A Clash Between 'Free and Clear' and Tenants' Rights Under Bankruptcy Code Section 365(h)

Soon thereafter, on Aug. 28, 2014, the debtors filed a motion to reject their agreements with various tenants, including IDEA Boardwalk, LLC. IDEA had a commercial lease with Revel, entered into in May 2012. IDEA and the other tenants gave notice under Section 365(h) of their intent to continue exercising possessory rights. IDEA also brought an adversary proceeding against Revel. IDEA, therefore, successfully preserved all of its rights in the fight with the landlord and its successor, Polo North Country Club, Inc., (Polo), the purchaser of Revel's assets.

A bankrupt landlord can cherry pick its leases, just like a bankrupt tenant, but Section 365(h) of the Bankruptcy Code allows the tenant to stay in the space at the same rental rate and to preserve all its rights under the lease for the life of the lease. In relevant part, §365(h) provides that “the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease.” 11 U.S.C. Section 365(h)(A)(ii). The purpose behind 365(h) is described as relieving the debtor-landlord from its obligations under the lease while protecting the lessees from being evicted. Congress took care, according to the code, to ensure that a “tenant will not be deprived of his estate for the term for which he bargained.”

Under a sale order, dated April 6, 2015, approving the transfer of the debtor's asset to Polo, the court ordered that “the Sale of the Assets … shall not be free and clear of (i) any existing tenancies and/or possessory interests of … IDEA, respectively, pending the Debtors' rejection pursuant to section 365 of the Bankruptcy Code of the agreements containing such tenancies and/or possessory interest (the Possessory Agreements) and (ii) any rights elected to be retained by each of the non-debtor counterparties to the Possessory Agreements pursuant to section 365 of the Bankruptcy Code after the Debtors' rejection of the respective Possessory Agreements.”

Pursuant to the sale order, Polo was to acquire certain legal claims Revel may have had against the tenant with respect to the lease, which the parties understood to include any rent payments that IDEA may owe under the lease.

Free and Clear?

The Third Circuit recently affirmed two lower courts' decisions that allowed IDEA to stay on the premises without paying rent under the rejected lease and after the sale to Polo was completed. IDEA Boardwalk v. Revel Entertainment Group (In re Revel AC Inc.), No. 17-3607 (3d Cir. 2018). The decision is one of a few dealing with the rights of commercial tenants in the context of a landlord's bankruptcy proceeding. The Revel case addresses the interplay between the tenant's rights under section 365 of the Bankruptcy Code and a third-party buyer's ability to acquire assets of the estate pursuant to Section 363(f). Section 363(f) of the Bankruptcy Code allows a debtor in possession to engage in the sale of a debtor's property free and clear of any interest in such property of an entity other than the estate provided, as long as one of five conditions is met:

• Applicable non-bankruptcy law permits the sale of such property free and clear of interests;
• The entity consents;
• The interest is a lien, and the price at which the property is to be sold is greater than the aggregate value of all liens on such property;
• The interest is a bona fide dispute; or
• The entity could be compelled in a legal or equitable proceeding to accept a money satisfaction.

The “free and clear” asset sales are a staple in bankruptcy cases and facilitate maximizing the value of the debtor's assets. “Free and clear” sales are crucial incentives to purchasers who otherwise have no traditional protections like holdbacks and indemnification. The majority of courts faced with the interplay between the “free and clear” sales and the tenant protections, have concluded that sections 363(f) and 365(h) are irreconcilable, and that Section 365(h) trumps 363(f) because a specific statute governs over a general statute when a conflict is presented: Since 365(h) governs a specific relationship between landlords and tenants, it supersedes the broad elimination of interests in 363(f). In re LHD Realty Corp., 20 B.R. 717 (Bankr. S.d. Ind. 1982); In re Haskell, 321 B.R. 1 (Bankr. D. Mass 2005); In re Churchill Props. III, 197 B.R. 283 (Bankr. N.D. Ill., 1996); Ultimate Sportsbar v. United States, 48 Fed. Cl. 540 (Fed. Cl. 2001). The minority view is that Section 365(h) applies only when the debtor in possession or trustee rejects a lease, which makes it irrelevant in the context of a Section 363 sale. Precision Indus. v. Qualitech Steel SBQ, 327 F.3d 537 (7th Cir. 2003).

The bankruptcy court held that the sale to Polo did not extinguish IDEA's rights under the lease, and IDEA may reduce its rent by the recoupment amounts, as defined in the lease agreement on the grounds that: 1) the recoupment amounts are preserved under 365(h); and 2) IDEA could deduct on the basis of the equitable doctrine of recoupment. The doctrine of equitable recoupment allows the netting of obligations between a creditor and debtor when both debts arise out of a single integrated transaction. In re Univ. Med. Ctr., 973 F.2d 1065 (3d Cir. 1992).

The district court affirmed the bankruptcy court's decision and, on appeal, the Third Circuit also affirmed the finding that the equitable right of recoupment is not an interest extinguished in a 363 sale. Since the sale order specified that the sale was made subject to the possessory interest and other rights under the lease that IDEA had, those rights were preserved. In addition, the Third Circuit held that a sale of assets free and clear of liens, encumbrances and interest did not extinguish IDEA's right to equitable recoupment because the doctrine of equitable recoupment is a defense not an interest.

In order to reach the conclusion that IDEA had no obligation to pay any rent to Polo, the Third Circuit focused on Revel's obligation to make certain recoupment payments to IDEA in the first four years of the lease term. The lease provided for capital contributions by both tenant and landlord to build out the tenant's venues and incorporated formulas for determination of the rent. The Court of Appeals concluded that the net effect of the rent and recoupment provisions in the agreement between Revel and IDEA ensured that IDEA would pay rent only when a venue turned profit in those first four years of the lease term. The court reasoned that the equitable doctrine of recoupment applied to the landlord's recoupment obligations under the lease and allowed IDEA to reduce its existing rent obligations.

Conclusion

The Revel case ultimately proved to be a win for the tenants; IDEA played its cards well and got the court's blessing to occupy the property rent-free until the venues became profitable, despite the asset sale of said property. The Third Circuit rejected the arguments advanced by the buyer of the Revel assets, Polo, that it obtained Revel's assets “free and clear of all liens, claims, encumbrances and other interests of any kind” in a sale under section 363(f) of the Bankruptcy Code.

The Third Circuit's decision reminds us that while the “free and clear” language appears all encompassing, there are carve outs that will limit the rights of an asset purchaser.

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Albena Petrakov is a principal in the New York office of Offit Kurman. She focuses her practice in matters involving bankruptcy litigation, creditor rights, secured and unsecured transactions, and real estate-related litigation. This article also appeared in the New Jersey Law Journal, and ALM sibling publication to this newsletter.