Staying on Leased Property After a Bankruptcy § 363 Sale

On May 28, 2014, the District Court for the Southern District of New York affirmed an order from the bankruptcy court in Dishi & Sons v. Bay Condos LLC, et al.¹, approving a sale of the Debtor’s assets, but found that the Debtor’s commercial tenant was entitled to remain in possession of the premises for the remainder of the lease at the specified rent.

The crux of the issue the District Court considered was the interplay between sections 363(f) and 365(h) of the Bankruptcy Code.

Section 363(f) allows a debtor-in-possession to sell property of the estate free and clear of any interests, including leasehold interests, provided that one of the following five scenarios exists: (1) applicable nonbankruptcy law permits such free and clear sale, (2) the entity consents, (3) the interest is a lien and the sale price is greater than all liens, (4) the interest is in bona fide dispute, or (5) the entity could be compelled to accept a money satisfaction of the interest. In any event, if property is being sold free and clear of an interest, adequate protection of the interest must be provided, if requested.

Section 365(h) addresses, inter alia, the debtor-in-possession’s ability to assume or reject unexpired leases. Assumption of such lease obligates the estate to the terms of the lease. Rejection is a decision not to assume and obligate the estate, and creates a breach of the lease; it does not act as termination of the lease. If the Debtor chooses to reject, but the term of the lease has commenced, the lessee may retain its rights appurtenant to the real property under the lease.

The question is whether, under § 363(f), a debtor can sell property free and clear of a lessee’s leasehold interest, including its rights appurtenant under § 365(h).

There are two interpretations of the interplay of these provisions. A majority of courts take the position that these sections are irreconcilable, and find that § 365(h) trumps § 363(f) as it provides the “exclusive remedy available to the debtor in an executory lease situation.”² The minority position is that § 365(h) applies to the distinct scenario of lease rejections. Thus, if the trustee chooses to sell property, § 363(f) controls and the property may be sold free and clear. Under the majority viewpoint, a sale of all assets in bankruptcy would not be free and clear of a lessee’s rights appurtenant to the real property under the lease. The minority would allow the sale free and clear, providing adequate protection to protect the lessee’s interest upon request.

The District Court declined to endorse either position, though looked favorably upon the minority view. It considered the purpose of the power to assume or reject, which is to avoid burdening the estate by allowing it to decide which leases to assume. The District Court found the two sections work in harmony to establish that rejection of a lease does not terminate the lessee’s appurtenant rights, and any such rights must be addressed in any proposed sale free and clear, and that the lessee’s rights generally will be enforceable against the transferee of the property.

The Court held that “the purpose of § 365(h) is to clarify that rejection is not an avoidance power — not to give the lessee rights that may never be avoided by some other means.”³ Rejection of a lease is not termination of the lease; rather, it gives rise to a prepetition breach for the lessee and prevents the estate from enjoying the lease benefits, such as the rent. Rejection makes the lease unenforceable against the estate, but does not affect the lessee’s appurtenant rights such continuing possession at the existing rent.

Section 365(h) simply preserves the lessee’s appurtenant rights if the lease is rejected. Nothing in § 365(h) precludes a debtor-in-possession from terminating the lessee’s appurtenant rights if another provision of the Bankruptcy Code, such as § 363(f), allows it.⁴ Any sale under § 363(f) must take the appurtenant rights into account, but, if grounds exist, the sale can be completed free and clear of the lessee’s appurtenant rights, subject to adequate protection if requested.

The District Court then turned its analysis to two of the five factors under § 363(f). It rejected an attempt to rely on foreclosure law, and held that a free and clear sale was not permitted under the first factor because the sale free and clear is analogous to a discretionary sale by the owner, and therefore subject to the lease under New York law.

Regarding the fifth factor, the District Court held that it did not permit a free and clear sale, as it should be read to refer to proceedings that could be brought by the debtor-in-possession as owner of the property — a point the proponent of the sale did not raise.

Finally, the District Court held that adequate protection under § 363(e) could only be provided through the lessee’s continued possession of the premises.

Practitioners in any district where there is no binding authority on the issue should be aware of this case, as it is well-reasoned and likely to be persuasive beyond the Southern District of New York. Under this ruling, lessees of bankrupt lessors wishing to stay in possession of the leased premises should explain to the court that none of the five scenarios under § 363(f) exist, and the only way they can be adequately protected is through continued possession.

Arent Fox regularly represents various parties in bankruptcy throughout the country. For more information on the issues raised herein, or Arent Fox’s Bankruptcy & Financial Restructuring practice, please contact Robert M. Hirsh or David J. Kozlowski.