9th Cir. Holds ‘Free and Clear’ Bankruptcy Sale Was Not Rejection of Unexpired Leases, Did Not Implicate 11 U.S.C. § 365(h)

The U.S. Court of Appeals for the Ninth Circuit recently held that a bankruptcy trustee was authorized to sell real estate free and clear of unexpired leases under 11 U.S.C. § 363(f), and the sale was not a rejection of the unexpired leases and therefore did not implicate 11 U.S.C. § 365(h).

In so ruling, the Ninth Circuit adopted the minority approach established in Precision Indus., Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003), which held that sections 363 and 365 may be given full effect without coming into conflict with one another.

By allowing the bankruptcy trustee to sell the property free and clear of the unexpired leases, in the Ninth Circuit’s view, the estate was able to fetch higher price for the property and maximized recovery for all creditors.

A copy of the opinion in Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC is available at:  Link to Opinion.

The developer of a 5,700-acre resort in Montana obtained a $130 million loan secured by a mortgage and assignment of rents from a lender, who later assigned the note and mortgage to a limited liability company.  A collection of interrelated entities owned the resort and managed its amenities, including a ski club, golf course, and residential and commercial real-estate sales and rentals.  At issue are two leases of commercial property at the resort.

The developer defaulted on loan payments and petitioned for bankruptcy protection.  The limited liability company had a claim of more than $122 million secured by the mortgage on the property, making it the largest creditor in the bankruptcy, and subsequently assigned its interest to an assignee (“creditor”).  The bankruptcy trustee and creditor agreed to a plan for liquidating “substantially” all of the developer’s real and personal property, and stated that the sale would be “free and clear of all liens.”

The trustee moved the bankruptcy court for an order authorizing and approving the sale free and clear of all liens except for certain specified encumbrances, and provided that other specified liens would be paid out of the proceeds of the sale or otherwise protected.

The two leases at issue were not mentioned in either the list of encumbrances that would survive the sale, or the list of liens for which protection would be provided.  The lessees objected and argued that 11 U.S.C. § 365 gave them the right to retain possession of the property notwithstanding the trustee’s sale.

After the bankruptcy court authorized the sale, the creditor won the auction with a bid of $26.1 million and argued that its bid was contingent on the property being free and clear of the leases.  The bankruptcy court approved the sale, and the order stated that the sale was free and clear of any “Interests,” a term defined to include any leases “(except any right a lessee may have under 11 U.S.C. § 365(h), with respect to a valid and enforceable lease, all as determined through a motion brought before the Court by proper procedure).”

The trustee then requested leave to reject the two leases because the subject property was no longer property of the estate.  Meanwhile, the creditor moved for a determination that the property was free and clear of the leases.  The lessees renewed their prior arguments as objections to the creditor’s motion.

At the evidentiary hearing, the bankruptcy court determined, among other things, that one of the leases was below fair market rental value, that the leases were junior to the creditor’s mortgage, and were not protected from foreclosure of the creditor’s mortgage by subordination or non-disturbance agreements.  Based on these findings, the bankruptcy court held that the sale was free and clear of the two commercial leases.  The lessees appealed to the district court, which affirmed, and this appeal followed.

The principal issue on appeal is whether the two leases survived the trustee’s sale of the property to the creditor.

As you may recall, 11 U.S.C. § 363 authorizes the trustee to sell property of the estate, both within the ordinary course of business and outside of bankruptcy.  See 11 U.S.C. § 363(b), (c).  Sales may be “free and clear of any interest in such property of an entity other than the estate,” only if:

(1) applicable nonbankruptcy law permits sale of such property free and clear of such interest;

(2) such entity consents;

(3) such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on the property;

(4) such interest is in bona fide dispute; or

(5) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.

11 U.S.C. § 363(f).

Meanwhile, 11 U.S.C. § 365 of the Code authorizes the trustee, “subject to the court’s approval,” to “assume or reject any executory contract or unexpired lease of the debtor.”  11 U.S.C. § 365(a).  The rejection of an unexpired lease leaves a lessee in possession with two options:  treat the lease as terminated (and make a claim against the estate for any breach), or retain any rights—including a right of continued possession—to the extent those rights are enforceable outside of bankruptcy.  11 U.S.C. § 365(h).

When the trustee sells property free and clear of encumbrances, and one of the encumbrances is an unexpired lease—federal courts have addressed the interplay between 11 U.S.C § 363 and 11 U.S.C. § 365 in different ways.

The majority of bankruptcy courts that have addressed this issue held that sections 363 and 365 conflict when they overlap because “each provision seems to provide an exclusive right that when invoked would override the interest of the other.”  In re Churchill Props., 197 B.R. 283, 286 (Bankr. N.D. Ill. 1996); see also In re Haskell, L.P., 321 B.R. 1, 8-9 (Bankr. D. Mass. 2005); In re Taylor, 198 B.R. 142, 164-66 (Bankr. D.S.C. 1996).  These courts held that section 365 trumps section 363 under the canon of statutory construction that the specific prevails over the general, and the legislative history regarding section 365 evinced a clear intent by Congress to protect a tenant’s estate when the landlord files bankruptcy.

However, in Precision Indus., Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003), the U.S. Court of Appeals for the Seventh Circuit held that sections 363 and 365 may be given full effect without coming into conflict with one another, because lessees are entitled to seek “adequate protection” under 11 U.S.C. § 363(e), and were not without recourse in the event of a sale free and clear of their interests.

The Ninth Circuit here followed the Seventh Circuit, and held that sections 363 and 365 did not conflict.  Section 363 governed the sale of estate property and section 365 governed the rejection of a lease, and according to the Ninth Circuit, where there was a sale but no rejection (or a rejection, but no sale), there was no conflict between the statutes.  Here, because the parties agreed that the two leases were not rejected prior to the sale, the Ninth Circuit ruled that section 365 was not triggered.

The Ninth Circuit noted that a limitation in the majority approach was that while it protected lessees, a property subject to a lease would presumably fetch a lower price and therefore reduce the value of the property of the estate.  Therefore, this approach is contrary to the goal of maximizing creditor recovery, which was a core purpose of the Bankruptcy Code.

Accordingly, the Ninth Circuit affirmed the lower court’s ruling that the bankruptcy trustee’s sale of the debtor’s property was free and clear of unexpired leases.

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Eric Tsai practices in Maurice Wutscher’s Commercial Litigation and Consumer Credit Litigation groups, and in its Regulatory Compliance group. He concentrates his practice primarily on the defense of consumer and commercial financial services companies, including mortgage lenders and servicers, mortgage loan investors, third party debt collectors, and other financial services providers. He also counsels clients on regulatory compliance, licensing, and other consumer protection matters. Eric earned his undergraduate degree from the University of California, Irvine. Prior to attending law school, he worked as a loan officer for national direct lenders. He earned his Juris Doctor from California Western School of Law and thereafter obtained a Master of Laws (LLM) in Taxation from the University of San Diego School of Law. Eric publishes extensively on various issues affecting consumer lending and litigation, including both federal and California-specific developments. He is licensed to practice law in California, Nevada, and Oregon, and is admitted in all United States District Courts in the State of California, the United States District Court for the District of Oregon, the United States District Court for the District of Nevada, the U.S. Tax Court, and the Ninth Circuit Court of Appeals. He is also a licensed real estate broker in the State of California.