Court Puts Leaseholds at Risk in Section 363 Sales
Qualitech Decision Calls Tenants’ Rights into Question

(TMA International Headquarters)

Although the language of the U.S. Bankruptcy Code often leaves room for argument and interpretation, there are some answers that those in the field thought they knew. For example, they knew that a tenant whose landlord was in bankruptcy could not be deprived of its possessory interest — its leasehold — in the landlord’s real property. If a debtor-landlord rejected a lease of real property, thereby repudiating its obligations to its tenant, those in the field knew that the tenant could not be uprooted without its consent.

Last year, the 7th Circuit Court of Appeals told those in the field that what they knew was wrong. In Precision Industries, Inc. v. Qualitech Steel SBQ LLC, 327 F.3d 537 (7th Cir. 2003), the court held that a debtor-landlord could sell its real property free and clear of its tenant’s leasehold interest without providing any of the rights and protections the tenant would normally have upon the debtor-landlord’s rejection of the lease. However, the court’s opinion also suggests how tenants might avoid — or try to avoid — losing their rights under a lease in a bankruptcy sale of a landlord’s assets.

When Rules Collide

At issue in Qualitech were Sections 363(f) and 365(h) of the Bankruptcy Code. Under Section 363, a trustee or, as in Qualitech , a debtor in possession, after notice to affected parties and a court hearing, may use, sell, or lease property of the estate outside the ordinary course of business. Additionally, if another entity holds an interest in the property to be sold — for example, a secured creditor holding a mortgage lien — the property may be sold free and clear of that interest only if the sale satisfies one of the five conditions set forth in Section 363(f):

• Applicable non-bankruptcy law permits the sale of the property free and clear of the relevant interest
• The party holding the interest consents
• The interest is a lien, and the price at which the property at issue is to be sold is greater than the total value of all of the liens on that property
• The interest is in bona fide dispute
• The party holding the interest could be compelled in a legal or equitable proceeding to accept a money satisfaction in exchange for the interest.

Although the code does not define the term “interest,” a tenant’s leasehold almost certainly qualifies as such, and the 7th Circuit treated the lease in Qualitech as an interest in the debtors’ real property.

The other statute at issue in Qualitech was Bankruptcy Code Section 365, which addresses the treatment of executory contracts and unexpired leases. Under Section 365, one of three things may happen to an unexpired lease of real property. A debtor may:

• Assume and keep it.
• Assume and assign it.
• Reject it.

When a debtor-landlord rejects a real property lease, it walks away from its obligations under the lease, such as its duty to provide security, common area maintenance, and utilities, for example. However, in that situation, Section 365(h) protects the non-debtor tenant by giving it a choice.

If rejection would constitute such a breach that the tenant would be permitted to terminate the lease, either by the terms of the lease or under state law, the tenant may treat the rejected lease as terminated. Alternatively, the tenant may remain in possession of the leasehold for the balance of the lease term and for any extensions or renewal terms enforceable under state law, deducting from rent due any damages caused by the debtor-landlord’s failure to perform its lease obligations.

The tenant may also retain its rights under the lease that are related to the real estate, including the right of “quiet enjoyment.” That includes the right of a tenant, as against the landlord or anyone claiming under the landlord, such as a purchaser, to have possession of the leased premises during the lease term.

Dueling Canons

The Qualitech debtors, Qualitech Steel Corporation and Qualitech Steel Holdings Corporation, owned and operated an Indiana steel mill. To improve its access to supplies, Qualitech contracted with Precision Industries, Inc., to build, stock, and operate a warehouse on Qualitech’s property, from which Precision would sell products to Qualitech.

Qualitech also entered into a 10-year ground lease with Precision that guaranteed to Precision, for rent of $1 per year, the use and possession of the warehouse and any other improvements it built on the leased property. At the end of the lease term, if it had not defaulted under the lease or supply agreement, Qualitech had the option of purchasing the warehouse, its fixtures, and any other improvements for $1.

About one month into the lease, Qualitech filed a Chapter 11 case and, five months later, the bankruptcy court entered an order approving the sale of substantially all of Qualitech’s assets, including the real property leased to Precision, to the debtor’s pre-petition senior lenders. The lenders assigned the assets to a new entity formed to own and operate them (for purposes of this article, the purchaser). The sale order provided, with specified exceptions, that the sale was free and clear of all interests and that no interest could be asserted against the purchaser.

Precision and the purchaser negotiated assumption of the lease for four months after the sale, but the negotiations failed, and the lease was deemed rejected when the extended time to assume contracts and leases under the sale order had expired. Notwithstanding Section 365(h), the purchaser changed the locks on Precision’s warehouse, constructively evicting the company. Precision sued the purchaser in U.S. District Court, which referred the matter to the Bankruptcy Court.

There, the purchaser argued that the sale order transferred Qualitech’s real estate to it free of Precision’s leasehold interest. Precision had received notice of the sale hearing and had neither objected to the sale nor sought adequate protection of its leasehold interest; nor had Precision ever contested that the sale satisfied at least one condition of Section 363(f) for sales free and clear of interests. Precision staked its case on the proposition that the specific provisions of Section 365(h) should trump the more general provisions of Section 363(f).

The Bankruptcy Court found that the lease had been extinguished by the sale order but, at the first level of appeal, the District Court reversed. It found that Sections 363(f) and 365(h) were, in fact, in conflict, and it applied the canon of statutory construction that the specific should control over the general. Finding that the more specific protections of Section 365(h) indicated an intent to protect tenants from losing their possessory interests in the property of their landlords, the district court revived Precision’s leasehold.

However, upon further appeal, the 7th Circuit Court of Appeals rolled out a bigger canon: the obligation of courts to interpret statutes, if reasonably possible, to avoid conflicts among them. The 7th Circuit determined that the two code sections at issue really address two different situations: Section 363(f) deals with the sale of property in which multiple parties may have interests — such as leases — while Section 365(h) deals with the effect of rejecting a tenant’s lease when the debtor-landlord chooses not to sell the property. As long as a tenant receives notice of a proposed sale of property in which it has a possessory interest, the sale may extinguish that interest, and the tenant is responsible for protecting itself.

Questions Remain

Leaving aside whether Qualitech was decided correctly, the case makes clear that tenants should not rely passively on their rights under Section 365(h), but must actively consider how to protect their leasehold interests in bankruptcy sales of the underlying real estate. The 7th Circuit’s opinion provides some limited guidance. For example, the court suggests that tenants should request adequate protection of their interests in the property to be sold, which the court must grant, under Section 363(e).

However, for leasehold interests, adequate protection may be difficult to quantify. The purely monetary value of a lease may be quite small if the rent is close to market rates. The more substantial value of a leasehold to a tenant arises from its investment in improvements and build-out, training and retaining employees at that site, making its presence at a particular site known, and cultivating a base of customer goodwill at that site. The value of these efforts may be lost by a sale free and clear of the leasehold and may be impossible to replace with money.

So, by endorsing a tenant’s pursuit of adequate protection under Section 363(e), the 7th Circuit may have inadvertently provided tenants with a path around its own opinion. The court suggested that Section 363(e) might help a tenant obtain some cash compensation from sale proceeds; however, because a bankruptcy court may, under Section 363(e), go so far as to prohibit a sale if that would be necessary to adequately protect a non-debtor’s interest in the property to be sold, a tenant should consider arguing that the only way to adequately protect its leasehold interest in property to be sold is, in fact, to prohibit the sale free and clear of that leasehold interest completely.

The 7th Circuit also noted in Qualitech that the tenant effectively had conceded that, absent Section 365(h), Section 363(f) permitted a sale free and clear of leasehold interests. The court, therefore, did not rule on that issue. As a result, tenants may object to a sale under Section 363(f) on the ground that none of the five conditions listed authorizes the sale of real estate free and clear of a leasehold interest.

Assuming the tenant does not consent — a refusal it may try to negotiate into its lease — and the lease is not in dispute, the only applicable subsections would be 363(f)(1) and (f)(5). Applicable state law may well prevent a landlord from transferring real property free of a lease (Section 363(f)(1)) and may not require a tenant to accept money in exchange for its possessory interest (Section 363(f)(5)).

Finally, the 7th Circuit stressed Precision’s failure to object to entry of the sale order, despite its having received notice of the sale. The court has observed in other cases that notice combined with silence equals consent. Conversely, then, if a tenant really did not receive notice of a sale, that fact should support a due-process defense. Further, that defense may not be confined to situations of actual failure of notice; the authors are aware of anecdotal evidence that bankruptcy judges, at least those outside the 7th Circuit, may be reluctant to apply Qualitech if the notice received did not make clear that the tenant’s leasehold would be extinguished by the sale.

Tenants may take other steps as well. When a tenant does receive notice of a bankruptcy sale of the property it leases from a debtor-landlord, it should press the debtor to commit, on the record, to how it intends to treat the lease and should object to sale procedures that do not require such a commitment and to sale motions and orders that do not specifically state that the leasehold will be preserved and the lease either assumed or rejected under Section 365.

Concurrently, the tenant may file a motion to compel assumption or rejection of the lease. While such motions are ordinarily hard to win, the Qualitech precedent, combined with a sale process that does not provide protections for tenants, creates uncertainty and risk for the tenant that could constitute cause to order the debtor to assume or reject. At minimum, such a motion could force the debtor-landlord to commit to treating the lease under Section 365 — thereby affording the tenant its Section 365(h) rights — or to explain why it cannot commit.

A Word to the Wise

Socrates taught that wisdom means knowing that one knows nothing. The wise bankruptcy professional knows that her understanding of bankruptcy law can change in the time it takes to read one court opinion. Qualitech has served notice that preserving a tenant’s rights under Section 365(h) may require taking a more active role than in the past in objecting to sales under Section 363.