Bankruptcy Sales and Leases: “Free And Clear” May Not Be So “Free And Clear”

by Pepper Hamilton LLP

Dishi & Sons v. Bay Condos LLC, 510 B.R. 696 (S.D.N.Y. 2014)

In approving the sale of a Chapter 11 debtor’s assets, a bankruptcy court found that a tenant of the debtor was entitled to continue in possession of the leased portion of the sold property for the remainder of its lease.  The successful bidder at the sale appealed, arguing that the sale was “free and clear” of the tenant’s interests. 

On the one hand, Section 363(f) of the Bankruptcy Code authorizes sale of a debtor’s property “free and clear of any interest in such property.”  On the other hand, Section 365(h) provides that if a lease is rejected by a debtor landlord, the tenant may elect to retain rights under its lease that are appurtenant to the real property, including the right to continue possession at the specified rent.

The bankruptcy court followed what the district court characterized as the majority view that (1) the two sections are in conflict and (2) Section 365(h) trumps Section 363(f).  Alternatively, the bankruptcy court held that even if the sale free of the tenant’s interests was permitted, the tenant was entitled to possession as “adequate protection” of its interest.

The district court framed the question as whether Section 365(h) preserves the tenant’s rights even if they would otherwise be extinguished in a Section 363(f) sale.  The district court declined to adopt the majority view.  It emphasized that Section 365(h) does not give a tenant absolute rights.  The goal of Section 365 is to allow a debtor to escape ongoing obligations where the benefits to the estate are outweighed by the obligations.  However, that does not mean that the non-debtor tenant’s property interest is affected or that the bankruptcy estate is entitled to remove the tenant.

The court concluded that (1) at the beginning of a bankruptcy case the interests acquired by the bankruptcy estate include both the lease and the landlord’s reversionary interest in the property at the end of the lease, (2) the power to assume or reject does not alter the tenant’s appurtenant rights, and (3) Section 365(h) simply preserves those tenant rights, but does not preclude terminating them under another provision of the Bankruptcy Code.

As for the right to sell under Section 363(f), interests can be extinguished only if one of five tests is met.  But if a sale free and clear is authorized under one of those tests, the court saw nothing in Section 365(h) that mandates a contrary result.

In considering whether Section 363 authorized a sale free of the lease interests, the parties agreed that only two sections were potentially applicable.

Section 363(f)(1) allows a sale free and clear if “applicable non-bankruptcy law permits sale of such property free and clear of such interest.”  The buyer contended that state foreclosure law, which allows a mortgagee to extinguish a junior leasehold interest, provides an appropriate basis.

The court analyzed the issue as whether this should be interpreted as a sale by any person or only circumstances where the sale could be accomplished by the trustee or debtor.  The court adopted the narrower interpretation and held that this section applies only when the owner could sell free and clear of an interest and does not refer to a foreclosure sale by a third party mortgagee.  In this case the buyer had notice of the lease.  So the sale would be subject to the lease under state law.

Section 365(f)(5) provides that property can be sold free and clear if the interest holder “could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of [its] interest.”  Again the court saw the issue as whether the section should be read narrowly to mean that the owner of the property could compel the interest holder, or more broadly to include hypothetical actions by third parties (such as eminent domain or foreclosure of tax liens).  Again the court opted for the narrow interpretation.  Consequently, it rejected the argument made by the bidder that relied on foreclosure by a third-party mortgagee as the basis for compelling the tenant to accept money.

However, even if Section 363(f) did authorize a sale free and clear of the tenant’s interests, it was still necessary to address Section 363(e) – which directs that if an interest is threatened by a proposed sale, the court “shall prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interests.”

Under Section 361, adequate protection may include payments or such “relief . . . as will result in the realization by such entity of the indubitable equivalent of such entity’s interest.”   Normally a tenant would be unlikely to receive compensation from the proceeds of the sale, and it would be difficult to value the unique property interests in any event.  This leaves providing the indubitable equivalent of the tenant’s interests as adequate protection, which translates into continued possession.

In sum, the district court did not agree that Section 365(h) trumps Section 363. Nor did it agree that the bidder was able to establish the grounds for selling free and clear of the tenant’s interest.  But even it could meet one of the tests in Section 363(f), the court concluded that in most instances the tenant would be able to argue that it was entitled to continued possession as adequate protection of its interests.

Putting aside the argument that Section 363(h) tenant rights should always be respected in a bankruptcy sale, a party seeking to acquire property free of a lease should recognize that not only may it be difficult to meet the tests for a sale free and clear (although that depends in part upon the jurisdiction), it may also be faced with continued possession by a tenant mandated as a matter of adequate protection.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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