Right to Protection of Leasehold Interest in Real Property in a Section 363 Sale by a Debtor-Landlord: Section 363(f) versus Section 365(h)

Two sections of the Bankruptcy Code seemingly stand at odds regarding the protections offered to lessees of real property owned by a bankrupt debtor. Section 365(h) strongly protects a lessee’s right to possession of real property in the face of debtor’s rejection of the lease. The legislative history of § 365(h) indicates that Congress had a desire to protect a lessee’s expectations in real estate transactions. However, § 363(f) allows a trustee or debtor in possession (DIP) to sell real property free and clear of “any interest” in such property, including a leasehold interest.

The questions become (1) whether the lessee’s possessory rights are only protected if the lease is rejected or, alternatively, whether the possessory right can be defeated through a Section 363(f) sale and (2) if a § 363(f) sale can dispose of a tenant’s property rights, whether the lessee is entitled to adequate protection for its possessory interest. This article will explore the split among the courts regarding the relationship between § 363(f) and § 365(h).

Discussion
Obviously recognizing the impact that ejectment could have on residential and commercial tenants, Congress enacted § 365(h) to ensure that rejection of a lease by the landlord or its trustee does not divest the tenant of its interest in the lease. [1] Pursuant to § 365(h)(1)(A)(ii), if a lease term has already commenced when a trustee or DIP, as landlord, rejects the lease, then the tenant can fully exercise its rights under the lease. Section 365(h)(1)(A)(ii) states:

[T]he lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of 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. [2]

On the other hand, § 363(f) allows a DIP or trustee to sell property of the estate free and clear of “any interest” in such property under certain circumstances. While the Code does not define “any interest(s),” it is clear from the reported decisions that the term is sufficiently broad to include a “possessory interest as a lessee.” [3]

  As one court noted, “the vast majority of lower court decisions that have addressed this issue have held that a debtor cannot use the provisions of § 363(f) to get around the rights of tenants” set forth in Section 365(h).” [4] The majority of cases hold that the more specific provisions of § 365(h) dictate the manner and procedure by which a DIP may terminate its interests in a lease; those specific provisions, rather than the more general provisions of § 363(f), must be followed. [5] The Haskell Court held:

If the Court were to grant the [§ 363(f) sale motion to sell the property free and clear of a lessee’s interests], the provisions of § 365(h) would be eviscerated. In other words, the debtor would be doing indirectly what it cannot do directly, namely, dispossessing [the tenant]. [6]

The minority position holds that statutory construction dictates that the two sections must be read in concert and that, notwithstanding § 365(h), a trustee or DIP may sell property free and clear of a leasehold interest if one of the conditions of § 363(f) can be satisfied. [7] Section 365(h), by its terms, applies “[i]f the trustee rejects an unexpired lease of real property.” Under a strict reading of § 365(h), a lessee’s interests are only protected in the event of rejection. The minority position concluded that § 365(h) therefore does not apply in a § 363 sale that divests “any interest” in the property but does not actually reject the lease. [8]

Qualitech is the only circuit-level case to address this issue. In Qualitech, the lessee and the debtor entered into a ground lease for real property on the campus of debtor’s steel mill, and the debtor subsequently filed a voluntary bankruptcy petition. During the bankruptcy, the DIP sold the leased property to several secured creditors who then conveyed the land to the reorganized debtor. The sale was approved “free and clear” of all interests pursuant to § 363(f). The lessee received notice of the sale but did not object.

After the sale, the reorganized debtor ejected the lessee from the property. The lessee brought suit for possession and the bankruptcy court held that the § 363(f) sale extinguished the lease and therefore extinguished lessee’s possessory interest in the property. On appeal, the district court reversed and held that § 365(h)(1)(A) protected lessee’s possessory interest, regardless of the sale. On appeal, the Seventh Circuit Court of Appeal concluded that the property subject to a leasehold interest may be transferred free of the leasehold interest, if the conditions of Section 363(f) are satisfied:

[I]t is apparent that the two statutory provisions [§ 363(f) and § 365(h)] can be construed in a way that does not disable § 363(f) vis-à-vis leasehold interests. Where estate property under lease is to be sold, § 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 for its interest. Where the property is not sold, and the debtor remains in possession thereof, but chooses to reject the lease, § 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. [9]

However, the Seventh Circuit explained:

“Adequate protection” does not necessarily guarantee a lessee’s continued possession of the property, but it does demand, in the alternative, that the lessee be compensated for the value of its leasehold--typically from the proceeds of the sale. Lessees…are therefore not without recourse in the event of a sale free and clear of their interests. They have the right to seek protection under § 363(e), and upon request, the bankruptcy court is obligated to ensure that their interests are adequately protected. [10]

Under § 363(e), any entity that has an interest in property to be sold may request that the court prohibit or condition such sale as is necessary to “provide adequate protection of such interest.” In Qualitech, the Seventh Circuit confirmed the sale dispossessing the tenant without adequate protection because the tenant received notice of the sale but failed to object to the sale or seek adequate protection.

In MMH Auto Group, the U.S. Bankruptcy Court for the Southern District of Florida sided with the minority Qualitech position when faced with a tenant’s objection to a previous sale. [11] The court upheld the sale under § 363(f)(5) because the express terms of the lease required the tenant to accept money in satisfaction of its leasehold interest (i.e., it gave the landlord the right to buyout the lease). However, since the tenant never had notice of the sale, the court granted the tenant adequate protection for its leasehold interest despite the fact that tenant never objected to the sale while it was pending. The bankruptcy court set the adequate protection equal to the amount of the buyout that the tenant could have been forced to accept under the terms of the lease.

What happens if the sales proceeds are insufficient to pay the secured claims in full? Are the tenants’ adequate protection rights superior to secured claims on the property being sold? Recently, in In re R.J. Dooley Realty Inc., [12] the debtor sold real property to a buyer “free and clear” of pre-existing leases. The successful bidder had placed a “credit-bid” and therefore, there were no proceeds to pay the adequate protection to displaced tenants. A tenant filed a motion seeking to enjoin the transfer of the property free and clear of the leases. The tenant argued that the leases should not be terminated unless there were sufficient sales proceeds to provide the tenants with adequate protection, citing §§ 363(e) and 365(h).

Following the minority position, the court held that the property could be sold free and clear of the leasehold interests. With respect to the tenant’s demand for adequate protection, the court held that providing adequate protection to a tenant to the detriment of secured creditors would be contrary to the Bankruptcy Code’s priority scheme because tenants hold general unsecured claims. The court criticized the Qualitech opinion, stating that “the [Qualitech] court failed to consider that offering such adequate protection to a general unsecured creditor would catapult it ahead of its position behind secured, administrative, and priority unsecured creditors, in complete contravention of the priorities of the Bankruptcy Code.” [13]

Consequently, the court held that the tenant did not have an “interest in property” within the meaning of § 363(e) and therefore was not entitled to adequate protection. The court stated that “bankruptcy causes fundamental relationship changes among the debtor, the creditors, and other parties with a relationship to the debtor.” [14] Finally, the court concluded that “[t]he fact that a natural consequence of a [§ 363 sale]…might cause a tenant’s lease to be terminated is not a public interest.” [15]

Conclusion
The majority of courts considering the issue of whether a § 363 sale can divest tenants of their leasehold interests have upheld Congress’ intention to strongly protect a lessee’s right to possession, even in the face of a “free and clear” sale. Most of the courts that do not follow the majority position seemingly protect the lessee’s right to adequate protection, assuming that the lessee acts promptly to preserve this right after a sale motion is filed. However, when advising lessees preparing to enter long-term leases and make substantial investments in leased property, cases such as Dooley Realty serve as a stark reminder that the right to absolute protection is not absolute and such investments may not be protected if the landlord files for bankruptcy.