Fifth Circuit Weighs In on Bankruptcy Asset Sales Free and Clear of Leasehold Interests

The ability of a trustee or chapter 11 debtor-in-possession ("DIP") to sell bankruptcy estate assets "free and clear" of competing interests in the property has long been recognized as one of the most important advantages of a bankruptcy filing as a vehicle for restructuring a debtor's balance sheet and generating value. Still, section 363(f) of the Bankruptcy Code, which delineates the circumstances under which an asset can be sold free and clear of "any interest in such property," has generated a fair amount of controversy. This is so in part because the statute itself does not define "interest." 

Although section 363(f) is generally acknowledged to encompass liens and security interests, some courts, taking into account both the language of the provision and its underlying purpose, have interpreted it much more broadly to also include leasehold interests, among other things. Broadly applied, however, section 363(f) arguably conflicts with certain other provisions of the Bankruptcy Code. 

One of those provisions is section 365(h)(1) of the Bankruptcy Code. That section provides that, if the trustee or DIP rejects an unexpired real property lease under which the debtor is the lessor, the nondebtor lessee (and any permitted successor or assign, pursuant to subsection (h)(1)(D)) has the option of retaining its rights under the lease for the balance of the lease term "to the extent that such rights are enforceable under applicable nonbankruptcy law."

Courts disagree as to whether the rights of a lessee (or sublessee) under section 365(h)(1) are effectively extinguished where the debtor does not reject the lease and the leased real property is sold free and clear under section 363(f). Until 2022, only two federal courts of appeals had weighed in on this question, both staking out what was previously considered to be the minority view. In Precision Industries, Inc. v. Qualitech Steel SBQ, 327 F.3d 537 (7th Cir. 2003), the U.S. Court of Appeals for the Seventh Circuit disagreed with several lower courts and held that a real property lease can be extinguished in a free-and-clear sale of the property under section 363(f), at least where the lease has not been formally rejected. In Pinnacle Rest. at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holding II, LLC), 872 F.3d 892 (9th Cir. 2017), the Ninth Circuit essentially endorsed this position, with certain caveats.

The Fifth Circuit is the latest circuit court to examine this issue, but in an oblique way. In In re Royal Street Bistro, L.L.C., 26 F.4th 326 (5th Cir. 2022), the court denied certain tenants' motion for a writ of mandamus directing a district court to issue a stay pending appeal of a bankruptcy court order approving the sale of leased real property free and clear of the tenants' leasehold interests. However, instead of issuing a summary order without explanation, the Fifth Circuit issued a brief per curiam opinion in which it agreed with the result reached by the lower courts, but signaled disagreement with Qualitech's holding and cautioned courts against "blithely accepting Qualitech's reasoning and textual exegesis." 

Free-and-Clear Sales

Section 363(f) of the Bankruptcy Code authorizes a trustee or DIP to sell property "free and clear of any interest in such property of an entity other than the estate" under any one of five specified conditions. These include, among other things, if applicable nonbankruptcy law permits a sale free and clear, if the sale price exceeds the aggregate value of all liens encumbering the property, or if the interest is in bona fide dispute.

A bankruptcy court's power to order sales free and clear of competing interests without the consent of the party asserting the interest has been recognized for more than a century. See Ray v. Norseworthy, 90 U.S. 128, 131–32 (1875); Van Huffel v. Harkelrode, 284 U.S. 225, 227 (1931). A court-ordered free-and-clear sale promotes the expeditious liquidation of estate assets by avoiding delay attendant to sorting out disputes concerning the validity and extent of competing interests, which can later be resolved in a centralized forum. It also facilitates the estate's realization of the maximum value possible from an asset. A prospective buyer would discount its offer significantly if it faced the prospect of protracted litigation to obtain clear title to an asset.

Section 363(e) of the Bankruptcy Code provides that, upon the request of an entity that has an "interest" in property proposed to be sold by the trustee or DIP, the court "shall prohibit or condition" the sale "as is necessary to provide adequate protection of such interest." Section 361 provides that "adequate protection may be provided" by periodic cash payments to protect against any decrease in value of the interest; an additional or replacement lien (if the interest is a lien); or other relief, such as an administrative expense claim, "as will result in the realization by such entity of the indubitable equivalent of such entity's interest in such property."

"Any Interest" Broadly Construed

Section 363(f) has been applied to a wide range of interests. Courts, however, disagree regarding the precise scope of the term "interest," which is not defined in the Bankruptcy Code or its accompanying legislative history. Most courts reject the narrow approach adopted in a minority of cases under which section 363(f) is limited to in rem property interests or only those claims that have already been asserted at the time the property is sold. Instead, the majority have construed the term broadly to encompass other obligations that may flow from ownership of property, including, for example, successor liability claims. See, e.g., Indiana State Police Pension Tr. v. Chrysler LLC (In re Chrysler LLC), 576 F.3d 108 (2d Cir. 2009), judgment vacated on other grounds, 558 U.S. 1087 (2009); In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir. 2003); UMWA 1992 Benefit Plan v. Leckie Smokeless Coal Co. (In re Leckie Smokeless Coal Co.), 99 F.3d 573 (4th Cir. 1996); In re PBBPC, Inc., 484 B.R. 860 (B.A.P. 1st Cir. 2013); In re ARSN Liquidating Corp., 2017 WL 279472 (Bankr. D.N.H. Jan. 20, 2017). 

The scope of section 363(f) becomes an issue if a debtor-lessor seeks to sell property free and clear of the possessory interests of tenants or subtenants. This is so because section 365(h)(1) specifically protects such interests. As noted previously, section 365(h)(1) provides that, if the trustee or DIP rejects an unexpired real property lease under which the debtor is the lessor, the nondebtor lessee (and any permitted successor or assign) has the option to either: (i) treat the lease as terminated and file a claim for breach; or (ii) retain its rights under the lease for the balance of the lease term (including any renewal or extension periods) "to the extent that such rights are enforceable under applicable nonbankruptcy law." 

In enacting section 365(h)(1), lawmakers sought to "codify a delicate balance between the rights of a debtor-lessor and the rights of its tenants" by preserving the parties' expectations in a real estate transaction. In re Lee Road Partners, Ltd., 155 B.R. 55, 60 (Bankr. E.D.N.Y. 1993). The provision's legislative history indicates that lawmakers intended that rejection of a lease by a debtor-lessor should not deprive the tenant of its estate for the term for which it bargained. See H.R. Rep. No. 95-595, 349–50 (1977); S. Rep. No. 95-989, 60 (1978).

Qualitech

The apparent conflict between sections 363(f) and 365(h)(1) was considered as a matter of first impression at the court of appeals level by the Seventh Circuit in Qualitech. In that case, a chapter 11 debtor sold substantially all of its assets (including a steel mill with a warehouse leased to Precision Industries, Inc. ("Precision") for 10 years) to the mortgagee of the property. At the time of the sale, the debtor had neither assumed nor rejected the Precision lease. The order approving the sale provided that the assets were to be conveyed "free and clear of all liens, claims, encumbrances, and interests," other than those specifically excepted. The Precision lease, which was unrecorded, was not among the exceptions. Precision was notified of the sale but chose not to object. Instead, it negotiated with the ultimate buyer of the property regarding the assumption of its lease. Those negotiations proved futile, and Precision's lease agreement ultimately was deemed rejected in accordance with the terms of the debtor's chapter 11 plan. 

Precision commenced litigation seeking a determination that, pursuant to section 365(h) of the Bankruptcy Code, it retained a possessory interest in the warehouse notwithstanding the sale of the property. The bankruptcy court ruled that, under the terms of both section 363(f) and the sale order, the new owner had obtained title to the property free and clear of Precision's leasehold interest. According to the court, that interest clearly qualified as "any interest" under the statute and was unequivocally "extinguished" by the terms of the sale order. The court also implicitly rejected the idea that section 365(h) somehow preserved Precision's rights. 

Precision appealed to the district court, which reversed. Reasoning that sections 363(f) and 365(h) are incongruous, the district court held that "the terms of section 365(h) prevail over those of section 363(f) as applied to the rights of lessees." It concluded that the more specific terms of section 365(h) must override the more general scope of section 363(f), observing that "[t]here is no statutory basis for allowing the debtor-lessor to terminate the lessee's position by selling the property out from under the lessee, and thus limiting a lessee's post-rejection rights solely to cases where the debtor-lessor remains in possession of its property." The new owner of the property appealed to the Seventh Circuit. 

The Seventh Circuit reversed. Given the U.S. Supreme Court's observations in other contexts that "interest" is a broad term, the Seventh Circuit concluded that the right conferred by a leasehold upon the lessee "readily may be understood as an 'interest' in the property" within the meaning of section 363(f). 

The Seventh Circuit faulted the district court's reliance upon an apparent contradiction between the two provisions as a basis for reversing the bankruptcy court. First, the Seventh Circuit noted, the provisions themselves do not suggest that one supersedes or limits the other, whereas other subsections of both sections 363 and 365 contain specific cross-references to other provisions that have a limiting effect on their scope. The court then observed that the plain language of section 365(h) suggests that it is limited in scope. In particular, section 365(h) expressly applies only to situations where the trustee rejects a lease but retains ownership of the property. By contrast, if the trustee does not reject the lease but sells the underlying property under section 363(f), as occurred in Qualitech, the sale will be free and clear of the tenant's possessory interest (provided it meets one of the five conditions in section 363(f)). 

According to the Seventh Circuit, a lessee is not without recourse if its leasehold rights are extinguished in this way. Section 363(e) gives the lessee the right to demand adequate protection of its interest in the property. This would most likely take the form of compensation for the value of its forfeited leasehold interest. 

A number of lower courts have reached the same conclusion as the Seventh Circuit for some or all of the same reasons. See, e.g., In re Downtown Athletic Club of N. Y. City, Inc., 2000 WL 744126 (S.D.N.Y. June 9, 2000); South Motor Co. v. Carter-Pritchett-Hodges, Inc. (In re MMH Auto. Grp., LLC), 385 B.R. 347 (Bankr. S.D. Fla. 2008).

Other courts have ruled to the contrary, reasoning that section 363(f) and section 365(h) conflict when they overlap, but that the more specific section 365(h) trumps section 363(f), and the legislative history of the former clearly indicates that lawmakers intended to protect a tenant's leasehold estate when the landlord files for bankruptcy. See, e.g., Dishi & Sons v. Bay Condos LLC, 510 B.R. 696 (S.D.N.Y. 2014) (criticizing Qualitech and adopting a third reading of the interplay between sections 363 and 365(h)); In re Zota Petroleums, LLC, 482 B.R. 154 (Bankr. E.D. Va. 2012); In re Samaritan Alliance, LLC, 2007 WL 4162918 (Bankr. E.D. Ky. Nov. 21, 2007); In re Haskell, L.P., 321 B.R. 1 (Bankr. D. Mass. 2005); In re Churchill Props. III, Ltd. P'ship, 197 B.R. 283 (Bankr. N.D. Ill. 1996). Those decisions represented what was considered to be the majority view on this issue.

Some commentators have also criticized Qualitech, which, according to one commentator, had "the potential to profoundly impact the bankruptcy world." Michael St. Patrick Baxter, Section 363 Sales Free and Clear of Interests: Why the Seventh Circuit Erred in Precision Industries v. Qualitech Steel, 59 Bus. Law. 475, 475 (2004); see also Robert M. Zinman, Precision in Statutory Drafting: The Qualitech Quagmire and the Sad History of § 365(h) of the Bankruptcy Code, 38 John Marshall L. Rev. (2004) (acknowledging the turmoil created by Qualitech and suggesting an alternative statutory reading).

Spanish Peaks

In Spanish Peaks, the Ninth Circuit affirmed lower court rulings that, under appropriate circumstances, real property could be sold pursuant to section 363(f) free and clear of tenants' leasehold interests notwithstanding section 365(h) because the sale did not amount to rejection of the lease. The court explained that, on the basis of a "proper understanding of the concept of 'rejection,'" sections 363(f) and 365(h) can "easily" be read to give effect to each while preserving their respective purposes. Spanish Peaks, 872 F.3d at 899. Although a sale free and clear of a lease may be considered an effective rejection of the lease "in some everyday sense," the Ninth Circuit wrote, "it is not the same thing as the 'rejection' contemplated by section 365," which requires an "affirmative declaration by the trustee that the estate will not take on the obligations of a lease or contract made by the debtor." Id.

Because the leases at issue were not formally rejected by the chapter 7 trustee, and the leases were not deemed rejected under section 365(d)(1) or 365(d)(4)(A), the Ninth Circuit concluded that section 365(h) simply did not apply.

Citing the reasoning in Qualitech with approval, the Ninth Circuit panel explained that section 363(e) makes mandatory the adequate protection of an interest to be terminated in a free‑and-clear sale if requested by the holder of the interest. Adequate protection could take the form of a lessee's continued possession of its leasehold interest. The broad definition of "adequate protection," the Ninth Circuit panel wrote, "makes it a powerful check on potential abuses of free-and-clear sales." Id. at 900.

Next, the court emphasized that section 363(f) authorizes free-and-clear sales only under certain circumstances, including when "applicable nonbankruptcy law permits sale of such property free and clear of such interest." Under applicable state law, the Ninth Circuit explained, a foreclosure sale to satisfy a mortgage terminates a subsequent lease on the mortgaged property. According to the court, "[the debtor's] bankruptcy proceeded, practically speaking, like a foreclosure sale … [and] had [the debtor] not declared bankruptcy, we can confidently say that there would have been an actual foreclosure sale," which would have terminated the leases.

The Ninth Circuit found it significant that section 365(h) recognizes appurtenant rights conferred by a lease "to the extent that such rights are enforceable under applicable nonbankruptcy law," and it saw "no reason to exclude the law governing foreclosure sales from the analogous language in section 363(f)(1)." Id.

Finally, the Ninth Circuit panel explained that its analysis "highlights a limitation inherent in the 'majority' approach"—namely, although section 365(h) embodies lawmakers' intent to protect lessees, "that intent is not absolute" and coexists with competing purposes, such as the goal of maximizing creditor recoveries. According to the court, its reading of sections 363(f) and 365(h) most faithfully balances those competing purposes in the way Congress intended. Id.

Other courts have adopted the Spanish Peaks rationale in authorizing sales free and clear of leasehold interests. See, e.g., In re Giga Watt, Inc., 2021 WL 321890 (B.A.P. 9th Cir. Jan. 29, 2021); In re Royal Alice Props., LLC, 637 B.R. 465 (Bankr. E.D. La. 2021), stay pending appeal denied, 2022 WL 326636, mandamus denied, 26 F.4th 326 (5th Cir. 2022).

Royal Street

Royal Alice Properties, LLC ("RAP") owned three properties in New Orleans. RAP's sole equity holder was Susan Hoffman ("Hoffman"). The properties were leased to Hoffman as her personal residence and to commercial tenants Royal Street Bistro, L.L.C. ("RSB") and Picture Pro, LLC ("Picture Pro" and, collectively with RSB and Hoffman, the "Tenants"). 

In August 2019, RAP filed for chapter 11 protection in the Eastern District of Louisiana. Shortly afterward, it commenced an adversary proceeding against AMAG Inc. ("AMAG"), the mortgagee of the properties, seeking a determination of the validity, extent, and priority of disputed liens AMAG had asserted against the properties.

While the adversary proceeding was pending, the court appointed a chapter 11 trustee. The court then granted summary judgment in favor of AMAG in the adversary proceeding. In July 2021, the trustee sought court approval of a settlement with AMAG and a sale of the properties free and clear of AMAG's liens and the Tenants' leasehold interests. 

The Tenants responded by filing a motion for adequate protection of their leasehold interests under section 363(e) in the form of retained possession of the leased premises through the end of their purported 20-year leases. They also asked the court to require the trustee to assume or reject the leases, arguing that rejection would trigger the protections set forth in section 365(h).

The bankruptcy court approved the settlement and the sale, but denied the Tenants' motion for adequate protection and an order compelling the trustee to assume or reject the leases. According to the bankruptcy court: (i) because AMAG could have foreclosed on its mortgages under state law and thereby extinguished the Tenants' leasehold interests, the properties could be sold free and clear of those interests under section 363(f)(1), which permits a sale free and clear if "applicable bankruptcy law permits sale of such property free and clear of such interest"; and (ii) because Picture Pro had not paid any rent for several months and was therefore in default of its lease, that property could be sold free and clear of the lease under section 363(f)(4), which permits a sale free and clear if "such interest is in bona fide dispute."

The Tenants appealed the ruling to the district court and simultaneously sought an emergency stay of the bankruptcy court's order pending the appeal. The district court denied the motion for a stay. Both the bankruptcy court and the district court relied on Qualitech and Spanish Peaks in denying the Tenants' requested relief.

The Tenants then filed a petition with the Fifth Circuit for a writ of mandamus compelling the district court to issue a stay pending appeal.

The Fifth Circuit's Ruling

A three-judge panel of the Fifth Circuit issued a per curiam (summary) opinion denying the Tenants' petition for a writ of mandamus. Such opinions generally provide no explanation for the court's ruling.

However, in this case, the court explained that "A brief explanation of our conclusion is necessary because both the bankruptcy court and the district court premised their denials of relief to the [Tenants], in part, on unnecessary and likely incorrect interpretations of the relationship between Sections 363 and 365 of the Bankruptcy Code." Royal Street, 26 F.4th at 327.

According to the Fifth Circuit, the bankruptcy court's first reason for authorizing the sale free and clear of the Tenants' leasehold interests—because AMAG could have foreclosed on the properties outside of bankruptcy and "wiped out the junior interests"—was "well grounded on state law." Moreover, Picture Pro's failure to pay any rent and default under its lease "provided another nonbankruptcy law basis for declining to allow that tenant to stop the sale free and clear." Id. at 328.

However, the Fifth Circuit wrote, both lower courts "made the mistake of relying on [Qualitech] for the excessively broad proposition that sales free and clear under Section 363 override, and essentially render nugatory, the critical lessee protections against a debtor-lessor under Section 365(h)." Id. In addition, the Fifth Circuit noted that both lower courts also relied on Spanish Peaks, "which essentially adopted Qualitech, but noted, importantly, that the leases there (as in this case) were legally subordinated to a senior mortgagee's interest in the real property." As a result, according to the Fifth Circuit, "Spanish Peaks, like the case before us, is susceptible of a narrower reading." Id. 

The Fifth Circuit acknowledged that the arguments on either side regarding the interplay between sections 363(f) and 365(h) are "textually sophisticated, fact-laden, and deeply rooted in commercial law far beyond the scope of the mandamus petition before us." Even so, it explained, "the essential state law rights of the tenants in this case are limited by the senior mortgagee's prior lien" on the properties. As such, "neither Section 363(e) nor 365(h)(1)(A)(ii) offers protection." Id. at 329.

The Fifth Circuit concluded that, even though the lower courts' reasoning was flawed, their rationale did not create "the kind of serious misinterpretation of law or facts that would support one of the criteria for mandamus relief." However, the Fifth Circuit cautioned, courts must not "blithely accept[] Qualitech's reasoning and textual exegesis."

Outlook

In Royal Street, the Fifth Circuit denied the petition for mandamus because it agreed with the result reached by the lower courts, but took issue with the lower courts' rationale. For this reason, instead of issuing a summary opinion, the court of appeals elected to offer an explanation in which it clearly distanced itself from Qualitech's broad pronouncements regarding the primacy of section 363(f) sales when it comes to leasehold interests that would otherwise be protected by section 365(h). The Fifth Circuit was also careful to note that Spanish Peaks does not speak as broadly on this point as the lower courts assumed in authorizing the Royal Street sale free and clear of the Tenants' leasehold interests, principally because, as in Royal Street, the leases in Spanish Peaks were never rejected (meaning that the protections of section 365(h) were not triggered) and the leasehold interests were legally subordinated to a mortgage under applicable state law.

In so ruling, the Fifth Circuit provided some rare appellate guidance on a question that has reached the federal courts of appeals only in a handful of cases, especially in connection with bankruptcy asset sales, where appeals are frequently foreclosed by the Bankruptcy Code's statutory mootness provisions.

A version of this article was published in Lexis Practical Guidance. It appears here by permission.