Tenants Beware - Your Lease Rights May Be Subject to Termination by the Bankruptcy Court

A tenant's possessory interest in property leased from a bankrupt debtor,
protected after rejection of a lease by §365(h) of the Bankruptcy Code,
may not survive a sale of the underlying property under §363, the U.S.
Court of Appeals for the Seventh Circuit held on April 23, 2003, in the matter
of <i>Precision Industries Inc. v. Qualitech Steel SBQ LLC (In re Qualitech
Steel Corp.),</i> 7 Cir., No. 01-2753
(4/23/03). In a somewhat surprising ruling, the court held that the protections
afforded to a tenant under §365(h) are overruled by the provisions of
§363(f), which allow for the sale of the debtor's property free and
clear of any interest in such property. Although the interesting interplay
between these two sections has never been adjudicated at the appellate court
level, commentators have heretofore believed that a lessee's possessory
interest protected by §365(h) would survive the sale of the debtor's
property even when such sale is made free and clear of all liens, claims and
interests. Although the <i>Qualitech</i> decision does not touch upon intellectual property rights, it raises
significant concerns for licensees of patent rights who enjoy similar
protection under §365(n) as those thought to be provided to lessees. Under
the <i>Qualitech</i> ruling, those
rights and interests may also be at risk in a sale "free and clear of
interests" under §363.

</p><h3>Factual Background</h3>

<p>The debtors in the underlying bankruptcy, Qualitech Steel Corp. and Qualitech Steel
Holding Corp. (collectively "Qualitech" or "debtor"),
owned and operated a steel mill in Pittsboro, Ind. Prior to bankruptcy, the
debtor had entered into a lease with its tenant, Precision Industries Inc., for
the property underlying a warehouse, built by Precision, for 10 years in
exchange for a nominal rent of $1 per year. The lease further granted Precision
exclusive possession of the warehouse until the end of the 10-year lease, at
which time it would revert to the debtor, assuming no defaults under the
agreements. The lease was never recorded.

</p><p>The debtor filed for
chapter 11 protection in March 1999, and in June of the same year sold
substantially all of its assets at auction for a bid of $180 million.
Precision, which had notice of the hearing, did not object to the sale. The
resulting order transferred all of the debtor's assets free and clear of
all liens, claims, encumbrances and interests. The sale order also reserved to
the purchaser the debtor's rights to assume and assign executory
contracts pursuant to §365. The sale of the debtor's assets closed
in August 1999 without an assumption of the lease; therefore the lease
agreements were <i>de facto</i> rejected. The
new buyers subsequently changed the locks on the warehouse, and Precision filed
a complaint in the U.S. District Court for trespass. That matter was ultimately
referred to the bankruptcy court, where the buyer sought clarification that the
sale order had extinguished Precision's possessory interests.

</p><p>The bankruptcy court determined that the buyer had obtained title to the
debtor's property free and clear of any possessory interest that
Precision may have had under the lease and that such a continued right to
possession after rejection of the lease was among the bundle of interests
extinguished by the sale order. The court explicitly rejected the notion that
the protection of §365(h) acted to preserve Precision's rights as a
lessee in the face of a sale order, which the court found was
"unequivocal and not left open to interpretation." Precision
appealed to the district court, which subsequently reversed. That court
determined at the outset that the provisions of §363(f) and 365(h) were
in apparent conflict and, after surveying the legislative history of both
provisions along with the divided case law on the subject, concluded that the
provisions of §365(h) prevailed over those of §363(f), as applied to
the rights of lessees. The debtor appealed.

</p><h3>Section 363 Prevails</h3>

<p>The Seventh Circuit agreed with the bankruptcy court and overturned the district
court's ruling. Initially, the appeals court determined that a
tenant's possessory interests are within the scope of interests in the
property in the bankruptcy estate.

</p><p>Section 365(h) provides that if a debtor rejects an unexpired lease for real property
under which the debtor is the lessor, the lessee may retain its rights under
the lease for the balance of such term, including any renewal or extension for
such rights. Therefore, the lessee may remain in possession of the leased
premises, notwithstanding the debtor's decision to reject the lease. In
this way, the statute strikes a balance between the respective rights of the
debtor/lessor and its tenant. The lessee retains the rights to possess the property
for the remainder of the term it bargained for, while the rejection frees the
debtor/lessor of other burdensome obligations that it assumed under the lease,
such as a duty to provide services to the lessee.

</p><p>The appeals court enumerated three reasons why the terms of §365(h) do not
trump the "free-and-clear" sale described in §363(f). First,
the statutory provisions themselves do not suggest that one supersedes or
limits the other. Both contain cross-references, indicating that certain of
their provisions are subject to other statutory mandates. However, nowhere is
there language indicating that the right to sell estate property free of
"any interest" is subordinated to the protection of §365(h).

</p><p>Second, the plain language of §365(h) suggests that it has limited scope. In
particular, §365(h) applies if a trustee <i>rejects</i> an unexpired lease of real property. The court
determined that what occurred was the sale of the property rather than a
rejection of the lease. Although the effect of the sale was a <i>de
facto</i> rejection, the court reasoned that
nothing in the express terms of §365(h) suggests that it applies to a <i>sale</i> of the debtor's property, but is rather
limited to a <i>rejection</i> situation.
The court concluded that the two statutory provisions thus applied to distinct
sets of circumstances.

</p><p>Third,
§363 itself provides for a mechanism to protect the rights of parties
whose interests may be adversely affected by the sale of estate property.
Specifically, §363 allows the courts to "prohibit or condition
such...sale...as is necessary to provide adequate protection of such
interests." Because a lease qualifies as an interest, the lessee of the
property being sold under §363 would have a right to object to ensure that
its interests are protected. Although such "adequate protection"
does not necessarily grant a lessee continued possession of the property, it
may demand that the lessee be compensated for the value of his leasehold,
typically from the proceeds of sale.

</p><p>Based
on this rationale, the court concluded that the two statutory provisions can be
construed in a way that does not disable §363(f) vis-à-vis
leasehold interests.

</p><blockquote><blockquote>
<hr>
<big><i></i><center>
<i>Until the ruling in</i> Qualitech, <i>many commentators believed that a licensee's
interest in the debtor's intellectual property would survive a sale under §363.
</i></center><i></i></big>
<hr>
</blockquote></blockquote>

<h3>The Practical Effect of the Ruling</h3>

<p>The practical effect of this ruling is that a lessee must be increasingly vigilant
with respect to its rights under a commercial lease where the lessor is in
bankruptcy. The lessee in <i>Qualitech</i> did
not object to the sale free and clear of its possessory interest in the
property. One can only speculate as to what would have happened had an
objection been filed by the lessee at the time the sale was proposed.
Correspondingly, a lawyer should advise his or her clients to "object
early and often" to any motion to sell a debtor's assets under
§363(f) and/or insist that any sale order protect the client's
interest. Although the protections provided under the Bankruptcy Code may not allow
the tenant to keep all of the beneficial aspects of the lease, the <i>Qualitech</i> ruling shows that if tenant sits on its rights, they
may be lost in their entirety.

</p><p>By
obvious analogy, licensees of intellectual property must be similarly vigilant.
The protections provided under §365(n) are very similar to those afforded
by §365(h). Until the ruling in <i>Qualitech,</i> many commentators believed that a licensee's interest in the
debtor's intellectual property would survive a sale under §363. <i>Qualitech</i> casts this assumption into doubt, and one is advised
to provide the same advice to licensees as one would tenants: Be vigilant and
aware if you want to protect your rights.