Are You Not Entertained? The SDNY Weighs In On the Battle Between Sections 363(f) and 365(h) of the Bankruptcy Code

Contributed by Christopher Hopkins
The conflict between sections 363(f) and 365(h) of the Bankruptcy Code involves the question of whether a debtor-lessor—through a free and clear sale pursuant to section 363(f)—can extinguish a lessee’s appurtenant rights in a lease despite the protections afforded such rights by section 365(h). Many courts have grappled with this question, often with diverging results. Some courts find that section 363(f)’s provision for sales free and clear of “any interest” includes a lessee’s appurtenant rights otherwise protected by section 365(h). Other courts reach the opposite conclusion, holding that 365(h)’s specific protections cannot be overcome by 363(f)’s broad language. We recently discussed a decision where the court held that the dispute should be resolved on a “case-by-case, fact intensive, totality of the circumstances approach, rather than a bright line rule.” Despite the diversity in authority, however, one thing most courts agree on is that the two sections seem to be irreconcilable.
The District Court for the Southern District of New York, in its recent decision in Dishi & Sons v. Bay Condos LLC, disagreed with the majority view and concluded that when read properly, section 363(f) and 365(h) do not conflict. The Bay Condos decision attempts to harmonize the language and resolve the tension between sections 363(f) and 365(h), advancing the prospect of a resolution to the current discord in the courts.
Section 363(f) authorizes the debtor to sell estate property free and clear of any interest, provided that one of five enumerated conditions is met. Section 365(h), on the other hand, provides a lessee with a seemingly unqualified right to retain its appurtenant rights to the lease if the lease is rejected. The conflict between these sections arises when a debtor seeks to sell a property free and clear of a leasehold interest. In other words, does section 363(f)’s “any interest” language trump the specific protections afforded to lessees under section 365(h)?
Most courts have concluded that the sections are irreconcilable and that 365(h) trumps 363(f). Courts adopting this view typically make three arguments in support of this result: (i) principles of statutory construction provide that the specific governs the general, and, therefore, section 365(h)’s specific protections trump 363(f)’s general language; (ii) the legislative history of section 365(h) evinces a congressional intent to protect lessees when the lessor files for bankruptcy; and (iii) the protections provided by section 365(h) would be nugatory if they could be defeated by section 363(f).
In contrast, a minority of courts have held that 365(h) only applies in the context of lease rejections, not property sales. Courts adopting this view reason that the protections of 365(h) only apply in the context of a lease rejection pursuant to section 365—the protections are irrelevant in the context of an asset sale under 363(f). These courts often note, however, that a lessee’s appurtenant rights are nonetheless protected by the adequate protection requirements of section 363(e) despite the inapplicability of section 365(h).
Bay Condos
In Bay Condos, the court adopted a novel approach for resolving the apparent conflict between sections 363(f) and 365(h) after the debtor sought to sell certain real property free and clear of a leasehold interest under its plan pursuant to section 363(f). The bankruptcy court’s order confirming the debtor’s plan approved the sale, but provided that the lessee had a right to elect to remain in possession of the property under section 365(h), or, in the alternative, as adequate protection of its interest under section 363(e).
Following the purchaser’s appeal, the District Court analyzed the “seemingly conflicting” provisions of 363(f) and 365(h) and rejected both the majority and minority approaches discussed above. The court found that the supposed conflict between the sections could be resolved by first considering the role of section 365(h) in isolation. The court reasoned that section 365(h) simply codifies the principle that a debtor’s power to reject a lease under section 365 does not affect the lessee’s appurtenant rights. Accordingly, whether the debtor assumes, rejects, or does nothing with the lease, the lessee retains such rights. Further, the court noted that “nothing in § 365(h) precludes the trustee from terminating the lessee’s appurtenant rights if so empowered under another provision of the Code.” The court reconciled the apparent conflict between section 365(h) and 363(f) by concluding that because section 365(h) does not grant the lessee any special rights—it merely protects what rights the lessee already has in the event of rejection—section 363(f) may allow a debtor to sell property free and clear of the lessee’s appurtenant rights. Because the debtor failed to show that any of section 363(f)’s grounds for extinguishment were met, however, the court held that the lessee’s appurtenant rights could not be set aside and the lessee had the right to remain in possession of the property.
Thus, although section 365(h) did not prevent the sale free and clear of the lessee’s interest, it did require the debtor to take the lessee’s rights into account before selling the property free and clear of the leasehold interest under section 363(f). The court’s holding appears to reconcile the apparent conflict between these provisions by observing that the purpose of 365(h) is limited to the context of lease rejections—it does not grant lessees rights that may never be avoided by some other means. The ruling also strikes a balance between the majority and minority views discussed above by avoiding a categorical rule that either section 363(f) or 365(h) controls. Instead, the court puts lessees’ appurtenant rights on par with any other interest subject to extinguishment under section 363(f). Because the court ultimately held that a seller can extinguish a lessee’s appurtenant rights through a 363(f) sale—provided that one of section 363(f)’s five grounds for extinguishment is met—Bay Condos appears to be a defeat for section 365(h).
Adequate Protection
The court’s ruling on the applicability of section 365(h) did not entirely resolve the issue of whether the lessee was entitled to retain possession of the property. The court continued its analysis to note that, even if the lessee’s appurtenant rights could be extinguished under section 363(f), section 363(e) requires the court to “prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interest.” Adequate protection is defined in section 361, which states that adequate protection may be provided by, among other things, the “indubitable equivalent” of the entity’s interest.
In Bay Condos, the court held that even if the lessee’s appurtenant rights—including the right to maintain possession of the property—could be extinguished in a sale pursuant to 363(f), the lessee would nonetheless be entitled to remain in possession as adequate protection of its interest. The court reasoned that adequate protection could only be achieved through the lessee’s continued possession because the lessee’s interest was difficult to value and the lessee was unlikely to receive any compensation for its interest under the terms of the sale. Accordingly, at least in certain circumstances, a lessee may be entitled to continued possession under section 363(e) regardless of whether a sale free and clear of the lessee’s appurtenant rights is permissible. Further, sellers should realize that extinguishing a lessee’s appurtenant rights through a 363(f) sale may be a pyrrhic victory if the lessee is entitled to remain in possession as adequate protection of its interest.
Bay Condos adds another branch to the split of authority surrounding the conflict between sections 363(f) and 365(h) of the Bankruptcy Code. By declining to adopt the majority or the minority approach, Bay Condos charts a “middle way,” giving effect to what the court believed to be the underlying purposes of both sections. Although it remains to be seen whether other courts will adopt this new approach, Bay Condos also suggests that the outcome of this dispute is not always determinative of whether a lessee may retain possession of a property sold pursuant to section 363(f). Even if section 365(h) is not an absolute protection of a lessee’s appurtenant rights in a free and clear sale, the lessee may, in certain circumstances, retain possession of the leased premises as adequate protection of its interest. Although Bay Condos does not declare a clear winner in the battle between section 363(f) and 365(h), it does suggest that lessee’s seeking to remain in possession following a free and clear sale have another dog in the fight in the adequate protection provisions of section 363(e).