Of Sales and Leases: Can a Bankrupt Landlord Sell Free and Clear of a Tenant’s Interest?

In re Zota Petroleums, LLC, 42 B.R. 154 (Bankr. E.D. Va. 2012) –

Zota addresses the interaction between (1) a sale free and clear of interests under Section 365(f) of the Bankruptcy Code and (2) a tenant’s right to retain possession under Section 365(h) of the Bankruptcy Code when a debtor landlord rejects the lease in a case where the debtor sold its assets, assumed and assigned its interests as a tenant under a prime lease, but rejected its interests as a landlord under a sublease.

The debtor leased 16 gas stations and convenience stores, some of which were subleased.  The bankruptcy trustee filed a motion for an order authorizing the sale of substantially all of the debtor’s assets, establishing bid procedures for the sale, and authorizing the assumption and assignment of leases and executory contracts – which  was granted.

The trustee filed a notice of assumption and assignment of 15 leases, including a lease (the Kelmont Lease) for property that the debtor in turn subleased to D & MRE, LLC.  Subsequently the trustee also filed a motion to reject certain leases, including the sublease with D & MRE.

An auction was held, and the order approving the sale provided that the assets would be sold free and clear of liens, encumbrances and claims, except as provided in the purchase agreement.  The order also authorized assumption and assignment of leases to the buyer, including the Kelmont Lease.  The rejection motion was approved on the same date as approval of the asset sale, but in a separate order.

Under Section 365(h)(1)(A) of the Bankruptcy Code, if a landlord debtor rejects a lease, a tenant may either treat the lease as terminated (assuming rejection amounts to a breach that would permit rejection under applicable non-bankruptcy law) or retain rights under the lease that are appurtenant to the property.  D & MRE filed a motion seeking confirmation that it would be able to retain its rights under the rejected lease.  The buyer objected arguing that, among other things, the sale of assets was free and clear under Section 363 of the Bankruptcy Code so that Section 365(h) was inapplicable.

An infamous Seventh Circuit case, Precision Industries, Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Circuit 2003), was cited for the proposition that a purchase of property “free and clear” under Section 363(f) made Section 365(h) inapplicable.  Among other things, the Seventh Circuit noted that a lessee could be provided adequate protection if necessary, and that Section 365(h) applied to leases that had been rejected, while in Qualitech there was no affirmative rejection, and that .

The Zota court noted that lower courts are split on the issue of whether Section 363 or Section 365 prevails and reviewed cases on both sides.  Those holding that a Section 363 sale can extinguish Section 365(h) rights generally rely on a statutory construction based on the plain meaning of the Bankruptcy Code in combination with the principle that a court should avoid creating conflicts between sections if possible.  In contrast, courts holding that Section 365(h) prevails typically rely on the argument that to hold otherwise would eviscerate Section 365(h), as well as an argument that the more specific section (Section 365(h)) should prevail over the more general section (Section 363).

The court took pains to distinguish the cases holding that Section 363 prevails from the circumstances in Zota.  It noted that in this case (1) the transaction was specifically presented as a sale free and clear and an assumption and assignment of the prime lease, (2) the parties had notice that Section 365 was at issue, (3) the APA included an exhibit listing leases to be assumed and assigned with cure amounts, and (4) the sublease was specifically rejected.  The court further noted that no adequate protection had been proposed and that allowing Section 365(h) to prevail was consistent with the indication in the legislative history that Congress wanted to preserve the right of tenants under leases rejected by landlords.  Consequently, it concluded that Section 365(h) prevailed in this case.

Many believe that Qualitech is incorrect.  However, subsequent cases are split, and it can be difficult to predict the results in a particular case.  A tenant that is interested in retaining rights to the leased premises should explicitly raise the issue as early as possible; and a landlord debtor that hopes to sell its interests in the property free and clear of a tenant’s interest should also address the issue directly.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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