Contributed by Katherine Doorley
Section 363(f) of the Bankruptcy Code allows a trustee to sell property of the estate free and clear of any interest of an entity other than the estate. Section 365(h) of the Bankruptcy Code, on the other hand, protects the interests of a lessee in the event the trustee rejects an unexpired lease of real property where the debtor was the lessor. Among the protections afforded by section 365(h) are the ability of the lessee to retain its rights under the lease such as the right of possession. The conflict between these two sections is apparent: does free and clear really mean free and clear, even of rights granted under the Bankruptcy Code? Or can another provision of the Bankruptcy Code, for example section 365(h), limit a sale under section 363(f)? What happens to a tenant (or a licensee of intellectual property with rights post-rejection under section 365(n) of the Bankruptcy Code) when a debtor sells substantially all of its assets, including assets subject to a lease or license during a bankruptcy case? The United States Bankruptcy Court for the District of Montana weighed in on this issue in In re Spanish Peaks Holdings II, LLC.
Spanish Peaks Holdings II, LLC and its affiliated debtors sought to develop a private high-end residential ski and golf resort in Big Sky, Montana. To that end, in November 2006, the debtor entered into a loan agreement secured by its real property. Subsequently, Spanish Peaks entered into a lease, as lessor, with one of its non-debtor affiliates for The Pinnacle at Big Sky Restaurant. The Pinnacle lease was for a term of 99 years at a rental rate that was significantly below market. Spanish Peaks also entered into a lease, known as the Opticom lease, with a separate affiliate, covering real property in Gallatin and Madison Counties, Montana, under which Spanish Peaks was the lessor. The lease was for a term of 60 years and was never recorded.
In October 2011, the debtors filed a petition under chapter 7 of the Bankruptcy Code. The chapter 7 trustee sought to sell substantially all of the debtors’ assets to the debtors’ prepetition lender pursuant to section 363. The trustee’s proposed sale order provided that the sale would be free and clear of all liens, claims, interests and encumbrances under section 363(f) with the exception of certain permitted encumbrances. The Pinnacle and Opticom leases were never listed as permitted encumbrances.
Section 363(f) vs. Section 365(h)
At the sale procedures hearing, the affiliates that were lessees under the Pinnacle and Opticom leases opposed the sale and stated that if the leases were rejected, the affiliates would elect to retain all of their rights under section 365(h). The parties agreed to postpone a decision on the nature of the affiliates’ rights until the sale hearing. Subsequently, the trustee filed a motion to reject the Pinnacle and Opticom leases. No timely objection was received, and the court granted the trustee’s motion.
At the sale hearing, the lender sought a determination that the sale was free and clear of the Pinnacle and Opticom leases under section 363, and that section 365(h) did not apply to preserve the affiliates’ subordinate and/or voidable leasehold interests following the sale. The affiliates objected.
In making its decision, the bankruptcy court examined a split in the case law between courts holding that section 365(h) rights may be terminated in a section 363 sale, and courts holding that a tenant’s rights under section 365(h) may not be ended by a sale free and clear.
The bankruptcy court noted that courts holding that section 363(f) trumps generally rely on two canons of statutory construction: (i) statutes should be given their plain meaning; and (ii) courts should interpret statutes so as to “avoid conflicts between them if such construction is possible and reasonable.” The main case holding that section 365(h) rights may be terminated by a section 363(f) sale is the Seventh Circuit’s decision in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC. In Precision Industries, the Seventh Circuit concluded that:
Where estate property under lease is to be sold, section 363 permits the sale to occur free and clear of a lessee’s possessory interest—provided that the lessee (upon request) is granted adequate protection for its interest. Where the property is not sold, and the debtor remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property.
327 F.3d at 548. Under Precision Industries, any lessee could have its possessory interest ended, subject to receiving adequate protection, if requested.
In contrast, the cases holding that section 365(h) trumps have noted that “specific legislation governs general legislation” and that section 365(h) “evinces a clear intent” that a “tenant will not be deprived of his estate for the term for which he bargained.” These cases further conclude that “since Congress decided [with the enactment of section 365(h)] that lessees have the option to remain in possession, it would make little sense to permit a general provision, such as section 363(f), to override its purpose.” In re Churchill Props. III, L.P. Thus, according to these cases, “the lessee’s leasehold estate cannot be diminished, changes or modified due to bankruptcy’s intervention . . . . In short, §365(h) seeks to prevent forcible evictions whenever possible.” In re Lee Road Partners, Ltd. These cases all agree that section 365(h) is intended to protect the terms for which a lessee has bargained, including the rights of possession and quiet enjoyment.
The bankruptcy court in Spanish Peaks adopted neither of these two approaches. Instead, it found that a “case-by-case, fact-intensive, totality of the circumstances, approach, rather than a bright line rule” should guide whether section 363(f) or section 365(h) governs in any situation. In the case before it the bankruptcy court held that the property could be sold free and clear of the affiliates’ section 365(h) possessory rights, based on findings that (i) the leases between the debtors and the affiliates were entered into at a time when all parties were controlled by the same individual, (ii) the Pinnacle lease provided for lease rates that were far below fair market rental rates, (iii) the Opticom lease was never recorded, and (iv) the affiliates neither sought nor obtained a nondisturbance agreement from the prepetition lender to protect their rights.
Moreover, notwithstanding section 363(e) of the Bankruptcy Code, which generally provides that a party with an interest in property being sold by the trustee/debtor is entitled to adequate protection, the court found that the affiliates were not entitled to adequate protection in the case before it. This is because they had not requested adequate protection and they provided no evidence that they would suffer any economic harm if their possessory interests were terminated.
Relevance for Section 365(n)
Just as section 365(h) protects the rights of lessees, section 365(n) protects the rights of licensees of intellectual property in the event the trustee rejects an executory contract under which the debtor is a licensor. Section 365(n), in part, allows a licensee to retain certain rights under any such contract for the duration of the agreement. The outcome of any 363(f)/365(n) dispute would likely turn on the approach adopted by the bankruptcy court. A court following Precision Industries would likely hold that a section 363(f) sale terminated the licensee’s section 365(n) rights, although the licensee would still be entitled to adequate protection to the extent damages were established. Courts following the Churchill Properties/Lee Road Partners line of cases would likely hold that the licensee’s section 365(n) rights are preserved in any sale under section 363(f). Finally, courts using a fact-intensive approach, similar to the one here, would conduct the requisite inquiry and allow a totality of the circumstances guide them.
Although here the court appeared to side with the cases holding that section 363(f) trumps, the facts before the court were unique enough that most courts applying a similar fact-intensive framework might decide that a lessee’s 365(h) rights should be preserved. The leases in this case were between insiders and were well under-market, and the lessees did not take any actions to protect themselves either by seeking a nondisturbance agreement with the lender or by establishing a case for adequate protection. Moreover, in most cases where courts hold that section 363(f) trumps, lessees would likely seek, and be granted, adequate protection. We here at the blog will continue to monitor the battle of section 363(f) versus 365(h)/365(n) and we will be sure (of course) to keep you informed of any future developments.