In In re Spanish Peaks Holdings II, LLC, Case No. 15-35572 (9th Cir. Sept. 12, 2017), the Ninth Circuit Court of Appeals held that a bankruptcy trustee may use Section 363(f) of the Bankruptcy Code to sell real property free and clear of unexpired leases without affording the non-debtor lessees the right to retain possession of the property. In reaching its decision, the Ninth Circuit also rejected an argument made by the buyer that the appeal was moot under Section 363(m) of the Bankruptcy Code, holding that Section 363(m) only applies to the transfer itself, as opposed to the free and clear aspect of the sale. A copy of the opinion may be found here.
One of the core powers of a bankruptcy trustee or debtor-in-possession is the ability to assume or reject executory contracts and unexpired leases. This power allows the trustee to keep the deals that are good for the estate and shed those that burden the estate, facilitating the trustee’s ability to reorganize or maximize the value of estate assets in liquidation. However, the Bankruptcy Code is in many ways a delicate balancing of competing interests, and here Congress did not leave the non-debtor counterparties to these contracts and leases completely out in the cold. The Bankruptcy Code rather includes a number of protections for such parties that have the apparent intent of softening the blow of the trustee’s rejection power on such parties. In the case of lessees, the Bankruptcy Code provides in Section 365(h) that a non-debtor lessee whose unexpired lease is rejected by the trustee-lessor may still opt to pay rent and remain in possession of the property for the duration of the lease.
Another core power of a trustee or debtor is the power to sell assets of the debtor’s estate free and clear of liens, claims, encumbrances and other interests pursuant to Section 363(f) of the Bankruptcy Code. This permits the trustee to maximize the value of the estate’s assets by providing buyers with clear title and relative certainty that the asset will be free from liens, litigation, and other issues. Indeed, it is to take advantage of this specific statutory provision that many bankruptcies are filed, as without the cleansing imprimatur of a bankruptcy court, distressed assets may be unsaleable, or at a minimum, significantly depressed in price.
These two powers – the power to reject leases and the power to sell free and clear – come in conflict in Spanish Peaks, which was a chapter 7 liquidation involving a resort property in Montana. The two leases at issue were a 99 year lease for a restaurant property that paid $1,000 per year in rent and a 60 year commercial lease that paid $1,285 per year in rent. Both leases were made to entities related to the debtor and its founders, and both were significantly below market.
The largest creditor in the case by far was the secured lender, whose $122 million debt was secured by a mortgage on the property. The chapter 7 trustee and the lender worked out a plan for liquidating the debtor’s property that involved selling the property “free and clear of all liens” at an auction. The secured lender, a special purpose entity, ended up as the winning bidder at the auction for $26.1 million.
The bankruptcy court approved the sale “free and clear” under Section 363(f), except for some specified permitted encumbrances. However, the sale order did not specify whether the two leases mentioned above would survive the sale. Despite the fact that the lessees had objected at the sale hearing, the bankruptcy court stated that it had not ruled on their objection one way or the other in approving the sale, and directed the parties to file further motions. The secured lender filed a motion for a determination that the sale of the property was free and clear of the two leases.
Bankruptcy Court Ruling:
In considering the secured lender’s motion, the bankruptcy court conducted a “case-by-case, fact-intensive, totality of the circumstances” analysis in which it found and expressly relied upon the following facts: (i) the restaurant lessor had not operated a restaurant on the property in several years; (ii) the leases were well below market; (iii) the leases were executed at a time when all parties were controlled by the same person; (iv) the secured lender’s mortgage was senior to leases; and (v) the leases were not protected from foreclosure of the secured lender’s mortgage by subordination or non-disturbance agreements. The bankruptcy court also noted that the lessees had never sought adequate protection for their leasehold interests prior to the sale, and had provided no evidence that they would suffer economic harm if their possessory interests were terminated.
Relying on the above factual findings, the bankruptcy court held that the sale was free and clear of the two leases, which had no possessory rights under Section 365(h) as a result. The district court affirmed, and the lessees appealed to the Ninth Circuit.
Ninth Circuit Ruling:
The Circuit noted that a majority of courts to have considered the interplay between the trustee’s ability to sell free and clear in Section 363(f) and the non-debtor lessee’s right to retain possession of the property under Section 365(h) had found Section 365(h) to trump Section 363(f) under the “specific prevails over the general” canon of statutory interpretation. However, the Seventh Circuit in In re Qualitech Steel Corp., 327 F.3d 537 (7th Cir. 2003) had found Section 363(f) to prevail in the apparent conflict due to the fact that Section 363(f) permitted sales to be free and clear of “any interest,” and did not provide any exception for leases entitled to the protections of Section 365(h). The Seventh Circuit reasoned that Section 363(f) and Section 365(h) do not conflict because a non-debtor lessee has the ability to request adequate protection under Section 363(e). That ability to request adequate protection protects the lessee in the sale context, while the ability to retain possession protects the lessee in the lease rejection context.
The Ninth Circuit affirmed the lower courts and agreed with the Seventh Circuit’s reasoning in Qualitech Steel. The Ninth Circuit, citing to the canon of statutory interpretation that courts must “read the statutes to give effect to each if we can,” agreed in particular with the Seventh Circuit’s reasoning that Section 363(f) and Section 363(h) do not conflict. The Circuit 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.” Spanish Peaks, slip op. at p. 15.
In reaching its decision, the Ninth Circuit rejected an argument by the secured lender that because there was a good faith finding under Section 363(m) and the sale had been consummated, the appeal was moot under Section 363(m). Section 363(m) is meant to provide buyers in bankruptcy with protection from the often lengthy appeal process, and therefore incentivize them to bid, by providing that the reversal or modification of a sale order on appeal “does not affect the validity of a sale.”
In a brief footnote, the Circuit took an extremely narrow view of the protections provided by Section 363(m), concluding that Section 363(m) only protects the validity of the transfer itself, as opposed to the issue of whether the sale was free and clear of particular liens, claims, or interests. Since the lessees did not seek to overturn the transfer, but merely to determine that the leases were still in force, the Circuit found that Section 363(m) did not apply to render the appeal moot. Spanish Peaks, slip op. at p. 9, n. 4.
The Spanish Peaks decision is an important one altering the field of play in bankruptcy cases for trustees, lessees, and leasehold mortgagees.
As to its effect on trustees and lessors, the opinion essentially gives them a new way of stripping unexpired leases from a property in bankruptcy. While the Ninth Circuit relies heavily on the fact that a court can order adequate protection, such awards are typically monetary and therefore are not as helpful to lessees wanting to stay in possession of their premises as is the clear right to retain possession embodied in Section 365(h).
However, the Spanish Peaks formula may not be easy for trustees and lessors to copy in the future. The bankruptcy court’s “totality of the circumstances” approach relies heavily on a number of factors unique to the case, including the fact that the lessees were controlled by the same party as the debtor-lessor when the leases were signed, were well below market and for extremely lengthy terms, and the restaurant lessee in particular had not even operated a restaurant on the leased premises in several years. All of these facts added a pretextual gloss on the lessees’ claims that they should be entitled to remain in possession of the property.
Further, trustees and debtors-in-possession in general are dealt a potentially significant blow by the Circuit’s footnote rejecting the secured lender’s Section 363(m) argument. Limiting the protections of Section 363(m) to the transfer only, as opposed to the entire sale transaction, severely limits the protections of that section. Consider a hypothetical situation in which a buyer buys a piece of property for $5 million in bankruptcy free and clear of a $10 million lien. To provide the buyer with protection from an appeal of the transfer only is meaningless. What the buyer wants and needs to know in order to go forward with its bid in the first place is that it is not going to be saddled with the $10 million lien after it closes. The Circuit’s limitation on Section 363(m) has the potential to depress prices received by bankruptcy estates in all sales, and perhaps turn debtors and their lenders away from the bankruptcy process altogether.
For lessees and leasehold mortgagees, the opinion is a call to take precautions both before and after a bankruptcy filing by the lessor. One way to protect the leasehold is, as the Circuit notes, through a subordination or non-disturbance agreement that prevents the lessor’s lender from wiping out the lease in a foreclosure. However, the ability to obtain such an agreement pre-petition is dependent on the parties’ bargaining power, and may not be available in many cases, especially situations such as this one where the fee interest is encumbered by a significant mortgage loan. As for what can be done once the bankruptcy is filed, the primary suggestion of the Circuit is to seek adequate protection immediately. Other potential options for a leasehold mortgagee would be to seek relief from stay to foreclose on the leasehold mortgage, or move the court for an early determination on rejection.
Further, in the same manner that the “all facts and circumstances” approach detracts from this opinion’s appeal to trustees and lessors, it softens the blow for lessees and leasehold mortgagees, in that it will not be easy to replicate in a standard case. Lessees and leasehold mortgagees may thus be well-advised to “tell the story of the deal” in the recitals of the lease and the leasehold deed of trust in order to distinguish the deal from that in Spanish Peaks – e.g., by adding recitals establishing that the parties are not related, that the rent is at market rate, etc.
Finally, from a purely academic point of view, the case seems to be a perfect illustration of Karl Llewellyn’s assertion that for every canon of statutory interpretation that may be cited in support of a given outcome in a case, another canon of statutory interpretation may be cited in support of the opposite outcome. Here, the Ninth Circuit notes that the majority of courts going the other way cite to the “specific controls over the general” canon, reasoning that Section 363 is a general power to sell and Section 365 deals with leases more specifically and thus should control. However, in support of the opposite outcome, the Ninth Circuit cites a different canon, one in which the court reads statutes to give effect to each if it can (and to avoid conflict). No reason is given why one canon would best the other. The Ninth Circuit’s reason for citing a canon at all seems to be to cancel out the citation of the majority courts’ canon, perhaps in an unintended nod to Llewellyn’s law.