (7th Cir. 2003), the U.S. Court of Appeals for the Seventh Circuit determined that there was no conflict, holding that ” 365(h) and 363(f) “apply to distinct sets of circumstances.” Id. at 547. The Qualitech court reconciled the alleged conflict by stating that the terms of ' 363(f) apply when a trustee or a debtor-in-possession seeks to sell property of which it is a lessor, whereas ' 365(h) only deals with the assumption or rejection of unexpired leases of real property. By contrast, the district court in Dishi & Sons v. Bay Condos LLC , 510 B.R. 696 (S.D.N.Y. 2014), recently reconciled these apparently conflicting Bankruptcy Code sections differently. The district court affirmed the bankruptcy court's order, which authorized a sale of real property pursuant to ' 363(f), but also permitted the existing tenant to remain in possession of the premises under ' 365(h) after the purchase (i.e., the sale was not free and clear of the lease).

Dishi & Sons

Dishi & Sons marks a clear repudiation of the Qualitech rationale, reading these two statutory provisions in harmony. In addition, its decision construes the apparent conflicting Bankruptcy Code provisions in a way that provides both with meaning in all situations and does not render ' 365(h) nugatory in the context of a free-and-clear sale under ' 363(f).

In addition, the legislative history of ' 365(h) evidences a clear congressional intent to protect lessees when a lessor files for bankruptcy. See, e.g., In re Zota Petroleums, LLC, 482 B.R. 154, 161-162 (Bankr. E.D.Va. 2012). Conversely, many courts have concluded that these two provisions are indeed irreconcilable and that because ' 365(h) is more specific, it trumps ' 363(f) and provides the “exclusive remedy available to the debtor in an executory lease situation.” In re LDH Realty Corp., 20 B.R. 717, 719 (Bankr. S.D. Ind. 1982). The decision in Dishi & Sons clearly holds the promise of a more rational interpretation of these provisions because the decision to reject a lease is merely a decision not to obligate the estate to continue in an unprofitable agreement, as opposed to terminating the lease. Thus, ' 365(h) provides the lessee with rights to continue in possession as long as it continues to honor its obligations under the lease.

The Revel Casino Bankruptcy Decision

More recently, a decision in the Revel Casino bankruptcy proceedings reflects a possible change in course away from the Qualitech rationale by another court of appeals. The bankruptcy court approved the sale of the defunct Revel Casino property in Atlantic City, NJ, free and clear of all liens, claims and encumbrances, including possessory rights of tenants under ' 365(h). See In re Revel AC, Inc.,'525 B.R. 12, 22 (D.N.J. 2015).

The district court in Revel dealt with an emergency application for a stay of the sale order by, among other parties, a group of appellants that were lessees of portions of the Revel casino facility and accompanying properties, which the district court referred to as the “365(h) Appellants.” Following Qualitech, the district court held that the 365(h) Appellants had failed to demonstrate a strong likelihood of success on the merits and denied their request for a stay of the sale order. Id. at 30-31, 35. The 365(h) Appellants then sought an emergency stay of the sale order from the U.S. Court of Appeal for the Third Circuit, which reversed the district court's decision. In re Revel AC, Inc., 2015 U.S. App. LEXIS 1936 (3d Cir. Feb. 6, 2015). It remanded the matter for a stay as to one particular appellant, maintaining a stay of the sale order in effect “until the District Court enters a stay order in conformity herewith.” Id.

On remand, the district court granted a stay of the specific provision of the sale order foreclosing certain parties' rights under ' 365(h) to a larger group of appellants, noting that “the Court cannot ignore the inescapable conclusion that the Court of Appeals' order, regardless of the specific underlying rationale, significantly called into question ' and indeed reversed in part ' this Court's January 21, 2015 decision.” In re Revel AC, Inc., 2015 U.S. Dist. LEXIS 15816, *10 (D.N.J. Feb. 10, 2015). Thus, it would appear that the Third Circuit may be telegraphing that ' 363(f) does not trump lessees' rights under ' 365(h) in a sale.

Adequate Protection of'a Tenant's Interest

In addition, as noted by the court in Dishi & Sons, even in the free-and-clear sale context, ' 363(e) entitles a tenant to adequate protection of its interest. The Dishi & Sons court noted that if the lessee's lease were rejected, and its claim simply treated as a general unsecured prepetition claim, in many sales under ' 363(f), it would not receive any compensation from the proceeds of its sale and that “adequate protection can be achieved only through continued possession of the leased premises.” Id. at 712 (citation omitted).

The Qualitech court similarly noted that in a sale under ' 363(f), where the real estate is sold free and clear of the tenant's possessory rights, a tenant has the right to request adequate protection of its interest under ' 363(e) and “the bankruptcy court is obligated to ensure that their interests are adequately protected.” However, the court did not address what form of adequate protection should or could be provided because the tenant in that case did not object to the sale or seek protection under ' 363(e). 327 F.3d at 548.

Conclusion

The decisions in Dishi & Sons and Revel seem to portend that the rationale and decision in Qualitech may not be the last word on the interplay between ” 363(f) and 365(h), and that the rationale and result espoused by the Dishi & Sons court is more persuasive. Thus, purchasers of real estate assets and potentially their secured lenders need to be concerned that tenants of leased real estate sold free and clear under ' 363(f) may nevertheless remain entitled to exercise their rights under 365(h) and remain in possession of the leased property.

Bruce Buechler is a member of Lowenstein Sandler LLP's Bankruptcy, Financial Reorganization & Creditors' Rights Department, located in Roseland, NJ. Mr. Buechler can be reached at [email protected]. The views expressed in this article are the personal views of the author, and do not reflect the views of Lowenstein Sandler or any of its clients.