A recent opinion issued by the Ninth Circuit Court of Appeals in the case of Pinnacle Restaurant at Big Sky LLC v. CH SP Acquisitions LLC( In re Spanish Peaks Holdings II LLC)[1] affirmed a holding that would allow, under certain circumstances, the sale of commercial real estate in a bankruptcy case to be free and clear of all liens, claims and encumbrances, including leasehold interests that are generally protected under § 365(h) of the Bankruptcy Code. The Ninth Circuit adopted a minority approach that finds no conflict between § 363 (dealing with free-and-clear sales) and § 365 (dealing with the rejection of leases).
The debtor in the underlying bankruptcy case was the owner of resort property in Big Sky, Mont., that, prior to bankruptcy, leased restaurant space to a related company at the rate of $1,000 a year for a 99-year term (the “restaurant lessee”) and additional space to a separate related company at the rate of $1,285 a year for a 60-year term (the “second lessee” and, collectively with the restaurant lessee, the “Big Sky Lessees”). The secured lender, which had a mortgage that predated the leasehold interests, held a claim for $122 million that was secured by a mortgage on the resort property. During the pendency of the chapter 7 bankruptcy, the trustee decided to sell the property “free and clear of any and all liens, claims, encumbrances and interest” using § 363(f) of the Bankruptcy Code. The lender was the successful purchaser of the resort property, for $26.1 million. Following the sale, the Big Sky Lessees attempted to invoke the protections of § 365(h) of the Bankruptcy Code that allow a lessee whose lease is rejected in bankruptcy to, among other things, retain possession of the property for the remaining term of the lease. The secured lender filed a motion for a determination that the sale was free and clear of the Big Sky Lessees’ leasehold interests in the resort property.
In reaching its decision, the bankruptcy court conducted a “totality of the circumstances” analysis in holding that the sale was free and clear of the Big Sky Lessees’ interests, leaving them no possessory rights under § 365(h). Specifically, the bankruptcy court relied on the following facts: (1) the restaurant lessee had not operated on the property in the several years prior to the bankruptcy filing; (2) the Big Sky Lessees leases were below market; (3) all parties to the lease transactions were controlled by the same entity at the time the leases were entered into; (4) the mortgage was senior to the leases; and (5) the leases were not protected by subordination or nondisturbance agreements. In terminating the Big Sky Lessees’ possessory interests in the leaseholds, the bankruptcy court also noted that the Big Sky Lessees had not requested adequate protection and provided no evidence of economic harm upon termination of the leasehold interests. The decision of the bankruptcy court was affirmed by the district court and appealed to the Ninth Circuit.
The Ninth Circuit, agreeing with the reasoning in the Seventh Circuit’s decision in In re Qualitech Steel Corp.,[2] cited to the canon of statutory interpretation that statutes must be read to “give effect to each if we can.” In its opinion, the Circuit Court stated that “section 363 governs the sale of estate property, while section 365 governs the formal rejection of a lease. Where there is a sale, but no rejection (or a rejection, but no sale), there is no conflict.”[3] Notably, while the lender was ultimately victorious and able to strip away the Big Sky Lessees’ leasehold interests as part of the sale, the circuit court rejected the lender’s argument that § 363(m) rendered the appeal moot because the sale had been consummated, finding that the protections of § 363(m) extend only to the validity of the transfer, not a determination as to whether the sale was “free and clear.” This limitation could create a lack of certainty that may depress prices received in bankruptcy sales or steer parties clear of the bankruptcy process entirely.
Because the bankruptcy court’s decision utilized an “all facts and circumstances” approach, the lasting effects of this decision remain unknown. However, lessees can take actions to protect their interests, including, but not limited to, obtaining subordination or nondisturbance agreements, seeking adequate protection from the bankruptcy court, or requesting a pre-sale determination on the rejection of the underlying lease to invoke the protections of § 365(h).
[1] Case No. 15-35572 (9th Cir. Sept. 12, 2017).
[2] 327 F.3d 537 (7th Cir. 2003).
[3] Spanish Peaks, slip op. at p. 15.