Sales Free and Clear: The Devil Is in the Details

In re Bridge Assoc. of Soho, Inc., 589 B.R. 512 (Bankr. E.D. N.Y. 2018) –

The debtor filed a motion to sell a residential loft building free and clear of possessory rights of the occupants. The bankruptcy court determined that the occupants had statutory rights of possession that could not be stripped in a bankruptcy sale.

The court focused on provisions of the New York Multiple Dwelling Law enacted in 1982, which it referred to as the “Loft Law.” The legislation was enacted to address illegal conversions of New York City buildings from commercial to residential use. The goal was to bring the buildings into compliance with requirements for residential occupancy and to protect tenants in those buildings.

On the one hand, there was a “serious public emergency” because of the increasing number of conversions of commercial and manufacturing loft buildings to residential use that did not comply with applicable requirements or conform to minimum standards for health, safety and fire protection. On the other hand, there was an “acute shortage of housing” so that tenants “would suffer great hardship if forced to relocate.”

Consequently, the law was designed to facilitate legalization of the illegal living arrangements in the “de facto” multiple dwellings through a system where rentals were “reasonably adjusted” so tenants could help pay the cost of bringing the buildings into compliance without being forced to relocate. Generally, rents cannot be collected if a building is occupied without a certificate of occupancy. However, under the Loft Law, an owner can collect rent without a certificate of occupancy as long as it is in compliance with the requirements for moving the building towards legalization.

The prior owners of the debtor’s building had conceded that the building was covered under the law as an interim multiple dwelling and had registered the building. At the time of the bankruptcy all parties agreed that (1) the building did not have a certificate of occupancy for residential use, and (2) the debtor was not in compliance with the process required to move the building towards legalization. Thus, the debtor was not authorized to collect rent.

The debtor sought court approval to sell the property free and clear of liens and interests, including the possessory rights of the occupants. Under the Bankruptcy Code, property may be sold free and clear of an interest only if one of the requirements of section 363(f) is met.

With respect to the secured creditors, the debtor proposed to conduct an auction of the property with a reserve price of $12.5 million. It contended this would be sufficient to pay the secured creditors, so section 363(f)(3) would be met (i.e. price is greater than the aggregate value of all liens on the property).

As for the occupancy rights, the tenants argued that they had possessory rights under the Loft Law that could not be altered in a section 363 sale. In response, the debtor argued that (1) it was permitted to sell the property free and clear of the interests under nonbankruptcy law, which would satisfy section 363(f)(1), and (2) the tenants’ interests were subject to a bona fide dispute, which would satisfy section 363(f)(4).

With respect to the debtor’s first argument, it contended that the tenants were merely holdover tenants who had not paid rent in decades and were subject to eviction under state law. According to the debtor, absent payment of rent, the tenants had no possessory rights.

The issue turned on a section of the Loft Law that stated (emphasis added:

Prior to compliance with safety and fire protection standards … residential occupants qualified for protection pursuant to this article shall be entitled to continued occupancy provided that the unit is their primary residence, and shall pay the same rent, including escalations, specified in their lease or rental agreement to the extent to which such to lease or rental agreement remains in effect …

The tenants contended that this meant the only condition for their possessory rights was that they occupied the property as their primary residence. The debtor interpreted this section to mean that occupancy rights required both use as a primary residence and payment of rent.

The court sided with the tenants. It interpreted the comma before “and shall pay the same rent” as separating the reference to rent from the residency requirement as a condition of occupancy. It interpreted the rent discussion as addressing the rents an owner could collect assuming it was permitted to collect rent. This interpretation was consistent with state cases holding that the bar on collecting rent while the owner was not in compliance with the Loft Law also precluded eviction based on nonpayment of rent.

On the specific argument that the debtor was entitled to evict the tenants as holdover tenants, the court noted that a holdover tenant does not have any vested right to remain in possession. However, in this case the tenants had a statutory right to remain in possession as long as the property was their primary residence.

Consequently, the court rejected the debtor’s argument that it could sell free and clear of the possessory interests under nonbankruptcy law, and the debtor did not raise any argument that would rise to the level of a bona fide dispute. With respect to an additional argument made by the debtor that the tenants could be compelled to accept a money satisfaction of their interests as contemplated by section 363(f)(5), the court concluded that a provision in the law authorizing an owner and occupant to agree to the sale of the occupant’s interest did not mean that the occupant could be compelled to sell.

Accordingly, the debtor could not use section 363 to sell the property free and clear of the tenants’ possessory rights under the Loft Law.

There can be a tendency to just assume that property can be sold free and clear of all interests. This case is a useful reminder that this holds true only if an interest comes within one of the categories in section 363(f).

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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