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“Free and Clear” Means You’re out of Here?

Section 365(h) of the Bankruptcy Code provides considerable protection to a tenant in the event of a bankruptcy filing by its landlord.  Despite rejection of its lease, the tenant can elect to retain its rights, including the right to possession, for the balance of the term of the lease, including any renewal or extension period.[1]  This is black-letter bankruptcy law reflecting a sound policy judgment:  it would be ruinous to business (not to mention an individual or family) if a landlord could upend a tenant’s possession whenever economic circumstances made a bankruptcy filing necessary or desirable. 

Section 363(f) of the Bankruptcy Code permits the sale of a debtor’s assets “free and clear” of any interest in those assets if one of five factors are satisfied.[2]  The ability to strip assets of liens, claims and other interests enhances their value because purchasers would pay far less for assets that remain subject to the claims of a debtor’s creditors.

But what happens when these two sections are implicated by the same transaction?  The sale of real property by a landlord “free and clear” of a tenant’s leasehold interest would terminate the tenant’s right to possession in apparent contravention of Section 365(h).  But, Section 363(f) brooks no exception for a leasehold interest:  it clearly provides for the sale of assets free and clear of “any interest” in the property.    

Majority Approach – Conflict Must be Resolved In Favor of 365(h)

Most courts to consider this issue have found that Section 365 must prevail over Section 363 because basic rules of construction hold that “the specific prevails over the general.”[3] Courts in the majority have also found that allowing landlords to circumvent the protection afforded to tenants by Section 365(h) would be at odds with Congressional intent.[4]  And, if the conflict between the two sections were resolved in favor of Section 363(f), then “the application of Section 365(h)(1)(A)(ii) as it relates to non-debtor lessees would be nugatory.”[5]

Minority Approach

A minority of courts, however, have concluded that the application of Section 365(h) is limited to lease rejection, not a sale of the debtor’s property.  As one court has explained, “Section 365(h) applies when a debtor-lessor remains in possession of its property and rejects a lease, not when the debtor-lessor sells property subject to an interest (such as a lease) free and clear of that interest pursuant to Section 363. Thus, when the debtor-lessor sells property subject to a lease free and clear of that lease pursuant to Section 363(f), the Court will not apply Section 365(h).”[6]  The Seventh Circuit Court of Appeals adopted substantially this same view a few years later, holding that “the terms of section 365(h) do not supersede those of section 363(f)” because:  (1) “the statutory provisions themselves do not suggest that one supersedes or limits the other,” (2) the plain language of section 365(h)(1)(A) suggests that it has a limited scope,” and (3) “section 363 itself provides for [adequate protection] to protect the rights of parties whose interests may be adversely affected by the sale of estate property.”[7]

In 2014, a judge in the Southern District of New York also declined to adopt the majority view.[8]   Dishi & Sons v. Bay Condos, LLC concerned a request from the tenant of a debtor to remain in possession of a leased condominium unit despite the “free and clear” sale of the unit to a buyer pursuant to Section 363(f).  After evaluating the majority and minority positions, the Dishi court began by noting its dissatisfaction with an outcome that would turn entirely on the precise timing of rejection and sale: 

[In the view of some courts,] if a trustee explicitly rejects a lease by the time of the sale, he triggers the protections for lessees set forth in § 365(h), but if there is no timely rejection, § 363(f) permits a free and clear sale because § 365(h) is irrelevant.[9] [. . .] This reading may reconcile the outcomes in the case law, but it does not address the underlying interpretive arguments. The majority can still argue that § 363(f) will be used to undermine the protections of § 365(h), and the minority can still assert that the sections ought to be read harmoniously (at least when possible).[10] 

Rejecting the majority view, the Court concluded that there is no conflict between sections 365(h) and 363(f):

The former does not grant the lessee special rights; it protects the lessee's existing appurtenant rights in the event that the trustee exercises its rejection power. The latter, in turn, authorizes the trustee to sell property free and clear of any interest, including the lessee's appurtenant rights, but only if one of its five grounds permits extinguishment of such rights. [. . . ] §§ 363(f) and 365(h) should be read harmoniously as addressing distinct issues. Whether there is a rejection triggering § 365(h) or not, the lessee may retain its appurtenant rights under the lease, which must be respected in any subsequent action by the trustee, including a free and clear sale. Here, because the [lease] was rejected in a timely manner, [the tenant] was entitled to retain its appurtenant rights under the lease pursuant to § 365(h). That does not mean, however, that such rights are unavoidable. Instead, the Court must assess whether there is any basis for a sale free and clear of [the tenant’s] rights under § 363(f).”[11]

The impact of the Dishi court’s determination that property can be sold free and clear of a tenant’s leasehold interest, however, was tempered significantly by the conclusion that followed.  After evaluating the five grounds for sales of property free and clear under Section 363(f), the Court found that none of them authorized a sale free and clear of the tenant’s leasehold interest in this case.[12] And, even if the sale could have been approved in accordance with one of those five subsections, the District Court concluded that the Bankruptcy Court did not abuse its discretion in holding that the adequate protection required by Section 363(e) of the Bankruptcy Code could be achieved only through the tenant’s continued possession of the leased premises.[13] 

A few years after Dishi, the Ninth Circuit also rejected the majority approach and instead followed Qualitech and the other “minority” decisions.[14]  As an initial matter, the Court concluded that it could “easily” read the two sections of the Bankruptcy Code in a manner that gives effect to each one.[15] 

Although undefined in the Code, a ‘rejection’ is universally understood as an affirmative declaration by the trustee that the estate will not take on the obligations of a lease or contract made by the debtor. A sale of property free and clear of a lease may be an effective rejection of the lease in some everyday sense, but it is not the same thing as the ‘rejection’ contemplated by section 365.  In sum, section 363 governs the sale of estate property, while section 365 governs the formal rejection of a lease. Where there is a sale, but no rejection (or a rejection, but no sale), there is no conflict.[16]

But, wary of its decision being construed as tantamount to “an effective repeal of Section 365(h),”[17] and recognizing that its precise holding would be of little use in a situation (like the one the court faced in Dishi) in which there was both a formal rejection of the lease and a proposed sale of property, the Spanish Peaks Court offered the following additional guidance.  First, as in Dishi, the Court noted that the requirement for adequate protection of an interest to be terminated by a Section 363(f) sale constitutes a “powerful check on potential abuses of free-and-clear sales.”[18]  Second, also as in Dishi, the Ninth Circuit observed that a sale free and clear of the tenant’s leasehold interest could only be consummated upon satisfaction of one of the five provisions of Section 363(f).[19]

Accordingly, even in the minority of cases in which courts appear to subordinate a tenant’s rights under Section 365(h) to the provisions of Section 363(f), the tenant is not without recourse.  To the contrary, a debtor seeking to sell property free and clear of a tenant’s leasehold interest must satisfy one of the five bases for approval of such sales set forth in Sections 363(f)(1)-(5).  And, if the tenant requests it, the Court can condition the sale on “adequate protection” of the leasehold interest, which may take the form of continued possession for the duration of the lease term.  Given these protections, the interplay between Sections 363(f) and 365(h) may be of more interest to academics and practitioners than to tenants, who appear to enjoy broad protection of their rights under both the majority and minority view. 

 

[1] 11 U.S.C. § 365(h)(1)(A)(ii). 

[2] 11 U.S.C. § 363(f)(1)-(5). 

[3] In re Churchill Props. III, Ltd. Pshp., 197 B.R. 283, 288 (Bankr. N.D. Ill. 1996). 

[4] See, e.g., In re Taylor, 198 B.R. 142, 165 (Bankr. D.S.C. 1996) and In re LHD Realty Corp., 20 B.R. 717, 719 (Bankr. S.D. Ind. 1982). 

[5] Churchill, 197 B.R. at 288.   Cf.  In re Revel AC, Inc., a recent decision of the Third Circuit Court of Appeals appears to be in accord with the majority view.  2018 U.S. App. LEXIS 34028 (3d Cir. Nov. 30, 2018) (tenant permitted to reduce its rent obligations by recoupment amounts applicable under the lease by virtue of its election under Section 365(h) notwithstanding new landlord’s acquisition of the property “free and clear” under Section 363(f)).

[6] In re Downtown Ath. Club of N.Y. City, 2000 U.S. Dist. LEXIS 7917, *12-13 (S.D.N.Y. 2000). 

[7] In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp., 327 F.3d 537 (7th Cir. 2003). 

[8] Dishi & Sons v. Bay Condos, LLC, 510 B.R. 696 (S.D.N.Y. 2014) (“Dishi”).

[9] Dishi at 704 (citing In re Zota Petroleums, LLC, 482 B.R. 154, 163 (Bankr. E.D. Va. 2012)). 

[10] Id.

[11] Id. at 707, 708 (emphasis added).

[12] Id. at 709-11.

[13] Id. 712.

[14] In re Spanish Peaks Holdings II, LLC, 872 F.3d 892 (9th Cir. 2017) (“Spanish Peaks”).   

[15] 872 F.3d at 899.

[16] Id. 

[17] Id. (citing Dishi, 510 B.R. at 704).

[18] Id. at 900. 

[19]  Unlike in Dishi, however, in Spanish Peaks there does not appear to have been any dispute “that at least one provision of § 363(f) was satisfied.”  Id.