Joining the Seventh Circuit and embracing a result reached by a minority of courts, the Ninth Circuit held that a “free and clear” sale under Section 363 can extinguish a lease of real property, at least when the bankruptcy sale is a rough equivalent of mortgage foreclosure and the lessee does not have a nondisturbance agreement or a subordination of the mortgage.
The July 13 opinion, written by Senior District Judge Frederic Block, sitting by designation from the Eastern District of New York, deals with the seeming conflict between Section 363(f), which permits sale of property free and clear “of any interest,” and Section 365(h), which allows a lessee of a rejected lease to retain possession of the property for the remainder of the term of the rejected lease.
The case involved a resort where one of the owners had two leases for commercial property. Both leases called for annual rent of about $1,000. One lease was for 99 years and the other for 60 years. When the project filed a chapter 7, the debtor owed more than $120 million on the mortgage. The bankruptcy court later found that the fair market value of the leases was between $40,000 and $100,000 a year.
The mortgage lender agreed to allow a sale of the property, where the winning bid was about $26 million. The insider-tenants contended that the sale could not be free and clear of the leases in view of Section 365(h). The bankruptcy court ruled that the leases did not survive the sale. The district court affirmed.
Judge Block said that a majority of courts – none at the circuit level – hold that Section 365(h), the more specific provision, protects tenants when property is sold free and clear under Section 363(f).
The minority, Judge Block said, is represented by the Seventh Circuit, which held in Qualitech Steel that property can be sold free and clear of a lease so long as the lessee is given adequate protection, as required by Section 363(e).
Coming down on the side of the Seventh Circuit, Judge Block held that Section 363 alone governed and there was no conflict between the sections because there had been no rejection of the lease prior to or alongside the sale. Therefore, he said, “Section 365 was not triggered.”
Although Section 365(h) may not apply, Judge Block said that “the broad definition of adequate protection makes it a powerful check on potential abuses of free-and-clear sales.” In that respect, he cited Dishi & Sons from the Southern District of New York, where adequate protection took the form of continued possession.
Judge Block was not required to decide what adequate protection the tenant was entitled to receive because there was no request by the tenant until after the sale. He therefore turned to the question of whether Section 363(f) entitled the trustee to sell the property free of leases.
Focusing on Section 363(f)(1), which permits free and clear sales under applicable nonbankruptcy law, Judge Block said that the “bankruptcy proceeded, practically speaking, like a foreclosure sale.” Were there no bankruptcy, he “confidently” said there would have been an actual foreclosure coupled with termination of the leases, because the mortgage was not subordinated to the leases and there were no nondisturbance agreements.
Upholding the sale free of the leases because they had not been rejected, Judge Block said that Section 365(h)(1)(A)(ii) shows an intent “to protect lessees’ rights outside of bankruptcy, not an intent to enhance them.”
Although the opinion avoids saying whether the insider-tenants would have been entitled to adequate protection had they made a timely request, Judge Block implies there would have been none because occupancy rights would have been extinguished in foreclosure.
Likewise, the opinion does not say whether the result would have been different had the trustee rejected the leases before selling the property. Given that rejection of a lease equates to a court-authorized breach, the result might have been the same since the right to possession would have been terminated by a subsequent foreclosure.