by Melanie Rovner Cohen, Christopher Combest, Faye B. Feinstein
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.
At issue in Qualitech were Sections 363(f) and
365(h) of the Bankruptcy Code. Under Section 363, a trustee or, as in
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
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.
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
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.
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
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
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.
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
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
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
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
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.
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