Real Estate Sales Free and Clear of Unexpired Leases Under § 363(f)

August 9, 2018

Christian A. Pereyda
Engel, Hairston & Johanson, P.C.; Birmingham, Ala.

 

Retail bankruptcies are at an all-time high,[1] and many familiar names are among the filers.[2] As major tenants like Toys “R” Us or Sears leave hundreds of square miles of commercial real estate unoccupied across the country, landlords are bound to struggle to replace them.[3] For unlucky fee-holders unable to replace these tenants and remain profitable, following sinking anchor-tenants to the bankruptcy courts may be the best solution. Once a landlord files for bankruptcy protection, what options will the trustee[4] have in dealing with their remaining tenants? In turn, what options will these remaining tenants have after the petition date?

Section 365 of the Bankruptcy Code authorizes the trustee, “subject to the court’s approval,” to “assume or reject any executory contract or unexpired lease of the debtor.”[5] Subsection (h) grants special protections to tenants under a rejected lease such that the tenant may “treat such lease as terminated by the rejection; or … retain its rights … that are in or appurtenant to the real property … enforceable under applicable nonbankruptcy law.”[6] Meanwhile, Bankruptcy Code § 363 empowers the trustee to sell property of the estate “free and clear of any interest in such property of an entity other than the estate” under certain conditions.[7] What, then, is the result of a sale of estate property encumbered by an unexpired lease under § 363(f) when that lease has not been assumed or rejected?[8]

Two Approaches: Conflict or Independence

Most bankruptcy courts addressing this issue have held that §§ 363 and 365 conflict when they overlap because “each provision seems to provide an exclusive right that when invoked would override the interest of the other.”[9] These courts hold that § 365 trumps § 363 on the grounds that “the specific prevails over the general,” that “the legislative history regarding § 365 evinces a clear intent on the part of Congress to protect a tenant’s estate when the landlord files bankruptcy,”[10] and that the protection “would be nugatory” if the property could be sold free and clear of the leasehold under § 363.[11]

The only two circuit courts of appeals to address the issue, however, have disagreed with the trend established by a majority of bankruptcy courts.[12] The Seventh Circuit Court of Appeals was the first circuit court to address the tension between §§ 363(f) and 365(h).[13] In Qualitech, the Seventh Circuit observed that “the statutory provisions themselves do not suggest that one supersedes or limits the other[,]”[14] and ultimately held that “section 363 permits [a] sale … free and clear of a lessee’s possessory interest — provided that the lessee (upon request) is granted adequate protection for its interest.”[15] Recently, in Spanish Peaks, the Ninth Circuit followed suit and also held that “Section 363(f)(1) authorize[s] the sale of [estate] property free and clear of [unrejected] leases.”[16]

Qualitech and Spanish Peaks Are Likely to Disrupt the Status Quo

To assess which view is correct, as with all questions of statutory interpretation, the starting point is the statutory language itself.[17] Section 363 provides, in relevant part:

(b)

(1) The trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, …

(c)

(1) [When authorized], the trustee may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, without notice or a hearing …

(d) The trustee may use, sell, or lease property under subsection (b) or (c) of this section …

(2) only to the extent not inconsistent with any relief granted under subsection (c), (d), (e), or (f) of section 362

(e) … on request of an entity that has an interest in property … proposed to be … sold … the court, with or without a hearing, shall prohibit or condition such … sale … as is necessary to provide adequate protection of such interest. …

(f) The trustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of an entity other than the estate, only if —

(1) applicable nonbankruptcy law permits sale of such property free and clear of such interest; … or

(5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.[18]

Section 365 provides, in relevant part:

(a) Except as provided in sections 765 and 766 of this title and in subsections (b), (c), and (d) of this section, the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.

*          *          *

(h)… If the trustee rejects an unexpired lease of real property under which the debtor is the lessor and —

(i) if the rejection by the trustee amounts to such a breach as would entitle the lessee to treat such lease as terminated by virtue of its terms, applicable nonbankruptcy law, or any agreement made by the lessee, then the lessee under such lease may treat such lease as terminated by the rejection; or

(ii) if the term of such lease has commenced, the lessee may retain its rights under such lease … that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable nonbankruptcy law.…[19]

With the relevant statutory language fully laid out, the difference of opinion becomes clear. The majority of courts to address the issue have implicitly found that the sale of property of the estate subject to an unexpired lease constitutes a rejection of the lease for § 365(h) purposes.[20] The Qualitech, Spanish Peaks and a minority of other courts to address the issue, on the other hand, hold that a lease must first be rejected to trigger the protections of § 365(h); absent prior rejection, nothing in § 363(f) prevents the sale of property of the estate free and clear of a lessee’s interest.[21]

The Qualitech and Spanish Peaks approach finds the most support from the statutes themselves. As the Seventh Circuit noted:

[S]ections 363 and 365 both contain cross-references indicating that certain of their provisions are subject to other statutory mandates. But nowhere in either section 363(f) or section 365(h) is there a similar cross-reference indicating that the broad right to sell estate property free of “any interest” is subordinate to the protections that section 365(h) accords to lessees.[22]

Section 365(h)(1)(A), by its own terms, applies when “the trustee rejects an unexpired lease of real property under which the debtor is the lessor.”[23] There is simply no language in § 365 to suggest that its protections apply absent a rejection of an executory contract by the trustee.[24] Thus, even if § 363(e) did not mandate that a lessee under an unexpired lease of real property sold under § 363(f) receive adequate protection of such interest,[25] the plain meaning of §§ 363(f) and 365(h) do not suggest that either is limited or triggered by the other.

Conclusion

Future courts to address the issue outside of the Seventh and Ninth Circuits could be persuaded by what is now two of the nation’s highest courts’ plain-meaning approach to §§ 363(f) and 365(h). Bearing this in mind, lessees under an unexpired lease on property slated for sale under § 363(f) should demand adequate protection of their leasehold interest, which may “take the form of continued possession.”[26] As a prophylactic measure, such lessees should also move the bankruptcy court to compel the trustee’s assumption or rejection of their leases. This perhaps unintended side effect of Qualitech and Spanish Peaks — a rash of motions to compel assumption or rejection — would, of course, complicate already complex large landlord bankruptcies.

 

[1] Gene Marks, “More Retailers than Ever Going Bankrupt,” The Washington Post, April 16, 2018, available at www.washingtonpost.com/news/on-small-business/wp/2018/04/16/more-retailers-are-going-bankrupt-than-ever/; Haley Peterson, “Retail Bankruptcies Just Hit an All-Time High — And These 18 Companies Could Be the Next to Default,” Business Insider, April 14, 2018, available at www.businessinsider.com/bankruptcies-expected-this-year-2018-4.

[2] See, e.g., In re Toys “R” Us Inc., No. 17-32665 (Bankr. E.D. Va. Sept. 19, 2017); In re The Bon-Ton Stores Inc., No. 18-10248 (Bankr. D. Del. Feb. 4, 2018); In re General Wireless Operations Inc., No. 17-10506 (Bankr. D. Del. Mar. 8, 2017).

[3] Rani Molla and Shelly Banjo, “Retail Landlords’ Prospects Dimming,” Herald-Tribune, May 23, 2016, available at www.heraldtribune.com/news/20160523/retail-landlords-prospects-dimming.

[4] This article refers only to the powers of the bankruptcy trustee, which are, as relevant to this article, wielded by the debtor-in-possession in a chapter 11 case.

[5] 11 U.S.C. § 365(a).

[6] Id. at § 365(h).

[7] Id. at § 363(f).

[8] See Pinnacle Rest. at Big Sky LLC v. CH SP Acquisitions LLC (In re Spanish Peaks Holding II LLC), 862 F.3d 1148, 1154-56 (9th Cir. 2017) (hereinafter “Spanish Peaks”).

[9] In re Churchill Props., 197 B.R. 283, 286 (Bankr. N.D. Ill. 1996); In re Haskell L.P., 321 B.R. 1, 8-9 (Bankr. D. Mass. 2005); In re Taylor, 198 B.R. 142, 164-66 (Bankr. D.S.C. 1996); In re LHD Realty Corp., 20 B.R. 717, 719 (Bankr. S.D. Ind. 1982).

[10] In re Taylor, 198 B.R. at 165 (citing S. Rep. No. 95-989, at 60 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5846).

[11] In re Churchill Props., 197 B.R. at 288. See also Spanish Peaks, 862 F.3d at 1154-55 (illustrating majority and minority approaches).

[12] Spanish Peaks, 862 F.3d 1148 (9th Cir. 2017); Precision Industries Inc. v. Qualitech Steel SBQ LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003) (hereinafter “Qualitech”).

[13] Qualitech, 327 F.3d at 537.

[14] Id. at 547.

[15] Id. at 548.

[16] Spanish Peaks, 862 F.3d at 1157.

[17] Moskal v. United States, 498 U.S. 103, 108 (1990) (“In determining the scope of a statute, we look first to its language, giving the words used in their ordinary meaning.”).

[18] 11 U.S.C. § 363(b-f).

[19] Id. at § 365(h)(1)(A) (emphasis added).

[20] See, e.g., In re Haskell, 321 B.R. at 9 (holding that if it were to allow a sale free and clear of a lessee’s interest in an unexpired lease under § 363(f), “the provisions of §365(h) would be eviscerated. In other words, the Debtor would be doing indirectly what it could not do directly, namely, dispossessing [the tenant].”).

[21] Spanish Peaks, 862 F.3d at 1157; Qualitech, 327 F.3d at 547. See also S. Motor Co. v. Carter-Pritchett-Hodges Inc. (In re MMH Auto. Group LLC), 385 B.R. 347 (Bankr. S.D. Fla. 2008).

[22] Qualitech, 327 F.3d at 547 (internal citations omitted) (citing §§ 363(d) and 365(a), which provide specific statutory limitations by cross-referencing other Bankruptcy Code sections).

[23] 11 U.S.C. § 365(h)(1)(A).

[24] See Qualitech, 327 F.3d at 547; Spanish Peaks, 862 F.3d at 1156 (“A bankruptcy court must provide adequate protection for an interest that will be terminated by a sale if the holder of the interest requests it.”) (emphasis in original).

[25] Qualitech, 327 F.3d at 547–48.

[26] Spanish Peaks, 862 F.3d at 1156 (citing 11 U.S.C. § 361(3) for the definition of “adequate protection” and Dishi & Sons v. Bay Condos LLC, 510 B.R. 696, 711-12 (S.D.N.Y. 2014), for the proposition that continued possession may be required to provide adequate protection).

 

 

This article was originally published in the July 2018 edition of the Business Reorganization Committee Newsletter. Participation in ABI's committees is one of the many benefits of becoming a member.  Committees provide networking and leadership opportunities.  For additional information on how you could become involved in ABI and our Committees please visit membership.abi.org.

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