In Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Matter of Spanish Peaks Holdings II, LLC), __ F.3d __, 2017 WL 4156370 (9th Cir. Sept. 12, 2017), the Ninth Circuit Court of Appeals held that a landlord debtor’s property may be sold free and clear of a tenant’s lease under Bankruptcy Code Section 363(f) as an alternative to affording the tenant the statutory right to remain in possession under Bankruptcy Code Section 365(h) upon rejection of the lease. The opinion can be found at: http://cdn.ca9.uscourts.gov/datastore/opinions/2017/09/12/15-35572.pdf.
Spanish Peaks is the latest of several published opinions stemming from the seedy and complex bankruptcy case of Timothy Blixseth. In this case, the debtor, Spanish Peaks Holdings II, LLC, leased parcels to two insider-controlled tenants on extremely favorable terms. The parcels were encumbered by a mortgage in favor of a lender. Upon experiencing financial troubles, the debtor filed a chapter 7 case. The trustee and the lender’s assignee agreed to a plan to liquidate the debtor’s assets that included a sale of the parcels “'free and clear of liens, claims, encumbrances and interests'” under Section 363(f), subject to overbidding. Id. at *2. The lender’s assignee planned to credit bid. The trustee’s resulting motion for approval of the sale did not specify whether the sale was free and clear of the leases.
The tenants objected to the motion as failing to recognize their right under Section 365(h) to elect to remain in possession under the leases notwithstanding the sale. Through several hearings, this issue came up again, but the bankruptcy court eventually approved the motion and resulting sale without ruling on the lease issue. Instead, the bankruptcy court required the parties to tee up the issue by a separate motion specifically addressing it. The purchaser then moved for a determination that the sale of the property was free and clear of the leases, and the tenants reasserted their right to retain possession.
Making various findings not relevant to the Ninth Circuit’s later ruling, the bankruptcy court decided that the sale had been free and clear of the leases and that the tenants, having failed to ask for adequate protection as provided in Section 363(e), were not entitled to any relief. The district court affirmed on appeal, and the Ninth Circuit also affirmed.
The Ninth Circuit first acknowledged a national split in authority on whether a sale free and clear under Section 363(f) can override the tenant-protection provisions of Section 365(h). The majority rule, it conceded, was that under applicable canons of statutory interpretation, the more specific provisions of Section 365(h) provide the exclusive framework for treatment of leases in bankruptcy. Under the minority approach, the Section 363(f) term “interest” in property is construed as broad enough to include leases and does not specifically exclude them. To this reasoning, the Ninth Circuit added that Sections 363 and 365 address distinct situations: sale of property, on the one hand, and rejection of leases, on the other, with each having different consequences. It therefore agreed with the minority position set forth in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003). It noted that this view also respects the canon of statutory interpretation prescribing harmonizing statutes where possible.
Responding to the problematic notion that permitting a sale free and clear of leases effectively repeals Section 365(h) by abrogating its protections for the tenant, the Ninth Circuit observed that any sale under Section 363(f) is subject to a tenant’s right of adequate protection under Section 363(e). Indeed, the opinion noted, at least one court has held that the tenant’s adequate protection when property was sold free and clear of its lease could be the right to remain in possession. See Dishi & Sons v. Bay Condos LLC, 510 B.R. 696, 711-12 (S.D.N.Y. 2014)
Unless the Supreme Court takes up the issue and reverses, the split in authority over whether Section 363(f) can apply to strip a lease from property without recourse to Section 365(h) will persist, and Spanish Peaks will be the law in the Ninth Circuit. But, recognizing that there is merit to both views both analytically and on policy considerations, this author thinks Spanish Peaks and cases like it are wrong.
The purpose of Section 365(h), both in its current statutory existence and in prior judicial doctrine, was to protect tenants against the potentially disastrous consequences of losing a lease, especially when the tenant may have built its business around the location. Receiving a claim for the costs of relocation and any resulting lost income that will probably pay pennies on the dollar hardly represents a meaningful remedy under those conditions, so the purpose of Section 365(h) is to provide a remedy that preserves the tenant’s rights to the greatest extent possible without eviscerating the debtor’s right to reject a lease. (The same is true of Section 365(n), which protects licensees who may have built their business around the license, from being deprived of the benefits of their license through rejection.). What form of adequate protection other than remaining in possession could there be for a tenant if the lease is central to its business? (If it is not, the tenant will, of course, elect to treat the lease as terminated and move elsewhere). Imagine the delay, costs and uncertainty of proceedings to evaluate some other proposed form of adequate protection. See, e.g., Dishi & Sons, 510 B.R. at 711-12.
If adequate protection were the answer, Congress would at least have built it into Section 365(h) (e.g., “the tenant shall be entitled to adequate protection, including the right to remain in possession….”), as it built it into Section 363(f) for use, sale or lease of estate property. But Congress did not. Moreover, were cases such as Dishi & Sonsthe answer, then the adequate protection provision of section 363(e) is superfluous for it in essence tracks section 365(h). And, to the extent that courts are free to offer up other forms of adequate protection under Section 363(e) for rejection of a lease, one can imagine that they will build “remedies” that do not really protect the tenant because they are designed, consciously or otherwise, to protect the estate and its creditors. Perhaps, it can be argued, a tenant might prefer some other kind of relief to protect itself. But in keeping Section 365(h) as the exclusive remedy for rejection, there is nothing to prevent the debtor and tenant from reaching some other kind of understanding subject to approval of the court that in their respective opinions serves them each better.
In any case, the lesson for those facing a motion to sell free and clear of a lease should, in addition to making any available argument why Section 365(h) should govern, always include a thoughtful request for adequate protection, either in the form of relief equivalent to Section 365(h)’s terms or some other tailored relief, or both. By the same token, a party filing such a motion should be prepared for, and to the extent possible, anticipate such an opposition.
One final note. The opinion at the outset says that it will affirm “on the facts of this case.” That phrase often is used to suggest that the holding is in some sense sui generis. Given the insider transactions involved and the long and seedy saga of the Timothy Blixseth-related bankruptcies, one must wonder whether the Ninth Circuit really means this decision to be of general significance on the Section 363(f)-365(h) subject or is signaling parties to look for some way around the case in more normal circumstances (although it is hard to see what that might be given the balance of the opinion). Indeed, perhaps a better solution might have been for the trustee to sue to avoid the insider-friendly leases as fraudulent conveyances, thus avoiding the whole Section 363-365 problem altogether.
These materials were written by Adam Lewis of Morrison & Foerster LLP in San Francisco, California (firstname.lastname@example.org). Editorial contributions were provided by Reno F.R. Fernandez III of Macdonald Fernandez in San Francisco and Modesto, California (email@example.com).