In In re Spanish Peaks Holdings II, LLC, the Ninth Circuit Court of Appeals on July 13, 2017 ruled that a bankruptcy estate may sell property free and clear of leases, notwithstanding the tenant protections contained in Section 365(h).  At the same time, the Court ruled that tenants are entitled to "adequate protection" of their interests, provided that they timely request adequate protection and actually provide evidence of what that adequate protection should be.  In Spanish Peaks the tenants only argued that they had the absolute right to stay at the property under Section 365(h);  they failed to request adequate protection of their interests, and failed to give evidence of the harm that would be caused to them by being forced to leave the property.  Because of that failure the property at issue was sold free and clear of their leases and the tenants were given no recompense.

 

The property at issue in Spanish Peaks was a 5,700-acre ski resort and casino in Big Sky Montana which was financed by a $120 million loan.  The leases at issue were made to insiders and were for very low dollar amounts:  one was a lease of restaurant space for $1,000 a month, and the other was for $1,285 per month for 60 years.

 

The secured lender in the case was owed more than $122 million by the time the motion to sell was considered.  The secured lender and the bankruptcy trustee agreed to a stipulation whereby the property would be sold at auction for not less than $20 million, and would be sold free and clear of all liens and interests.

 

The lessees who objected were not mentioned in the Motion.  They objected to the sale arguing that Section 365(h) of the Bankruptcy Code gave them the right to retain possession of the property.  They did not ask for adequate protection of their interests. 

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The property was sold for $26.1 million at auction.  The buyer took the position that the property was purchased free and clear of the leases, while the bankruptcy trustee took a neutral position.  The bankruptcy court order approving the sale was ambiguous as to whether the property was sold free and clear of the leases at issue.  For that reason motions for clarification of the sale order were filed.

 

The bankruptcy court ruled that the subject leases were far below fair market value, that one of the leases was never recorded, that the leases were executed by an insider, that the leases were the subject of bona fide disputes, and that the leases were not protected from foreclosure of the underlying mortgage by any subordination or non‑disturbance agreements.   The bankruptcy court noted that the lessees had not requested adequate protection for the leasehold interest prior to the sale.  As a result the bankruptcy court held that the sale was free and clear of the leases,  and the district court affirmed.  The district court held that the sale extinguished the leases because the foreclosure of a mortgage would, under Montana law, terminate any leasehold interest junior to the mortgage.

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The Ninth Circuit noted the tension between Section 363(f) - - which provides for sales free and clear of any interests - - and Section 365(h) which allows tenants to retain property rights notwithstanding the rejection of their lease.  As noted by the Ninth Circuit "The statutes frequently operate in isolation.  Many bankruptcies will involve a sale of property unencumbered by a lease, and many will involve the rejection of a lease on property that the trustee does not intend to sell.  But when both provisions come into play -- that is, when the trustee proposes to sell property free and clear of encumbrances, and one of the encumbrances is an unexpired lease -- federal courts have addressed the resulting dilemma in different ways."

 

Citing to bankruptcy decisions from throughout the country, the Ninth Circuit first noted that the majority approach is to rule that the rights of a tenant trump the right of a bankruptcy estate to sell free and clear.  That is, that Section 365(h) trumps Section 363.  The Ninth Circuit then noted that the only circuit court of appeals which has already addressed the issue (i.e., the 7th Circuit) reached a different conclusion based exclusively on the statutory language at issue.  In Qualitech Steel Corp. & Qualitech Steel Holdings Corp., 327 F.3d 537 (7th Cir. 2003), the Seventh Circuit noted that Section 363 is far broader than Section 365(h), which only focuses on a specific type of event -- the rejection of an executory contact.  Section 365(h) "says nothing at all about sales of estate property, which are the province of Section 363." 

 

The Seventh Circuit in Qualitech noted that lessees are entitled to seek adequate protection, and "are therefore not without recourse in the event of a sale free and clear of their interests.  They have the right to seek protection under Section 363(e), and upon request, the Bankruptcy Court is obligated to ensure that their interests are adequately protected."

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The Ninth Circuit agreed with the Seventh Circuit.  First the Ninth Circuit reasoned that the rejection of a lease is a declaration that the bankruptcy estate will not take on the obligations of the lease made by the debtor.  While the sale of property free and clear of a lease is similar "in some every day sense, Yit is not the same thing as the 'rejection' contemplated by Section 365."

 

 "In sum, section 363 governs the sale of estate property, while section 365 governs the formal rejection of a lease.  Where there is a sale, but no rejection (or a rejection, but no sale), there is no conflict."  The Ninth Circuit was careful to note that no automatic rejection had occurred in the case at bar, as the automatic rejection of commercial leases (120 days after the filing of a Chapter 7 case) only applies when the debtor is the lessee. 

In an interesting footnote the Ninth Circuit noted that it is possible for a trustee to formally reject a lease and then thereafter to sell the property.  The Ninth Circuit noted that because that is not what happened here, "We have no occasion to address the interplay between sections 363 and 365 in such circumstances."

 

The Ninth Circuit, however, noted that a bankruptcy court "must" provide adequate protection for an interest that will be terminated by a sale if the holder of the interest makes such a request:

“Moreover, 'adequate protection' includes any relief -- other than compensation as an administrative expense -- that will 'result in the realization by such entity of the indubitable equivalent' of the terminated interests.  11 USC ' 361(3).  In Dishi & Sons, the district court concluded that adequate protection could take the form of continued possession."

 

Since Pinnacle and Opticom did not ask for adequate protection until after the sale had taken place, "the question of what adequate protection the bankruptcy  court could have or should have awarded is not before us.  Still, we think it worth mentioning that the broad definition of adequate protection makes it a powerful check on potential abuses of free-and-clear sales.”

 

The Ninth Circuit then noted that the subsection of 363(f) which authorized the sale in this case was the provision allowing sales where "applicable non‑bankruptcy law permits a sale of such property free and clear of such interest."  The Ninth Circuit noted that under Montana law a foreclosure sale terminates a subsequent lease on the mortgaged property.  The Ninth Circuit noted that the bankruptcy proceeded, practically speaking, like a foreclosure sale and that had the bankruptcy case not been filed there would have been an actual foreclosure sale.  The Ninth Circuit then noted that the purpose of Section 365(h) is to protect lessees' rights outside of bankruptcy, but not to enhance them.  "We see no reason to exclude the law governing foreclosure sales from the analogous language in Section 363(f)(1).”

 

For trustees and debtors-in-possession, the lesson of the case is that commercial leases should not be rejected unless it is almost certain that the property at issue will not be sold.  Rejection may enhance the rights of tenants, since then the provisions of 365(h) would take effect.  Again, this is an issue the Ninth Circuit sidestepped in its decision.  At the same time, the longer a lease is left in limbo, the higher the administrative claim a landlord is likely to be entitled to in the case.     

 

The lesson for tenants is that rejection of their lease may actually secure their right to retain possession of the property in the event of a later sale. And, faced with a motion to sell, tenants must affirmatively request adequate protection of their interests by providing evidence of the harm they would suffer if they were forced to move.  This would include moving costs, alternative rental prices, and the disruption to their business that would occur. 

Instead of taking the position that they have an absolute right to stay, tenants will have to fight for a financial payoff adequate to reimburse them if and when they are required to move.  If that number is high enough, the new buyer (or the Judge) may be willing to allow the tenant to remain at the property, or may decide not to buy the property at all.  That is especially true for retail locations, where a business’ location may be tied closely to its goodwill.  Failing to raise the issue, and failing to quickly provide evidence of the harm to their business, is a mistake that no tenant can afford to make. 

 

On a broader level, the decision’s biggest impact on bankruptcy practice will be its ruling that assets may be sold free and clear of liens and interests where such liens/interests would have been extinguished in a foreclosure sale.  In this author’s experience that will almost always be the case, allowing for a large number of sales to occur.   The ruling’s insistence that such interests  be adequately protected will shift the focus to determining precisely what such adequate protection constitutes. 

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