Ninth Circuit Joins Seventh that Sale Under § 363(f) Can Strip Tenants of Their § 365(h) Rights

The Ninth Circuit Court of Appeals recently joined the Seventh Circuit in adopting what it referred to as the “minority rule” in holding that a free-and-clear sale of property under § 363(f) of the Bankruptcy Code strips a tenant of its statutory right to remain in the premises notwithstanding rejection of the lease pursuant to § 365(h) of the Bankruptcy Code in In the Matter of Spanish Peaks Holdings II, LLC.[1]

In the Matter of Spanish Peaks Holdings II LLC

Spanish Peaks was a 5,700-acre resort in Big Sky, Mont. The project was financed by a $130 million loan held by Citigroup. Citigroup later assigned the note and mortgage to Spanish Peaks Acquisition Partners LLC (the lender). A collection of interrelated entities owned the resort and managed its amenities, including a ski club, a golf course, and residential and commercial real estate sales and rentals. Pre-petition, the debtors entered into two undermarket, long-term commercial leases (99 and 60 years, respectively) with two different commercial tenants.

On Oct. 14, 2011, the debtors filed voluntary chapter 7 petitions. The lender was by far the debtors’ largest creditor, holding a claim of more than $122 million. The bankruptcy trustee moved for an order approving an auction and sale process with a minimum bid of $20 million. The sale motion contemplated that the sale would be “free and clear of any and all liens, claims, encumbrances and interests.” The lender won the auction with a bid of $26.1 million.

The tenants objected to any effort to sell the debtors’ assets free and clear of their leasehold interests. They noted that § 365(h) of the Bankruptcy Code gave them the right to retain possession of the property pursuant to their leases upon rejection. Without addressing the tenants’ argument, the bankruptcy court approved the sale, holding that the sale was free and clear of any interests, including leases, “except any right a lessee may have under 11 U.S.C. § 365(h).”[2] Both sides moved for clarification of the approval order.

Thereafter, the trustee filed a motion to reject the tenants’ leases on the ground that the subject property was no longer property of the estate. The lender, meanwhile, moved for a determination that it had acquired the property free and clear of the leases. After a two-day evidentiary hearing, the bankruptcy court, applying what it called a “case-by-case, fact-intensive, totality of the circumstances approach,” held that the sale was free and clear of the tenants’ leases.[3] The district court affirmed.

The Ninth Circuit Court of Appeals stated that “the issue brings two sections of the Code into apparent conflict.”[4] Section 363(f), the court noted, authorizes sales “free and clear of any interest in such property of an entity other than the estate.” Meanwhile, § 365(a) authorizes a debtor to reject any executory contract or unexpired lease of the debtor subject to subsection (h), which

leaves a lessee in possession with two options: treat the lease as terminated (and make a claim against the estate for any breach), or retain any rights — including a right of continued possession — to the extent those rights are enforceable outside of bankruptcy.[5]

The court noted that when both provisions come into play (i.e., when the trustee proposes to sell property free and clear of encumbrances, and one of the encumbrances is an unexpired lease), federal courts have addressed the resulting dilemma in two different ways.

The “majority approach,” adopted by numerous bankruptcy courts, concludes that the statutory provisions overlap.[6] Such courts hold that § 365(h) trumps § 363(f) under the canon of statutory construction that “the specific prevails over the general.”[7] Such courts further reason that “the legislative history regarding § 365 evinces a clear intent on the part of Congress to protect a tenant’s estate when the landlord files bankruptcy, and that the protection would be nugatory if the property could be sold free and clear of the leasehold under section 363.”[8]

The “minority approach,” the Ninth Circuit noted, is based on the Seventh Circuit Court of Appeals’ 2003 ruling in In re Qualitech Steel Corp,[9] where that court held that § 363 confers a right to sell property free and clear of “any interest,” without excepting from that authority leases entitled to the protections of § 365(h). After reviewing the statutory text, the Qualitech court found that the statutory provisions do not necessarily conflict with each other, reasoning that § 365(h) focuses solely on the rejection of an executory contract and says nothing at all about sales of estate property, “which are the province of section 363.” The court explained:

Where estate property under lease is to be sold, section 363 permits the sale to occur free and clear of a lessee’s possessory interest — provided that the lessee (upon request) is granted adequate protection [under § 363(e)] for its interest. Where the property is not sold, and the [estate] remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property. So understood, both provisions may be given full effect without coming into conflict with one another and without disregarding the rights of lessees.[10]

The Ninth Circuit adopted the “minority approach,” holding that §§ 363 and 365 do not conflict. The court reasoned that while a sale of property free and clear of a lease “may be an effective rejection of the lease in some everyday sense,” it is not the same thing as the “rejection” contemplated by § 365.[11] Adopting the Seventh Circuit’s analysis, the court stated: “In sum, section 363 governs the sale of estate property, while section 365 governs the formal rejection of a lease. Where this is a sale, but no rejection (or a rejection, but no sale), there is no conflict.”[12]

The court then responded to the argument of some of the “majority approach” courts that its attempt to harmonize the two statutes “arguably results in the effective repeal of § 365(h).”[13] First, the court explained, the mandatory language of § 363(e) of the Bankruptcy Code, which provides that a bankruptcy court must provide adequate protection for an interest that will be terminated by a sale if the holder of the interest requests it, addresses this concern. The court suggested that if the tenants had simply sought adequate protection of their leasehold interest under § 363(e), the bankruptcy court may have had no choice but to allow them to continue in possession. But no such request was timely made. Second, the court reasoned, a foreclosure sale under Montana state law would terminate a subsequent lease on the mortgaged property. Section 365(h), the court opined, should be interpreted in a manner that protects lessees’ rights outside of bankruptcy, but does not enhance them.

The court concluded by stating that while § 365(h) embodies a congressional intent to protect lessees, that intent is not absolute. Rather, “it exists alongside other purposes and sometimes conflicts with them.”[14] The oft-stated bankruptcy purpose of maximizing value and creditor recoveries, the court said, is core to the Code. And that purpose, the court reasoned, is best served by permitting the sale of assets free and clear of leases notwithstanding § 365(h).

Because the debtors’ assets were sold free and clear of all interests pursuant to § 363(f), and since the trustee did not seek to reject the leases as part of the sale, the Ninth Circuit held that § 365(h) was not implicated. Accordingly, the judgment of the district court was affirmed.

Conclusion

In the Matter of Spanish Peaks Holdings II LLC addresses a difficult issue of statutory interpretation involving two statutory provisions that appear to conflict. The Seventh Circuit’s opinion in Qualitech has been criticized by bankruptcy commentators for nearly 15 years and has been ignored by most bankruptcy courts that have been faced with this issue. Nevertheless, the law in the Ninth Circuit is now consistent with the law in the Seventh Circuit. Without a circuit split on the issue, it seems unlikely that the Supreme Court will weigh in on this issue anytime soon.

In the meantime, Spanish Peaks suggests that tenants of real property that a debtor seeks to sell “free and clear” of their leases in a § 363(f) sale should brush up on § 363(e) of the Bankruptcy Code. That section provides, in pertinent part: “[A]t any time, on request of an entity that has an interest in property used, sold, or leased, or proposed to be used, sold, or leased, by the trustee, the court, with or without a hearing, shall prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interest.”[15] This provision is far too often forgotten by tenants facing a § 363(f) sale. However, as noted by the Ninth Circuit, in cases where a tenant invokes § 363(e), it is hard to imagine what “adequate protection” a debtor or the court could provide other than the right to continue to occupy the premises.