One of the fundamental rights afforded to a debtor is the right to reject burdensome contracts and unexpired leases. However, where the debtor is the lessor of real property or the assignor of intellectual property, rejection of the underlying agreement could be catastrophic to the nondebtor counterparty. Recognizing the potential prejudice to contract counterparties, Congress incorporated provisions into the Bankruptcy Code (§§ 365(f) and 365(n)) that permit these affected nondebtor parties to continue to use the leased properties for the life of the term, if they so choose.
However, this protection for nondebtor counterparties potentially interferes with another fundamental right afforded to debtors — namely the right to sell assets free and clear of all liens, claims, and interests under § 363(f). As a pair of recent chapter 11 decisions from the U.S. Bankruptcy Court for the District of New Jersey illustrate, courts continue to struggle with the tension between a debtor’s § 363 rights and its nondebtor contractual counterparty’s § 365 rights.
Sections 365(h), 365(n) and 363(f): A Brief Primer:
Section 365 of the Bankruptcy Code permits a debtor to “reject” burdensome contracts and unexpired leases.[1] In essence, rejection relieves a debtor of the obligation to continue performing under an executory contract by converting the debtor's unfulfilled obligations to a (pre-petition) damages claim.[2] However, it does not terminate the contract.[3] Following rejection, the contract counterparty is not permitted to seek to enforce the agreement; instead, the counterparty’s rights will be reduced to a money claim in the bankruptcy for breach.
In order to protect the property interests of nondebtors who lease real property from a debtor, Congress incorporated § 365(h), which gives the nondebtor a choice following the debtor’s rejection of an unexpired lease: A tenant can either accept money damages or remain in possession of the property for the natural term of the lease, plus any extensions.[4] However, the debtor is relieved from any obligations under the agreement other than the obligation to permit use of the property.[5]
Section 365(n) affords similar protection to the licensee of intellectual property.[6] Much like its analog provision (§ 365(h)), a lessee of intellectual property from the debtor is given the choice of either damages or continued use of the intellectual property post-rejection for the term of the agreement. Again, the debtor is relieved of the obligation to provide any services to the lessee post-rejection.[7]
Section 363 of the Bankruptcy Code permits a debtor in possession to sell property outside of the ordinary course of its business.[8] In addition, § 363(f) provides that upon the satisfaction of certain conditions (including notice), assets sold pursuant to a bankruptcy sale can be transferred free and clear of liens, claims, and interests in the property.[9] As a practical matter, that means that assets that are sold through a bankruptcy sale have the cleanest possible title because no one can credibly claim an interest in the property after the sale.
The broad scope of § 363(f) necessarily conflicts with the protections set forth in § 365. Section 363(f) provides that upon certain conditions, a debtor can sell an asset free and clear of any lien, claim or interest. Perhaps surprisingly, courts are split as to whether “interest” in § 363(f) includes possessory rights that are otherwise protected under § 365(h) and (n).[10]
In re Crumbs Bake Shop
In 2014, Crumbs Bake Shop filed for chapter 11 protection and on the petition date, moved to sell substantially all of its assets free and clear under § 363. Months after the sale was approved, the purchaser moved in the U.S. Bankruptcy Court for the District of New Jersey for an order clarifying that the sale was free and clear of the rights of assignees of Crumbs’s trademarks, arguing that a sale free and clear under § 363(f) includes the possessory interest afforded by § 365(n).
Hon. Michael B. Kaplan flatly rejected the Seventh Circuit’s Qualtech opinion as unpersuasive, holding instead that “the interests held by [the licensees] were not extinguished by the sale because in the absence of consent, a sale under § 363(f) does not trump the rights granted to Licensees by § 365(n).”[11] The court’s ruling was “based on two factors: the principle of statutory construction that the specific governs the general, and the legislative history of § 365.”[12] As to the former, the Court explained it was “well established that the appropriate way to construe a statute is to conclude that the specific governs over the general” and that like “§ 365(h), subsection (n) is specific in granting certain rights to licensees of rejected intellectual property licenses. The specific language in § 365(n) should not be overcome by the broad text of § 363(f).” [13] As to the latter, the court held the legislative history of § 365 evidenced congressional intent to protect the rights of the tenants and by extension, licensees, and that permitting a sale free and clear under § 363(f) would eviscerate that intent.[14]
In Revel AC Inc.
In re Revel AC Inc., Hon. Gloria Burns of the U.S. Bankruptcy Court for the District of New Jersey reached an entirely different result on similar facts. The debtor’s assets consist primarily of a non-operating casino, significant portions of which were encumbered by leases to the various restaurants and shops that operated throughout the casino. As part of the sale, the debtor agreed to reject the leases and attempt to sell the casino free and clear of all tenants’ leasehold interests.
In an oral opinion, Judge Burns expressly determined that Qualtech controlled the fundamental issue, and that § 363(f) could undo the protections of § 365(h). The court reasoned that a sale under § 363(f) that would divest a tenant of its protected possessory interest was not akin to rejection:
[Section] 363(h) deals with leases — the assumption and rejections of leases and executory contracts. And in the . . . context where a trustee or a debtor decides to reject a lease, the leaseholder has the option of opting to stay in possession…. I think [that] Congress felt that in the event that the trustee or the debtor-in-possession determines to — to reject that lease, there’s still rights that the — that the tenant would have. [Section] 363(f) deals with instances where a trustee, or in this case the debtor-in-possession, wants to liquidate an asset of the case.[15]
Numerous tenants have appealed Judge Burn’s order. On February 6, 2015, the Third Circuit Court of Appeals issued an order staying those parts of Judge Burns’ opinion that purported to divest the tenants of their possessory interests, though the Court of Appeals’ reasoning has not yet been made available.[16] On February 9, 2015, the United States District Court for the District of New Jersey followed suit and issued its own order staying Judge Burns’ opinion. [17]
Conclusion
Following the diametrically opposite decisions in Revel and Crumbs, counterparties remain at risk that a bankruptcy court may not enforce their possessory rights. Such counterparties would do well to involve themselves in the sale of the debtor’s assets as early as possible in order to reach a commercial solution with the potential buyer. Any tenant looking to ride through a bankruptcy in reliance on the Bankruptcy Code’s protections for their rights may be in for a terrible surprise, as §§ 365(h) and 365(n) may only be a paper tiger in an asset sale.
[1] See, e.g., 11 U.S.C. § 365(a) (“Except as provided in sections 765 and 766 … and in subsections (b), (c), and (d) … the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.”).
[2] Sunbeam Prods. Inc. v. Chi. Am. Mfg. LLC, 686 F.3d 372, 377 (7th Cir. 2012)
[3] 2 Norton Bankr. Law and Prac. § 46:57 (3d ed. 2008) ("The Bankruptcy Code instructs us that rejection is a breach of the executory contract. It is not avoidance, rescission, or termination." (footnotes omitted)), quoted by In re Exide Techs., 607 F.3d 957, 967 (3d Cir., 2010), cert. denied, 2011 U.S. Lexis 1385 (U.S., Feb. 22, 2011) (“Exide”), Ambro, J., concurring opinion.
[4] See 11 U.S.C. §365(h)(1)(A) (“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 nonbankrutpcy 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 (including rights such as those relating to the amount and timing of any payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) 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.”).
[5] Dishi & Sons v. Bay Condos LLC, 510 B.R. 696 (SDNY, 2014).
[6] In re Crumbs Bake Shop Inc., 2014 Bankr. LEXIS 4568 at *17 (Bankr. D.N.J. Oct. 31, 2014).
[7] Exide at 966 (Ambro, J., Concurring).
[8] In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983).
[9] 11 U.S.C. §363(f).
[10] E.g., compare RJ Dooley Realty Inc., 2010 Bankr. Lexis 1761 (Bankr, SDNY, May 21, 2010); In re Crumbs Bake Shop Inc., 2014 Bankr. LEXIS 4568 (Bankr. D.N.J. Oct. 31, 2014). The only circuit court to hear the question thus far held that § 365(h) is, by its terms, limited to “rejection” and cannot apply in other contexts, including a sale free and clear. See Precision Indus. Inc. v Qualtech Steel SBQ LLC (In re Qualtech Steel Corp.), 327 F.3rd 537, 544 (7th Cir. 2003).
[11] In re Crumbs Bake Shop Inc., 2014 Bankr. LEXIS 4568 at *17 (Bankr. D.N.J. Oct. 31, 2014).
[12] Id. at *26.
[13] Id. at *27.
[14] Id. at *26.
[15] Transcript, In re Revel AC Inc., at 51:13-52:5, No. 14-22654 (Bankr. D.N.J. Jan. 8, 2015).
[16] See Order, In re Revel AC, Inc., No. 15-1253, (3d Cir. Feb. 6, 2015).
[17] See Order, In re Revel AC, Inc., No. 15-00352, (D.N.J. Feb. 9, 2015).