In 2003 the Seventh Circuit Court of Appeals surprised many observers when it held that a sale of real property under section 363 of title 11 of the United States Code (Bankruptcy Code) could be approved free and clear of a lessee’s leasehold interest in the property. Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003) (Qualitech).

Until that time, courts consistently had held that the rights of a non-debtor lessee in commercial property it leased from a debtor in bankruptcy were preserved by special protections afforded such lessees elsewhere in the Bankruptcy Code. The Qualitech case set off alarm bells, particularly among commercial tenants and lenders that utilized leasehold interests as collateral. In the ensuing years, however, most courts declined to follow Qualitech and the holding generally came to be viewed as an anomaly.

That changed in July, when the Ninth Circuit Court of Appeals joined what it described as the minority position espoused in Qualitech and held that the rights of a lessee in a debtor’s real property may be extinguished in connection with a 363 asset sale. Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings, II, LLC), 2017 U.S. App. LEXIS 12526 (9th Cir. July 13, 2017) (Spanish Peaks).

In Spanish Peaks, the court addressed the perceived clash between Bankruptcy Code sections 363 and 365 that bear on this issue, and determined the two sections do not conflict.

When Sections Collide – The “Conflict” Between Bankruptcy Code Sections 363 and 365

Subject to certain conditions, Bankruptcy Code section 363(f) permits a debtor or trustee in bankruptcy to sell the debtor’s assets free and clear of interests held by third parties. 11 U.S.C. § 363(f).

Bankruptcy Code section 365, meanwhile, generally allows a debtor or trustee to assume or reject an unexpired lease of the debtor’s property. 11 U.S.C. § 365(a). Section 365(h) applies specifically to situations where the debtor, as lessor, seeks to reject a lease with a non-debtor lessee. Under 365(h), upon rejection, the non-debtor lessee may retain existing rights in the leased property, including the right to continue to remain in possession of the property, as long as the lessee continues to perform the obligations specified in the lease. 11 U.S.C. § 365(h)(1)(A).

The two provisions provide different rights for different parties, and they usually operate independently of one another. However, in situations where the two sections overlap, a number of courts have held they are in conflict, because a party invoking one of the provisions will override the interest of a party invoking the other.

Most courts have resolved the perceived conflict in favor of the tenant by holding that the specific protections set forth in section 365(h) prevail over the more general sale rights provided in 363(f). In other words, a sale of a debtor’s property under section 363 may only be approved subject to the specific possessory rights of a commercial tenant under 365(h).

Spanish Peaks – No Conflict Between 363 and 365

The Spanish Peaks court concluded sections 363(f) and 365(h) are not inherently at odds. In doing so, the court pointed out the different scopes and purposes of the two provisions and emphasized the importance of giving effect to both, observing that where there is a sale, but no rejection (or a rejection, but no sale), there is no conflict between the two.

Accordingly, the 363 sale, which did not include a formal, statutory rejection of the tenant’s lease rights, could proceed free and clear of any continuing burdens associated with the leasehold. As a result, the tenant’s lease rights, including any right of possession, were extinguished.

Impact on Commercial Tenants

Based on the rationale of the Qualitech and Spanish Peaks decisions, tenants in commercial spaces owned by landlords in financial distress are at risk of having their leasehold rights extinguished if the property owner files bankruptcy, notwithstanding the protections provided to them by section 365(h). While the regular income stream from a tenant typically is viewed as a valuable asset to be preserved, that is not always the case, particularly in connection with a below-market lease.

Notably, the Spanish Peaks court provided a roadmap to minimize a tenant’s risk, as well as to avoid an interpretation of the court’s holding that would arguably result in an effective repeal of section 365(h). Specifically, the court pointed to the mandatory language of Bankruptcy Code section 363(e), which obligates a court to provide “adequate protection” to a holder of an interest that will be terminated by a sale if the holder of such interest requests it. In this case, the tenants had objected to the sale free of their leasehold interests; however, they did not specifically request adequate protection of their interests until after the sale had already been approved. By then, it was too late.

Because “adequate protection” is not defined in the Bankruptcy Code, courts have considerable flexibility to determine what types and amounts of protection are adequate under the particular circumstances. If a timely request for adequate protection is made, appropriate forms of protection for a tenant under 363(e) arguably might include, among other possibilities, the right to remain in possession of the property for the remainder of the lease term, or, alternatively, suitable compensation for loss of the leased space, such as for the cost of relocating and for any damages arising from the business interruption associated with such disruption.

The Spanish Peaks court held that the tenants lost their rights to adequate protection by not asserting them prior to the sale. Tenants in future cases should take heed and assert their adequate protection rights early and vigorously, by demanding possession, monetary relief and other forms of adequate protection.