Losing Your Lease: Ninth Circuit Permits Stripping Leasehold Interests Under § 363(f)

What happens when property of the estate that a trustee or debtor-in-possession proposes to sell “free and clear” is subject to unexpired lease interests? The resolution of this question requires the reconciliation of two separate provisions of the Bankruptcy Code that most often operate independently and in isolation. The first provision, 11 U.S.C. § 363(f), permits a trustee or debtor in possession[1] in bankruptcy to sell assets of the estate free and clear of third-party interests. The second provision, § 365(h), permits a debtor in possession or trustee to reject an unexpired lease of property of the estate, with the lessee retaining the option of treating the entire lease as terminated or remaining in possession of the property.

Ninth Circuit Takes Up the Issue: In re Spanish Peaks Holdings II, LLC[2]

The debtors in Spanish Peaks were a collection of interrelated companies that owned a 5,700-acre resort in Big Sky, Mont., and managed its amenities, which included several residential and commercial real estate rentals.[3] After the real estate market contracted and the operational losses of the debtors mounted, the debtors each filed for chapter 7 relief.[4] The chapter 7 trustee of the debtors’ consolidated bankruptcy estate and the debtors’ largest creditor developed a “plan” for liquidating substantially all of the debtors’ real and personal property — including two commercial properties subject to an unexpired lease (the “leases”) — “free and clear of all liens.”[5]

Objecting to the trustee’s motion to sell substantially all of the debtors’ assets “free and clear,” the lessees under the leases argued that the Bankruptcy Code authorized them to retain possession of the leased properties notwithstanding the proposed sale.[6] The bankruptcy court, after multiple hearings, eventually entered an order providing that the sale of the debtors’ assets was free and clear of the lessees’ interests under the leases.

After the district court affirmed the ruling of the bankruptcy court on appeal, the lessees appealed to the Ninth Circuit.

The Apparent Clash of §§ 363 and 365

As noted at the outset of this article, the Spanish Peaks court was called to reconcile two sections of the Bankruptcy Code that were in apparent conflict: §§ 363 and 365. Section 363 generally provides for the use, sale or lease of property belonging to the bankruptcy estate. As relevant for the Spanish Peaks court, subsections (b) and (c) authorize the trustee to sell estate property either within the normal course of a debtor’s business (in which case, the sale may take place without prior notice and a hearing) or outside the normal course of business (in which case, the sale must take place upon notice and hearing).

Section 363(f) makes apparent that such property may be sold unencumbered by third-party interests if one of five conditions is met:[7]

The trustee may sell property under subsection (b) or (c) of this section free and clear of any interest in such property of an entity other than the estate, only if —

(1) applicable nonbankruptcy law permits sale of such property free and clear of such interest;

(2) such entity consents;

(3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;

(4) such interest is in bona fide dispute; or

(5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.

Section 363(e) further provides that, upon request from a party with an interest in the property to be sold, the court, with or without a hearing, shall prohibit or condition such ... sale ... as is necessary to provide adequate protection of such interest.”[8] This may entail a cash payment, an additional or replacement lien, or other relief sufficient to result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property.[9] Together, § 363 makes clear that a debtor in possession or trustee may sell property of the estate outside the normal course of business after notice and a hearing, and such sale may be free and clear of interests held by others if one of five conditions is met. In turn, any party with an interest in the property may request adequate protection as a condition to such sale.

Meanwhile, § 365(h) governs the rejection of leases of a debtor/lessor by the trustee or debtor in possession.[10] Section 365 authorizes the trustee to assume or reject unexpired leases or executory contracts of the debtor, subject to court approval.[11] Under this section, “rejection” is tantamount to an election not to obligate the estate on a contract or lease and gives rise to a remedy for breach of contract in the non-debtor party.[12] Section 365(h) makes special provision for the remedies available to a lessee when the debtor is the lessor by affording the lessee the option of (1) treating the entire lease as terminated and making a claim against the estate for any breach or (2) retaining its appurtenant rights under the lease, including the right of continued possession.[13]

Although §§ 363 and 365(h) generally operate harmoniously in isolation,[14] when applied concomitantly the disparate analyses undertaken by courts, including Spanish Peaks, highlight that the reconciliation of the provisions can be quite a difficult task.

The “Majority,” “Minority” and Ninth Circuit Approaches

In Spanish Peaks, through Judge Frederic Block,[15] the Ninth Circuit “easily” resolved the issue on appeal, holding that § 363(f) authorizes the sale of estate property free and clear of the unexpired leasehold interests.[16] In reaching this conclusion, the Ninth Circuit identified and rejected the “majority approach” adopted by several bankruptcy courts, which provides that the protections to lessees under § 365 trumps the right to reject unexpired leases under § 363.[17] Under this “majority approach,” §§ 363(f) and 365(h) are effectively irreconcilable when applied together and therefore hold that a trustee’s only options under these circumstances are to either assume the lease or reject the lease subject to the special remedies provided for under § 365(h).[18]

Instead, the Ninth Circuit sided with the approach taken by the Seventh Circuit — the only circuit to have addressed the issue presented. In its opinion,[19] the Seventh Circuit relied exclusively on statutory text to determine that neither §§ 363 nor 365 “suggest that one supersedes or limits the other.”[20] Indeed, § 363 authorizes the trustee or debtor-in-possession to sell property free and clear of “any interest” and does not except the protections provided for under § 365(h) from that authority.[21] Under this minority approach, § 363(f) authorizes a debtor/lessor to bypass § 365(h) and sell its interest in estate property free and clear of the leasehold interest, with the lessee retaining its right to seek adequate protection under § 363(e).[22]

Adding to the Seventh Circuit’s “minority approach,” the Spanish Peaks court elaborated that a sale of property free and clear of a lease is not tantamount to “rejection” under the Bankruptcy Code, and therefore, “[w]here there is a sale, but no rejection (or a rejection, but no sale), there is no conflict.”[23] Further, § 363(e) incorporates a mandatory remedy for lessees when there is a sale but no rejection: adequate protection, which “could take the form of continued possession.”[24] Therefore, under Spanish Peaks, although § 365(h) embodies a congressional intent to protect lessees, such an intent is not absolute and must exist alongside other competing policy norms of the Bankruptcy Code, such as maximizing the value of the estate for distribution to creditors.

Takeaway

Whether you are involved in a bankruptcy case in a district that has adopted the majority or minority positions set forth above, Spanish Peaks serves as a reminder to attorneys who represent lessees to undertake basic protectionary measures within the context of the bankruptcy case. First, such attorneys should timely seek adequate protection under § 363(e) should their client’s leasehold interest be subject to a sale conducted by a trustee or debtor in possession under § 363(f). Such adequate protection is mandatory and may include compensation for the value of its leasehold from the proceeds of the sale,[25] continued possession of the leased premises,[26] or some other relief that will “‘result in the realization by such entity of the indubitable equivalent’ of the terminated interest.”[27] Second, such attorneys should also object to any such sale and specifically target the factors set forth in § 363(f) in order to test whether the § 363(f) sale is appropriate under the circumstances.

The reasoning of the Ninth Circuit in Spanish Peaks and the Seventh Circuit in Qualitech nonetheless constitute a potentially potent tool in the toolkit of debtors in possession and trustees.