In re Zota Petroleums, LLC, 482 B.R. 154 (Bankr. E.D. Va. 2012)


At a "free and clear" asset sale, a buyer obtained a lease of real property that the bankruptcy court held was not free and clear of interests after all. The chapter 11 debtor was both the tenant under the lease and the sub-landlord under a related sublease. The debtor simultaneously assumed and assigned the lease and rejected the sublease. The subtenant, however, opted under section 365(h) of the Bankruptcy Code to retain its rights under the sublease and remain a subtenant. The bankruptcy court held that the free and clear sale under section 363(f) did not extinguish the rights of the subtenant under section 365(h) to continue to pay rent and remain in the property. Thus, the "free and clear" buyer took the lease subject to the rights of the subtenant.


Zota Petroleums, LLC, the chapter 11 debtor in this case, was the tenant under a lease with Kelmont, LLC for real property. Zota subleased this property to D&MRE, LLC. Zota sold substantially all of its assets, pursuant to section 363(f), and, in connection with the sale, assumed and assigned leases, including the lease between Zota and Kelmont, pursuant to section 365. Zota also rejected the sublease with D&MRE. At the sale, LAP Petroleum, LLC was the successful bidder and purchased Zota’s assets "free and clear of any and all liens, encumbrances, and any and all ‘claims’ as defined in section 101(5) of the Bankruptcy Code…." After the sale, LAP notified D&MRE of its intention to take possession of the property. D&MRE responded that section 365(h)(1)(A)(ii) gave it the ability to retain its rights under the rejected sublease and remain in the property as a subtenant, notwithstanding the "free and clear" sale.


The bankruptcy court summarized the issue as "whether the assignment of the assumed Kelmont lease extinguished the section 365(h) rights of D&MRE, debtor’s sublessee, when that assignment was made as part of a transaction including both the sale of assets free and clear pursuant to the provisions of section 363 of the Bankruptcy Code and the assumption and assignment of various leases and executory contracts pursuant to section 365 of the Bankruptcy Code."

The bankruptcy court noted that lower courts were divided on the issue, some finding that a free and clear sale under section 363(f) extinguishes a tenant’s rights under 365(h) and others finding that it does not. The bankruptcy court further noted that only the Court of Appeals for the Seventh Circuit had previously addressed the interplay of 365(h) and 363(f).

Section 365(h)(1)(A)(ii) generally provides that a tenant may opt to retain its rights under a lease, notwithstanding the rejection of the lease by the debtor. Section 363(f), on the other hand, provides that the debtor may sell property, including a lease, "free and clear of any interest in such property of an entity other than the estate."

In Precision Industries, Inc. v. Qualitech Steel SBQ, LLC, the Seventh Circuit Court of Appeals held that if a lease were sold as part of a 363(f) sale, such sale was free and clear of a tenant’s rights under 365(h), noting that the tenant may request adequate protection of such rights in connection with such sale under section 363(e). It and other courts holding that a tenant’s rights under 365(h) may be extinguished by a 363 sale generally rely on two canons of statutory construction. The first is that courts should apply the plain meaning of statutory language. Using this rule, courts reason that nothing in 365(h) prohibits a 363 sale free and clear of the rights granted to tenants by 365(h), and that if Congress had intended such a prohibition, it could have expressly done so. The second canon is that courts should interpret statutes so as to avoid conflicts between them where possible and reasonable. Using this rule, courts reason that both 363 and 365(h) can be given full effect without conflict because, under section 363(e), a tenant can request adequte protection of its rights under 365(h) in connection with any sale free and clear of such rights and, thus, such rights are ultimately protected.

Other courts, however, have not been persuaded by the adequate protection argument, holding "that a lease may not be sold in a section 363(f) sale in an attempt to evade a tenant’s section 365(h) rights." These courts reason that allowing the tenant’s specific rights under section 365(h) to be extinguished (or replaced and/or cashed out) in a section 363(f) sale would eviscerate section 365(h) and permit the debtor to do indirectly what it could not do directly, i.e., remove a tenant from possession of the property, when it does not desire to leave the property. Courts upholding the tenant’s 365(h) rights typically do so based, in part, on the principle that the more specific statutory provision should prevail over the general. Under this rule, courts reason that, because section 365(h) is clear and specific in providing rights to tenants and 363(f) is general, 363(f) sales cannot extinguish tenants’ rights under 365(h). These courts also view this holding as consistent with Congress’ intent in enacting 365(h) to protect the rights of tenants.

Here, the bankruptcy court agreed with the latter cases, holding that D&MRE’s rights under the sublease survived the 363 sale of the underlying lease and, therefore, LAP purchased such lease subject to such rights. Thus, D&MRE was entitled to continue to pay rent and remain in possession of the property, notwithstanding the sale of the lease to LAP. The bankruptcy court noted that "to hold to the contrary would give open license to debtors to dispossess tenants by utilizing the section 363 sale mechanism" and be inconsistent with Congress’ intent to preserve the possessory rights of tenants to rejected leases.


The Zota decision appears to add the Eastern District of Virginia to the jurisdictions holding that a free and clear sale under section 363(f) does not xtinguish the rights of tenants to rejected leases to opt under section 365(h) to continue to pay rent and remain in the property. The bankruptcy court, however, did make it a point to note that D&MRE had not been offered any adequate protection of its 365(h) rights in connection with the sale process, and specifically limited its decision to the facts of the case. Thus, buyers of leases at 363 sales are cautioned to not only perform due diligence and not simply rely on the "free and clear" order, but to also obtain certainty, explore possible replacement rights and/or cash out payments that might serve as "adequate protection" to tenants and allow the sales to proceed. In either case, it appears that purchases of assets of debtor-landlords may have gotten more expensive.