Protecting a Tenant When a Debtor-Landlord Attempts the Sale of Leased Property
March 29, 2004
A tenant of real property is vulnerable to a landlord’s potential bankruptcy
because Section 365(d) of the Bankruptcy Code (the Code) provides debtors with
the power to reject unexpired leases of real property. In the past, even if a
landlord filed bankruptcy and rejected its lease with the tenant, the tenant
would have been comforted by the protections afforded by Section 365(h)(1)(A)(ii)
of the Code, which provides:
... if the term of such lease has commenced, the lessee may retain its
rights under such lease (including rights such as those relating to the
amount and timing of payment of rent and other amounts payable by the lessee and
any right of use, possession, quiet enjoyment, subletting, assignment, or
hypothecation) that are in or appurtenant to the real property for the
balance of the term of such lease and for any renewal or extension of such
rights to the extent that such rights are enforceable under applicable
non-bankruptcy law.
This means that, even if a landlord rejects an unexpired real property lease,
the tenant could continue in possession of the leased property for the remainder
of the lease term, including any renewal periods. Tenants under real property
leases may continue to rely on Section 365(h) of the Code to remain in
possession of leased property when a landlord rejects the lease. However,
in light of a recent Seventh Circuit opinion, Precision Ind., Inc. v.
Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp.), 327 F.3d 537 (7th
Cir. 2003), if a landlord seeks to sell real property subject to a lease,
the tenant will need to vigilantly protect its rights.
Section 363(f) of the Code allows a debtor to sell property of the bankruptcy
estate free and clear “of any interest” so long as certain conditions are met.
In a sale of bankruptcy estate property subject to a real property lease, Code
Sections 363(f) and 365(h) appear to conflict – Section 365(h) allows a tenant
to retain possession of the real estate for the duration of its lease, but
Section 363(f) allows a debtor-landlord to sell the real estate free and clear
of the lease.
The Seventh Circuit recently reconciled Sections 363(f) and 365(h) in a way
that may alarm tenants of commercial property who invest heavily in construction
and/or remodeling of leased property in reliance on the advantages of long-term
leases. In Precision, Qualitech Steel Holdings Corporation leased ground
to Precision Industries, Inc., for a ten-year period for nominal rent ($1 per
year). On the ground subject to the ground lease, Precision constructed a
warehouse. Qualitech purchased goods manufactured by Precision and at the end of
the ten-year lease term was to purchase the warehouse for $1.
Shortly after Qualitech filed for bankruptcy in March 1999, a group of senior
prepetition lenders purchased substantially all of Qualitech’s assets. The
court’s order authorizing the sale authorized Qualitech to convey its assets
“free and clear of all liens, claims, encumbrances, and interests,” except for
specific listed liens. By the end of 1999, Precision had vacated the warehouse,
and the reorganized Qualitech, now called New Qualitech, changed the locks on
the building. Having failed to object to the sale, Precision returned to the
property after the sale and discovered that the locks on the warehouse had been
changed.
Precision then filed a lawsuit alleging that New Qualitech was guilty of
trespass and conversion, among other things. New Qualitech asked the district
court to refer Precision’s complaint to the bankruptcy court and asked the
bankruptcy court to clarify that the sale order had authorized the sale free of
Precision’s lease, extinguishing Precision’s right to possess the leased
property.
The bankruptcy court found that because, among other things, Precision did
not object to the sale, the sale order had extinguished Precision’s right to
possess the property. Precision appealed the bankruptcy court’s decision and
obtained a reversal from the district court. On further appeal, the Seventh
Circuit reversed the district court and held that a sale of property under
Section 363(f) may extinguish a lease of the property notwithstanding the
protections afforded a tenant under Section 365(h) for the following reasons:
First, unlike other provisions of Sections 363 and 365, Section 363(f) does
not contain a cross-reference to Section 363(h) – or any other Code section that
would make the trustee’s ability to sell estate property free of interests
subject to the protections afforded tenants under Section 365(h).
Second, by its unambiguous terms, Section 365(h) only applies when a debtor
rejects an unexpired lease of real property. The Seventh Circuit
determined that the plain language of Section 365(h) limits its scope because
the section does not refer to sales of estate property.
Finally, the Seventh Circuit found that a party whose interest is adversely
affected under Section 363(f) is protected by Section 363(e) of the Code, which
provides that a party with an interest in the property to be sold may object
to the sale and request that the bankruptcy court protect its interest. The
Seventh Circuit noted, however, that if the tenant is not allowed to remain in
possession of the property, the tenant will need to be compensated for the value
of its lost leasehold interest, typically from the proceeds of the sale.
Thus, the Seventh Circuit reconciled Sections 363(f) and 365(h) by holding:
Where estate property under lease is to be sold, section 363 permits the sale
to occur free and clear of a lessee’s possessory interest – provided that the
lessee (upon request) is granted adequate protection for its interest. 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.
The Seventh Circuit’s decision in Qualitech should certainly trouble a
tenant of real estate, especially within that circuit, because of the risk that
the tenant could lose possession of leased property in the event a landlord in
bankruptcy sells the leased property under Section 363(f) of the Code. Although
the tenant may still rely on Section 365(h) of the Code to protect its right to
possess leased property when a bankruptcy trustee or landlord rejects the
lease, the tenant must be vigilant in protecting its interests when a landlord
or bankruptcy trustee seeks to sell the leased property under Section
363(f).
Because Section 363(e) requires that the party seeking to protect its
interest “request” that the court condition the sale of the leased property on
protecting the tenant’s interest, the tenant risks losing its leasehold interest
if it does not object to any proposed Section 363(f) sale of property it leases.
In its objection, the tenant should request that the court either allow the
tenant to remain in possession, or grant the tenant adequate protection by
compensating it for the loss of its leasehold interest. This compensation could
be included in the sale price and paid by the buyer.
The more difficult question then becomes what constitutes “adequate
protection” if a landlord in bankruptcy seeks to sell property free and clear of
the tenant’s leasehold interest. In the future, a tenant may want to consider
including a provision in its leases that establishes a mutually agreeable method
for establishing the amount of adequate protection up front.
For more information, e-mail Jennifer Nichols-Moore at
jennifer.nichols-moore@hklaw.com
or call toll-free, 1-888-688-8500.
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