Bankruptcy Sale of Debtor’s Property “Free and Clear” Terminates Lease

By John C. Murray © 2003

In a case of first impression, Precision Industries, Inc. v. Qualitech SBQ, LLC, 327 F.3d 537, 2003 U.S. App. LEXIS 7612 (7th Cir. April 23, 2003), the U.S. Seventh Circuit Court of Appeals held that under § 363(f) of the Bankruptcy Code, the sale of the lessor-debtor’s real property “free and clear” of any “interest” trumps § 365(h) of the Bankruptcy Code, which protects the rights of the lessee when the lessor-debtor rejects a lease.

The debtors (collectively, “Qualitech”) owned and operated a steel mill in Indiana. The lessees (collectively, “Precision”) constructed a supply warehouse at the property, for the sole purpose of providing supply services for Qualitech. In 1998, Precision entered into a ten-year supply agreement with Qualitech. Precision also leased the real property, in 1999, under an unrecorded ten-year lease for a nominal rent of one dollar per year. If an early termination or default occurred under either agreement, Precision had the right to remove all improve-ments and fixtures. At the end of the lease term, Precision had the right to purchase the property for one dollar provided that the lease was not in default.

Qualitech filed its Chapter 11 bankruptcy petition on March 22, 1999, and on June 30, 1999, sold substantially all of its assets at auction pursuant to a sale order “free and clear of all liens, claims, encumbrances, and interest” under § 363(f) of the Bankruptcy Code. The sale order approved the sale to a group of pre-petition secured lenders for $180 million. Precision, which had proper notice of the sale, did not object. The purchasers subsequently transferred their interests in the property to a new entity, (“New Qualitech”), which assumed the rights of the purchaser under the sale order and took title to the property. The sale order also provided that the purchaser retained the debtor’s right to assume and assign executory contracts pursuant to § 365 of the Bankruptcy Code. Negotia-tions subsequently ensued with respect to assumption of the lease, but were unsuccessful. The result, according to the Seventh Circuit, was that “Precision’s lease and supply agreement were de facto rejected.” Id. at *4-5. By December 3, 1999, Precision had vacated and padlocked the warehouse on the property. Shortly thereafter, New Qualitech, without Precision’s knowledge or approval, changed the locks on the building.

Precision then filed suit, claiming that its possessory interest in the leased property, pursuant to § 365(h), survived the bankruptcy sale. The bankruptcy court held that, based on § 365(h) and the fact that Precision’s lease was an “interest” under the sale order, New Qualitech had obtained title to the property free and clear of Precision’s leasehold interest. The District Court reversed, ruling that the terms of § 365(h) prevailed over those of § 363(f). The District Court reasoned that there was no statutory basis for allowing the debtor-lessor to sell its property and terminate an underlying lease, which would limit the lessee’s post-rejection rights solely to cases where the debtor-lessor retained title and possession of the property.

The Seventh Circuit reversed the holding of the District Court, noting as a threshold issue that Precision never objected to the sale order and that “[s]ale orders are final, appealable orders,” i.e., once the appeal period has expired, res judicata precludes a subsequent lawsuit contesting the order. Id. at *11. The court then examined the meaning of the word “interest” in § 363(f) (which term is not defined in the Bankruptcy Code), and found that based on applicable case law a leasehold estate was clearly an “interest” subject to the provisions of § 363(f). The court also noted that the parties never disputed the fact that the conditions of § 363(f) (which, standing alone, authorized the sale of the bankruptcy estate’s property, including any “interest” therein, free and clear of the lessee’s possessory interest), had been complied with.

The court then turned its analysis to § 365(h), and concluded that the terms of this section did not supersede those of § 363(f). The court reasoned that because § 363(f) does not contain any cross-reference subordinating its provisions to the lessee protections of § § 365(h), Congress did not intend for § 365(h) to limit § 363(f). (According to the court, “Congress authorized the sale of the estate property free and clear of ‘any interest,’ not ‘any interest except a lessee’s possessory interest.’” Id. at *27 (emphasis in text)) The court then held that § 365(h) applies only where the trustee (or debtor in possession) actually rejects the lease, whereas in the present case a statutory sale of the property (which was leased) had occurred. According to the court, “[t]he two statutory provisions thus apply to distinct sets of circumstances.” Id. at *24. Finally, the court ruled that § 363(e) provides a mechanism for lessees to protect their interests, i.e., it directs the bankruptcy court upon the request of any party with an interest in the property to be sold or transferred, to “prohibit or condition such . . . sale . . . as is necessary to provide adequate protection of such interest.” The court reasoned that the lessee therefore was not without an adequate remedy to protect its interests, and that while it was not guaranteed continued possession of the property, it was entitled to adequate protection and could seek to “be compensated for the value of its leasehold interest -- typically from the proceeds of the sale.” Id. at *26. The court also found, conversely, where the property is not sold and the lessor-debtor remains in title and possession and rejects the lease, the lessee is entitled to invoke its rights under § 363(f) and remain in possession. Thus, according to the court, both statutory provisions are given effect and are not in conflict. The court also reasoned that its interpreta-tion “is . . . consistent with the process of marshalling the estate’s assets for the twin purposes of maximizing creditor recovery and rehabilitating the debtor.” Id. at *27-28.

Discussion

1) It is interesting that the Seventh Circuit’s statement (in connection with its ruling that that § 363(f) trumps § 365(h)) that, “Where the property is not sold, and the debtor remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property,” Id. at *27, is exactly the reason that the District Court held that § 363(f) should not trump § 365(h) (“There is no statutory basis for allowing the debtor-lessor to terminate the lessee’s possession by selling the property out from under the lessee, and thus limiting a lessee’s post-rejection rights solely to cases where the debtor-lessor remains in possession of the property.” 2001 U.S. Dist. LEXIS 8328, at *14.) There is obviously a major philosophical disagreement between the two courts as to the proper application of the relevant statutory provisions, with both camps claiming that applicable case law (which, as the District Court noted, is divided on the issue) and legislative history support their respective positions.

2) The court’s holding that § 365(h) applies only where the trustee (or debtor in possession) actually rejects the lease, as opposed to the situation where a statutory sale under § 363(f) occurs with respect to leased property, and its state-ment that “the two statutory provisions apply to distinct sets of circumstances,” appears to be a distinction without a differ-ence because the result is exactly the same in either scenario if, as the Seventh Circuit ruled in this case, § 363(f) trumps § 365(h). This appears to be a somewhat disingenuous attempt by the Seventh Circuit to shoehorn the facts into the statutory interpre-tation the court desires in this case.

3) Outside of a bankruptcy case, the seller and purchaser generally are free to keep a potential sale confidential. In a bankruptcy case, the sale must be made public by the filing of a motion in the bankruptcy court requesting the court’s approval of the sale. Notice of the sale must be provided to all credi-tors, unless the court limits notice to appointed committees, such as the unsecured creditors’ committee and others who have formally requested notice of all matters arising in the case. Section 363(f) provides that the trustee may sell property of the estate “free and clear of any interest in such property of an entity other than the estate” if: applicable nonbankruptcy law permits such a sale; such entity consents; the interest is a lien and the sale price is greater than the aggregate value of all liens against the property; the interest is in bona fide dispute; or such entity could be compelled to accept a money satisfaction of the interest. A sample provision for a sale free and clear of an existing lease, to be inserted in a sale order, would be as follows:
The Debtor is authorized to sell the Debtor's interest in the Property to the Successful Purchaser free and clear of all liens, claims, encumbrances and interests, including, but not limited to, any lease of the Property by __________, pursuant to section 363 of the Bankruptcy Code, with all such valid and enforceable liens, claims, encumbrances and interests to attach to the proceeds of the sale of the Property in the same relative priority as existed with respect to the Property.

4) As noted above, one of the subsections of 363(f) must be complied with in order to sell bankruptcy estate property “free and clear.” In the Precision Industries case, the parties may have consented to the sale – a horrible mistake by the debtor’s attorneys, if true. The only other possible applicable subsection would be § 363(f)(5) – on the theory that (depending on what the lease says), the lessee could be forced in a condemnation proceeding to accept a money satisfaction (although it is problematic that this subsection can – or should – be interpreted to apply to a highly hypothetical and improbable situation where there exists an ability to get money for one’s leasehold interest, let alone entitle the debtor or trustee to sell the property free and clear of such interest. Under state law a lessee can’t be forced to surrender the leased premises for a payment of money, absent a provision in the lease permitting such payment).

5) Section 363(e) provides that upon request of any entity that has an interest in such property, the court shall prohibit or condition such sale “as is necessary to provide adequate protection of such interest.” When the bankruptcy court has approved the sale of property of the estate by a trustee, § 363(f) provides that the buyer acquires title free and clear of all claims in bankruptcy and the property may not be brought back into the estate in the absence of fraud or collusion in the sale. It is difficult to understand why, in the Precision Industries case, Precision did not seek protection under § 363(e) prior to entry of the sale order by the bankruptcy court.

6) Assets sold in a bank-ruptcy case pursuant to a § 363(f) order may be sold free of liens, claims and interests. The liens and claims attach to the proceeds of sale. Unless the party appealing a sale order obtains a stay pending appeal, a good-faith purchaser of assets is protected from reversal on appeal. Under Rule 6004(g) of the Bankruptcy Rules, an order authorizing the use, sale, or lease of property is automati-cally stayed until the expiration of 10 days after entry of the order, unless the court orders otherwise. The trustee (and the purchaser) should seek to have the sale order contain specific language that, notwithstanding Rule 6004(g), the order is effective immediately (the same is true, under Rule 6006(d), for an order authorizing the trustee to assign an executory contract or unexpired lease). Section 363(m) of the Bankruptcy Code provides that the reversal or modification on appeal of a sale authorized by the court does not affect the validity of the sale to an entity that purchased the property in good faith unless such authorization and sale were stayed pending appeal. The sale order therefore also will often contain an express finding of good faith as well as language similar to the following:

Pursuant to 11 U.S.C. § 363(m), absent a stay of this Order pending appeal, the reversal or modification on appeal of this Order, or any provision thereof, shall not affect the validity of any sale transaction approved hereby which is consummated prior to such stay, reversal of modifica-tion on appeal.

7) Under section 365(h) of the Bankruptcy Code, a lessor who files for reorganization has the right to reject any lease, subject to bankruptcy court approval. The lessee then has the right, under section 365(h)(1)(A), either to (1) treat the lease as terminated and vacate the space, or (2) remain in possession for the balance of the lease term and any renewal or extension. Before the enactment of the 1994 Bankruptcy Reform (“Reform Act”), there was uncertainty concern-ing the nature and extent of the lessee’s right to remain in possession. Bankruptcy court decisions were divided as to whether restrictive lease covenants binding on the lessor (for example, an exclusive business use granted to the lessee) would continue if the lessor rejected the lease. Section 365(h) was amended by the Reform Act to eliminate these uncertainties. Section 365(h)(1)(A)(ii) now provides that the lessee may retain those rights in the lease that are in or appurtenant to the real property, “including rights such as those relating to the amount and timing of the payment of rent and any right of use, possession, quiet enjoyment, subletting, assignment or hypothecation,” to the extent that such rights are enforceable under applicable nonbankruptcy law.