The Bottom Line

The Ninth Circuit recently held, in Pinnacle Rest. at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), No. 15-35572, 2017 U.S. App. LEXIS 12526, 2017 WL 2979660 (9th Cir. July 13, 2017), that a sale of real property free and clear of liens and interests under section 363(f) can terminate a leasehold in the underlying property notwithstanding the provisions of section 365(h) favoring non-debtor lessees. In so holding, the Ninth Circuit joins the minority of courts allowing such property to be sold in bankruptcy free and clear of these leasehold rights.

What Happened?

In Pinnacle Rest. at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), No. 15-35572, 2017 U.S. App. LEXIS 12526, 2017 WL 2979660 (9th Cir. July 13, 2017), the Ninth Circuit upheld decisions by the Montana bankruptcy court and district court allowing the trustee to sell property of the estate free and clear of two unexpired leases under section 363(f) of the Bankruptcy Code.

The debtor was the owner of a 5,700-acre parcel of real property that was the site of a resort in Big Sky, Montana. As part of the development, the debtor granted two “sweetheart” leases to two insider companies controlled by the debtor’s principal. One was a 99-year lease with an annual rent of $1,000 and the other was a 60-year lease with an annual rent of $1,285. The bankruptcy court found that the market rate for these leases was between $40,000 and $100,000 per year.

The property was encumbered by a mortgage well in excess of the value of the property. Business did not pan out and the resort was unable to keep up with the payments on the mortgage. As a result, the debtor and several related entities filed for chapter 7 bankruptcy.

After the filing, the chapter 7 trustee moved to sell all the debtor’s assets free and clear of any and all liens, claims, encumbrances, and interests except for certain specified encumbrances and liens. The two leases were not specified in these lists. The non-debtor tenancy entities holding the leases objected to sale arguing that the property could not be sold free and clear of their leasehold interests. At the sale approval hearing, the bankruptcy court held, based on the totality of the circumstances, that the property could be sold free and clear of the leasehold interests. Among those factors was that, under Montana law, the leases would not have survived a foreclosure of the property. The district court affirmed the bankruptcy court on this basis. The Ninth Circuit agreed.

The decision focuses on the apparent conflict between sections 363(f) and 365(h) of the Bankruptcy Code. On the one hand, section 363(f) allows a trustee (or debtor-in-possession) to sell property of the estate free and clear of any interests in that property under certain conditions. On the other hand, section 365(h) allows the lessee of a rejected lease where the debtor is the lessor to retain any rights, including remaining in possession of the leasehold, to the extent such rights are enforceable outside of bankruptcy.

The Court first analyzed the “majority” position, which holds that section 365(h), as a more specific provision dealing with leases, governs over the more general section 363(f) that deals with sales of property generally. Under standard canons of statutory interpretation, if there is a conflict between a general statutory provision and a more specific provision, the more specific provision governs. Thus, under the majority approach, real property may not be sold free and clear of an unexpired lease without the consent of the lessee.

The “minority” position is typified by Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003). In that case, the Seventh Circuit held that no conflict existed between sections 363(f) and 365(h). Rather, section 365(h) is limited in scope and applies only when the trustee has formally rejected an unexpired lease. The court reasoned that the protections of section 365(h) are not necessary in the context of a sale under section 363, because section 363(e) allows the holder of any interest in property of the estate to seek adequate protection from the court before such property is sold. Thus, under the Seventh Circuit’s rule, real property may be sold free and clear of a lease under section 363 (so long as requested adequate protection is provided), and section 365(h) only comes into play where the property is not sold and the lease is rejected.

The Ninth Circuit agreed with the Seventh Circuit. It highlighted that “rejection” under section 365 is a term of art. While the leases in question here were effectively rejected in the everyday sense of the term, they were not “rejected” under the Bankruptcy Code. The Court held that the provisions of section 365(h) only apply to formal rejection. In response to arguments that this interpretation would effectively repeal the protections of section 365(h), the Court emphasized that, under section 363(e), a court is required to provide adequate protection for an interest that will be terminated by a free and clear sale. As some courts have noted, such adequate protection can even take the form of continued possession. The Court stated that this provided “a powerful check on potential abuses of free-and-clear sales.” In re Spanish Peaks Holdings II, LLC, 2017 U.S. App. LEXIS 12526, at *15.

The Court also emphasized that this ruling did not create open season for trustees and debtors to eliminate leases in sales. Section 363(f) only allows sales free and clear of liens and interests under certain conditions. In this case, the Court pointed to section 363(f)(1) which allows a sale free and clear if “applicable nonbankruptcy law” would permit the property to be sold free and clear of the interest. Under Montana law, a foreclosure sale to satisfy a mortgage terminates a subsequent lease on the property. Here, the mortgage holder was the largest single creditor by a large margin and the court was comfortable saying that, absent a bankruptcy filing, a foreclosure sale was inevitable. Thus, the property could be sold free and clear of the leases and the lessees were not entitled to remain in possession.

Why This Case is Interesting

With this decision, the Ninth Circuit has formally joined the “minority” when it comes to the question of whether property in bankruptcy may be sold free and clear of leaseholds. The approach adopted by the “majority” courts provided strong protections for the rights of lessees in the face of sales of the underlying property. Going forward in the Ninth Circuit, however, lessees facing a bankruptcy sale of their leased property must seek adequate protection of their interests before any sale. This is important, because while section 365(h) protection was automatic, a party must affirmatively request adequate protection under section 363(e) to receive it. The Ninth Circuit noted the lessees’ failure to seek adequate protection before the court approved the sale. Adequate protection also requires an evidentiary showing of the value of the lessee’s interest. The burden is on the party seeking adequate protection to prove the value of the interest by competent evidence such as appraisals or expert testimony. Rather than sitting back with the passive protection of section 365(h), lessees of debtors in bankruptcy in the Ninth Circuit should take proactive steps to protect their interests.