Ninth Circuit Reignites Debate over the Interplay of Sections 363, 365

In 2003, the U.S. Court of Appeals for the Seventh Circuit surprised many observers when it held that a sale of real property under section 363 of title 11 of the United States Code (the Bankruptcy Code) could be approved free and clear of a lessee's leasehold interest in the property. Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003).

Until that time, courts consistently had held that the rights of a non-debtor lessee in commercial property it leased from a debtor in bankruptcy were preserved by special protections afforded such lessees under section 365 of the Bankruptcy Code. The Qualitech case set off alarm bells, particularly among commercial tenants and lenders that utilized leasehold interests as collateral. In the ensuing years, however, most courts declined to follow Qualitech, and the case generally became to be viewed as an anomaly.

That changed in July, when the U.S. Court of Appeals for the Ninth Circuit joined the minority position espoused in Qualitech and held that the rights of a lessee in a debtor's real property may be extinguished in connection with a 363 asset sale. Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings, II, LLC), 2017 U.S. App. LEXIS 12526 (9th Cir. July 13, 2017).

In Spanish Peaks, the court addressed the perceived clash between Bankruptcy Code sections 363 and 365 that bear on this issue, and determined the two sections do not conflict.

When Sections Collide: The 'Conflict' Between 363 and 365

Subject to certain conditions, Bankruptcy Code section 363(f) permits a debtor or trustee in bankruptcy to sell the debtor's assets free and clear of interests held by third parties. 11 U.S.C.
§ 363(f).

Bankruptcy Code section 365, meanwhile, generally allows a debtor or trustee to assume or reject an unexpired lease of the debtor's property. 11 U.S.C. § 365(a). Section 365(h) applies specifically to situations where the debtor, as lessor, seeks to reject a lease with a non-debtor lessee. Under 365(h), upon rejection, the non-debtor lessee may retain existing rights in the leased property, including the right to continue to remain in possession of the property, as long as the lessee continues to perform the obligations specified in the lease. 11 U.S.C. § 365(h)(1)(A).

The two provisions provide different rights for different parties, and they usually operate independently of one another. However, in situations where the two sections overlap, a number of courts have held they are in conflict, because a party invoking one of the provisions will seek to override the interest of a party invoking the other. See, e.g., In re Taylor, 198 B.R. 142, 167 (Bankr. D.S.C. 1996) (relying heavily on legislative history of section 365(h) and concluding, “Congress intended § 365(h) to control the rights of the landlord and the tenant when a landlord files bankruptcy and … 365(h) reflects a careful balance between the needs of the bankrupt's estate and the rights of a tenant to the estate to which the tenant bargained.”)

Most courts have resolved the perceived conflict in favor of the tenant by holding that the specific protections set forth in section 365(h) prevail over the more general sale rights provided in 363(f). In other words, a sale of a debtor's property under section 363 may only be approved subject to the specific possessory rights of a commercial tenant under 365(h). See, among others, In re Churchill Properties III, L.P., 197 B.R. 283, 288 (Bankr. N.D. Ill. 1996) (“Section 365(h) is clear and specific in providing for certain rights and remedies available to the lessee after rejection of its lease … [and] it would make little sense to permit a general provision, such as Section 363(f), to override its purpose.”); and In re Haskell, L.P., 321 B.R. 1 (Bankr. D. Mass. 2005). As discussed in Spanish Peaks, this has been the majority approach. Spanish Peaks, 2017 U.S. App. LEXIS 12526 at *11.

Spanish Peaks: No Conflict Between Sections

The Spanish Peaks court noted that sections 363(f) and 365(h) frequently operate in isolation. For example, many bankruptcies involve sales of property unencumbered by a lease; other bankruptcies involve rejections of leases on property a debtor is not proposing to sell. Spanish Peaks, 2017 U.S. App. LEXIS 12526 at *11.

Still, there are times when both provisions have come into play. When that has occurred, the courts have addressed the resulting dilemma in two ways. As discussed, one approach has been to elevate the specific protections of 365(h) over the general provisions of 365(f). The other, embraced by Qualtiech, was to read 363(f), which allows a sale free and clear of “any interest,” to govern the rights of a tenant in those cases in which the debtor was not seeking to “reject” the lease. Qualitech, 327 F.3d at 547.

The Spanish Peaks court, joining Qualitech, concluded the two statutes are not inherently at odds. In doing so, the court pointed out the different scopes and purposes of the two provisions and emphasized the importance of giving effect to both, observing that where there is a sale, but no rejection, there is no conflict between the two. Spanish Peaks, 2017 U.S. App. LEXIS 12526 at *13.

Accordingly, the 363 sale in Spanish Peaks, which did not include a formal, statutory rejection of the tenant's lease rights, could proceed free and clear of any continuing burdens associated with the leasehold. As a result, the tenant's lease rights, including any right of possession, were extinguished.

Impact on Commercial Tenants and Adequate Protection

Based on the rationale of the Qualitech and Spanish Peaks decisions, tenants in commercial spaces owned by landlords in financial distress are at risk of having their leasehold rights extinguished if the property owner files bankruptcy, notwithstanding the protections provided to them by section 365(h). In some instances, there will be no cause for concern, as a buyer of a debtor's assets will typically view the regular income stream from the tenant as a valuable asset to be preserved. That will not always be the case, however, particularly in connection with a below market lease, i.e., a lease of real property under which the tenant is enjoying favorable terms in light of existing market conditions. In such an instance, a commercial tenant may well be in danger of being deprived of its section 365(h) protections.

Notably, the Spanish Peaks court provided a roadmap to minimize a tenant's risk, as well as to avoid an interpretation of the court's holding that would arguably result in an effective repeal of section 365(h). Specifically, the court pointed to the mandatory language of Bankruptcy Code section 363(e), which obligates a court to provide “adequate protection” to a holder of an interest that will be terminated by a sale if the holder of such interest requests it. 11 U.S.C. § 363(e) (“[O]n request of an entity that has an interest in property [being] sold … the court … shall prohibit or condition such … sale … as is necessary to provide adequate protection of such interest.”) According to the Spanish Peaks court, the availability of adequate protection is a powerful check against potential abuses of free and clear sales. Spanish Peaks, 2017 U.S. App. LEXIS 12526 at *15.

In Spanish Peaks, the tenants had objected to the sale free of their leasehold interests; however, they did not specifically request adequate protection of their interests until after the sale had already been approved. By then, it was too late.

Because “adequate protection” is not defined in the Bankruptcy Code, courts have considerable flexibility to determine what types and amounts of protection are adequate under the particular circumstances. If a timely request for adequate protection is made, appropriate forms of protection for a commercial tenant under 363(e) might include, among other possibilities, the right to remain in possession of the property for the remainder of the lease term, or, alternatively, suitable compensation for loss of the leased space, such as for the cost of relocating and for any damages arising from the business interruption associated with such disruption. See Haskell, 321 B.R. at 9.

The Spanish Peaks court held that the tenants lost their rights to adequate protection by not asserting them prior to the sale, sending a strong signal to tenants in future cases that they should assert their adequate protection rights early and vigorously, by demanding possession, monetary relief, or other forms of adequate protection.

Repercussions of Spanish Peaks

In the wake of Qualitech and Spanish Peaks, holders of leasehold interests undoubtedly will do just that. It is worth noting, though, that notwithstanding the Spanish Peaks court's apparent presumption that adequate protection is available to holders of such interests, that proposition may not be entirely clear. Some commentators have expressed a measure of doubt as to whether holders of leasehold interests are entitled to adequate protection at all and, even if they are, whether the types and amounts of adequate protection available to them are, indeed, adequate in the true sense of the word. See, e.g., Precision in Statutory Drafting: The Qualitech Quagmire and the Sad History of 365(h) of the Bankruptcy Code, 38 J. Marshall L. Rev. 97, 121-22 (Fall 2004) (critiquing Qualitech and casting doubt on whether and to what meaningful extent adequate protection is available to commercial lessees).

As courts continue to wrestle with the interplay between Bankruptcy Code sections 363 and 365, these questions will come into sharper focus, particularly if the Qualitech and Spanish Peaks rationale gains greater traction with other courts in the future.

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Alan R. Lepene and Andrew L. Turscak are partners in the Business Restructuring, Creditors' Rights & Bankruptcy Group at Thompson Hine LLP in Cleveland. Louis F. Solimine is a partner in the group in Cincinnati.