On July 13, 2017, the United States Court of Appeals for the Ninth Circuit issued an opinion that is an interesting—yes I really think so—lesson for trustees in bankruptcy as well as lessees who find that their lessor has filed for bankruptcy protection. The issue resolved by the Ninth Circuit—an issue of first impression in the circuit—was whether a Chapter 7 Trustee’s sale of the Chapter 7 Debtor’s real property under 11 U.S.C. § 363(f) was free and clear of unexpired leases to the property. The Ninth Circuit held, in a case that effortlessly rolls of the tongue, Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), __ F.3d __, 2017 WL 2979660 (9th Cir. July 13, 2017), that the sale of the Debtor’s real property was indeed free and clear of the current leases on the property. In so holding, the Ninth Circuit noted and overruled the argument, accepted by a majority of other courts, that such a sale violated 11 U.S.C. § 365(h); a section addressing lessees’ rights in the event of a trustee, standing in the position of the lessor, rejects a lease.
The Debtor in this case, Spanish Peaks, was one of the multiple entities involved with Timothy Blixseth and the resort he and others had planned in Big Sky, Montana. Prior to bankruptcy, the Debtor leased to a related company restaurant space at the resort for a lease term of 99 years for $1,000 per year in rent. Also prior to bankruptcy, the Debtor leased to another related entity a separate parcel of property at the resort for 60 years at an annual rent amount of $1,285.
The Debtor then defaulted on its loan payments for the resort and eventually filed a Chapter 7 bankruptcy petition. The largest creditor of the Debtor was a lender that held a claim for $122 million secured by a mortgage on the resort property (the “Lender”). The Lender’s mortgage was in place before the leases were established. The Chapter 7 Trustee and the Lender agreed that the trustee would sell the resort property “free and clear of any and all liens, claims, encumbrances and interest” via 11 U.S.C. § 363(f), which allows sales “free and clear of any interest in such property of an entity other than the estate” if certain requirements are met. The Bankruptcy Court, after some procedural hurdles, entered an order approving the sale of the resort property to the Lender for $26.1 million under 11 U.S.C. § 363(f).
At the conclusion of the sale to the Lender, the two lessees argued that, under 11 U.S.C. § 365(h), that the Lender took the property subject to the two long-term leases (with extremely good rent terms) by the related entities. Section 365(h) provides that lessees who have their leases rejected in bankruptcy by the lessor debtor (or the debtor’s trustee in the case) have certain rights to: (1) treat the rejection as a termination of the lease; or (2) notwithstanding the rejection, retain the rights—including the right of possession—under the lease for the remaining term of the lease. The two lessees attempted to take advantage of option (2) under 11 U.S.C. § 365(h).
II. Legal Framework
As noted by the Ninth Circuit, “the issue brings two sections of the Code into apparent conflict;” those being § 363(f) and § 365(h). “[W]hen 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.”
The Ninth Circuit noted the “Majority Approach” in this circumstance is to conclude that § 365(h) trumps § 363(f) and any sale by a trustee in this instance is subject to the rights provided the lessees in § 365(h).
The “Minority Approach,” holds otherwise. It reasons that § 363(f) allows for the sale of the property free and clear of “any interest” without expressly excluding a leasehold interest, and thus § 363(f) and § 365(h) do not conflict at all. This analysis was adopted by the Seventh Circuit Court of Appeals in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003). The “Minority Approach” is bolstered by § 363(e), argues its proponents, because that provision states the bankruptcy court “shall prohibit or condition such . . . sale . . . as is necessary to provide adequate protection of such interest” of a lessee. Therefore, pursuant to § 363(e) the lessees impacted by a sale under § 363 have the right to seek adequate protection from the bankruptcy court.
III. Ninth Circuit’s Approach
The Ninth Circuit concluded that the “Minority Approach” was the correct analysis. The Ninth Circuit echoed the Seventh Circuit’s statutory analysis and concluded that because the statutes can be read in harmony—that is, they do not conflict because § 363 allows for sales free and clear of “any interest” and § 365(h) has a more “limited scope” focused on rejection of a lease.
Moreover, the Ninth Circuit noted, on these facts, that § 365(h) is not even implicated because there has been no true rejection by the trustee. The Ninth Circuit noted that in § 365, there are provisions that deem leases rejected after a period of time has passed. However, the Court pointed out that those sections deal with residential leases or, in the context of nonresidential leases, a trustee or debtor who is a lessee, not a landlord. See, e.g., 11 U.S.C. § 365(d)(1), (d)(4)(A).
The trustee, in this case, said nothing about the leases in its sale motion and order and thus the leases were not truly rejected, according to the Ninth Circuit analysis. Succinctly put, “[i]n 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 [as occurred here] (or a rejection, but no sale), there is no conflict.” Therefore, because § 365(h) was not triggered by a rejection of the lease, and because the lessees did not seek the protection of § 363(e), the Ninth Circuit held that the leases were extinguished via the trustee’s sale under § 363(f).
IV. Lessons from In re Spanish Peaks Holdings II, LLC
Both trustees and lessees can benefit from the lessons of the Ninth Circuit’s holding in In re Spanish Peaks Holdings II, LLC.
As for lessees, the Ninth Circuit’s analysis of the contents of § 363(e) should be remembered. If a lessee finds that their landlord has filed for bankruptcy protection, the real property is going to be sold via a § 363 sale, and the trustee or debtor-in-possession has not formally rejected the lease (thus implicating § 365(h)), lessees should consider proactively seeking the protections of § 363(e) to obtain “adequate protection” of the lessees’ interest.
As for trustees or debtors-in-possession, the Ninth Circuit’s analysis of § 363(f) sales is helpful. Trustee’s should consider the implications of formally rejecting a lease in which the debtor is the landlord and the scope and protections of doing so under § 365(h). If trustees do not formally reject the lease, then it is possible the sale, as occurred here, can be free and clear of junior leases.
This recent decision of the Ninth Circuit highlights the interesting complexities of when Bankruptcy Code provisions intersect. Paying particular attention to such an intersection can be of benefit to both trustees, lessees, and their bankruptcy counsel.