Sale Free and Clear of Lease: The Battle Between Section 363 and Section 365

Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), 862 F.3d 1148 (9th Cir 2017)

The buyer of substantially all of the debtor’s real and personal property moved for an order confirming that the sale was “free and clear” of all liens and encumbrances, specifically including restaurant and telecommunication leases. The bankruptcy court ruled in favor of the buyer; the district court affirmed; and the tenants appealed to the 9th Circuit.

The debtor (SPH) was part of a group of related entities that owned and managed a 5,700 acre residential ski and golf resort.

  • SPH leased restaurant space in the resort to another entity (SPD). A principal of the debtor (Dolan) was an officer of both SPH and SPD and signed the lease on behalf of both landlord and tenant. The original lease was replaced by a 99-year lease with annual rent of $1,000. The tenant subsequently assigned its interests to an entity specially created for that purpose (Pinnacle).
  • SPH also leased a parcel of real estate at the resort to a third entity (Opticom). Dolan was the sole member of Opticom. The lease was for 60 years with annual rent of $1,285.

After the debtor defaulted on a loan, it filed a chapter 7 petition along with two related entities. The lender was the debtor’s largest creditor and had a valid claim of more than $122 million secured by a mortgage on the resort.

The lender and the chapter 7 trustee agreed on a plan to liquidate substantially all of the debtors’ property. They stipulated that there would be an auction with a $20 million minimum bid that would be “free and clear” of all liens. In seeking an order authorizing and approving the sale, the trustee represented that it would be “free and clear of any and all liens, claims, encumbrances and interests” with certain specified exceptions, and with certain specified liens to be paid out of the proceeds or otherwise protected.

The Pinnacle and Opticom leases were not identified as either surviving the sale or receiving protection. Consequently, both objected to any effort to sell the property free and clear of their leases. They argued that the Bankruptcy Code gave them the right to retain possession of the leased property. The court deferred ruling on their objections.

The lender’s assignee was the successful bidder at the auction with a bid of $26.1 million. Pinnacle and Opticom renewed their objections, and the buyer testified that its bid was contingent on the sale being free and clear of the leases. (The trustee took no position.)

The court ruled that the sale was free and clear of any “Interests,” which was defined to include leases “(except any right a lessee may have under 11 USC § 365(h), with respect to a valid and enforceable lease, all as determined through a motion brought before the Court by proper procedure).” When asked for clarification, the court said it would not consider the issue until there was a proper motion.

The trustee filed a motion seeking leave to reject the leases since the property was no longer property of the estate. The trustee’s motion was granted with no objection from the tenants. The buyer also moved for a determination that the sale was free and clear of the leases, which the tenants objected to. The bankruptcy court made a series of findings, including: the restaurant lease was far below market ($1,000 v. $40,000 to $100,000 per year); the telecommunications lease was not recorded; at the time the leases were executed all parties were controlled by Dolan; the leases were subject to bona fide disputes; the mortgage was senior to the leases; and the leases were not protected from foreclosure of the mortgage by subordination or non-disturbance agreements. The court further noted that neither of the tenants requested adequate protection for their leasehold interests prior to the sale, and at no time provided evidence that they would suffer economic harm if their ‘s possessory interests were terminated.

Based on these facts, the bankruptcy court held that the sale was free and clear of the leasehold interests. The district court affirmed on the grounds the foreclosure of the mortgage would terminate lease interests junior to the mortgage.

The 9th Circuit framed the issue as whether the leases survived the sale, which turned on statutory interpretation. Section 363 of the Bankruptcy Code authorizes the sale of property of the estate. Under section 363(f) the sale may be free and clear of interests if one of the listed criteria is met. Section 363 further provides that upon the request of a party with an interest in the property the court “shall prohibit or condition such sale … as is necessary to provide adequate protection of such interest.”

On the other hand, section 365 authorizes the trustee, subject to court approval, to assume or reject an unexpired lease. There is a special provision in section 365(h) that deals with the circumstance where a landlord rejects a lease. If rejection would entitle the tenant to terminate the lease, the tenant has an option to treat the lease as terminated by the rejection and make a claim for any breach. Alternatively, the tenant can retain the rights under the lease, including the right to possession, for the balance of the lease to the extent enforceable under applicable nonbankruptcy law.

This leads to an apparent conflict between section 363 and section 365 – can a tenant’s rights be cut off, or can it elect to retain possession? The court noted that other courts have taken different approaches.

The view that it characterized as the majority approach notes the conflict and then holds that section 365 trumps section 363 under the principal that a specific provision prevails over a general provision. These courts further find support in legislative history indicating a clear intent to protect a tenant’s interests when a landlord files bankruptcy.

The minority approach, which was adopted by the only Circuit Court to address the issue (Precision Industries v. Qualitech), comes to the opposite conclusion and finds that section 363 permits a sale free and clear of leasehold interests. Under this view the issue involves a provision with a broader scope (363) and one with a more limited scope (365), concluding that there is no conflict since the broader sale provision (363) applies to lease interests, while the narrower lease provision (365) does not address the circumstance of a sale.

The 9th Circuit took a variation on these approaches. It decided that section 365(h) applies only when there has been a formal rejection. If there is a sale but no rejection, or rejection but no sale, there is no conflict. In this case all parties agreed that the leases were not formally rejected prior to the sale. Thus, the court concluded that section 365(h) was not applicable.

Anticipating the criticism that this approach effectively repeals section 365(h), the court emphasized that in a sale free and clear the bankruptcy court must provide adequate protection for an interest terminated by the sale if requested. Further, relief can be almost anything that provides the “indubitable equivalent” of the interest – which could take the form of continued possession.

In addition, the ability to sell free and clear applies only in specified circumstances. In this case the fact that a foreclosure sale would have terminated the leases was sufficient. In a clarification added after the initial release of the opinion, the court noted that section 363 did not require that there be an actual or anticipated foreclosure. It was sufficient if it was legally permissible.

The court closed by noting that there was a limitation in the majority approach. Their emphasis on congressional intent to protect tenants overlooks the fact that protecting tenants reduces the value of the estate, which is contrary to the competing goal of maximizing creditor recovery.

Consequently, the court affirmed the district court on the basis that section 363 authorized the sale free and clear of the leases, and since the trustee did not reject the leases, section 365 was not applicable.

The status of leases in the context of a sale of the property remains murky and unsettled. In this case it is likely that the blatant attempt to favor insiders made it more appealing to find in favor of the buyer. From the viewpoint of a tenant, the clear message is that it should object early and often, and in particular, should push for adequate protection (getting creative if necessary).

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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