If a debtor seeks to sell, pursuant to a 363 sale, real property as to which it is the landlord under an unexpired prepetition lease, can such property be sold “free and clear” of the non-debtor tenant’s leasehold interest? Although section 365(h) of the Bankruptcy Code allows a nondebtor tenant to elect to remain in possession of nonresidential leased property following rejection by a debtor landlord, the Ninth Circuit has held in In re Spanish Peaks Holdings II, LLC that section 365(h) does not act as an absolute bar to extinguishing a non-debtor tenant’s leasehold interest in a 363 sale.

Case Background

Spanish Peaks was a 5,700-acre resort in Big Sky, Montana, which included a ski club, a golf course, and residential and commercial real estate sales and rentals. Facing a shrinking real estate market, the debtors commenced liquidation cases under chapter 7 of the Bankruptcy Code. The bankruptcy trustee moved for an order authorizing a sale of substantially all of the debtors’ real and personal property, which sale purported to be, with limited exceptions, free and clear of all liens, claims, encumbrances, and interests.

Noting that their leases were not mentioned in the list of encumbrances that would survive the sale, two non-debtor tenants, The Pinnacle Restaurant at Big Sky, LLC (“Pinnacle”) and Montana Opticom, LLC (“Opticom”), objected on the basis that section 365(h) permitted them to remain in possession notwithstanding the sale. Nevertheless, the bankruptcy court authorized the sale to proceed and deferred consideration of the objections until the hearing to approve the sale. At the auction, an entity created by the senior secured creditor (which held a mortgage on the property) was the successful bidder. The court subsequently approved the sale without explicitly ruling whether the property was free and clear of the leases. When the purchaser moved to clarify the ruling, the bankruptcy court found that the leases were the subject of bona fide disputes, which is one basis to sell “free and clear” under section 363(f) of the Bankruptcy Code. Importantly, the bankruptcy court also concluded that the mortgage held by the purchaser on the leased property was senior to the leases, and the purchaser could have eliminated the leases outside of bankruptcy through foreclosure because the tenants did not have nondisturbance agreements. Applying what it called a “case-by-case, fact intensive, totality of the circumstances, approach,” the bankruptcy court ruled that the sale was free and clear of the leases held by Pinnacle and Opticom. The district court affirmed. An appeal to the Ninth Circuit followed.

Ninth Circuit’s Opinion

According to the Ninth Circuit, a majority of courts to have considered the interplay between sections 363(f) and 365(h) hold that the former is trumped by the latter because section 365(h) provides very specific rights to tenants while section 363(f) provides only general rights. The majority of courts also reason that the legislative history of section 365 evinces a clear intent by Congress to protect a tenant’s interest in bankruptcy, and such protection would be nullified if the property could be sold free and clear of that interest under section 363.

However, the Ninth Circuit sided with the only circuit court to have addressed the issue, the Seventh Circuit in In re Qualitech Steel Corp., which held that the statutory provisions do not conflict because section 363 alone governs in the event of a sale, and section 365(h) governs when the lease is rejected in the absence of a sale. The Ninth Circuit stated that, because the leases were not rejected prior to the sale in the instant case, section 365 was not triggered.

Downplaying concerns that its holding effectively repeals section 365(h), the Ninth Circuit stated that, first, a tenant still has the right before a sale to seek adequate protection of its leasehold interest under section 363(e), which was not sought in this case. Although the Court did not opine on what may constitute adequate protection of a lease, it stated that adequate protection provides a “powerful check on potential abuses of free-and-clear sales.” Second, the Ninth Circuit reiterated there must still be a basis for a “free and clear” sale under section 363(f). In this case, the basis was section 363(f)(1), which applies where “applicable nonbankruptcy law permits sale of such property free and clear of such interest.” Here, Montana law provides that a foreclosure sale to satisfy a mortgage terminates a subsequent lease on the property. The Court stated that the bankruptcy proceeded like a foreclosure sale because the purchaser was the holder of the mortgage on the leased property, and, in any event, section 363(f)(1) is satisfied even without an actual or anticipated foreclosure sale as long as it would be legally permissible.

In closing, the Ninth Circuit emphasized that section 365(h) expressly provides that the right of a tenant to stay in possession exists only “to the extent that such rights are enforceable under applicable nonbankruptcy law.” The Court discerned from that language an intent to protect lessees’ rights outside of bankruptcy, but not an intent to enhance them. That Montana law permits subsequent leases to be extinguished upon a foreclosure sale was a compelling reason to the Court that the leases should receive no better treatment in bankruptcy.

For counsel representing a nondebtor tenant, the Ninth Circuit’s opinion highlights the importance of monitoring bankruptcy cases and seeking adequate protection of a tenant’s leasehold interest prior to a sale taking place. It will be interesting to see whether a trend will develop among bankruptcy courts to gravitate towards the holding of the only two circuit opinions to address this issue as opposed to the “majority” approach adopted by the lower courts. The opinions of the circuit courts even have implications for intellectual property licenses, given the similarities of section 365(h) to section 365(n) of the Bankruptcy Code, which permits a nondebtor licensee of intellectual property to retain its rights even after the license has been rejected by a debtor licensor. Due to the very specific facts of the case, though, Spanish Peaks cannot be cited as a blanket endorsement by the Ninth Circuit of sales free and clear of statutorily retained rights.