Relating to Real Estate

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Tenants May Lose Their Leases in a Bankruptcy Sale

In a recent decision, the United States Court of Appeals for the Ninth Circuit held that a bankruptcy trustee’s right to sell property free and clear of all “interests” under the Bankruptcy Code superseded a tenant’s right to remain in possession of its leasehold when its lease is rejected by a landlord debtor under a separate section of the Code. As a result, two tenants of the bankrupt debtor lost their leases in a sale free and clear of interests. In re Spanish Peaks Holdings II, LLC, 862 F.3d 1148 (9th Cir. 2017).

The statutory problem is that Section 363(f) of the Code provides that a trustee may sell property free and clear of any interest under certain conditions while, on the other hand, Section 365(h) of the Code permits a tenant to remain in possession for the remainder of its lease term if its lease is rejected by a landlord who is a debtor. Neither Sections363(f) nor 365(h) refers to the other.

Under the facts of the Ninth Circuit’s decision, prior to bankruptcy the debtor, which operated a large resort in Montana, entered into two long-term, below-market leases with related parties. The leases were not recorded, and the tenants did not obtain non-disturbance agreements from a lender whose mortgage lien was senior to the leases. The resort failed and ended up in Chapter 7 bankruptcy. The court-appointed trustee moved for authority to sell the property under Section 363(f) free and clear of all interests and served notice of the motion on the tenants under the two leases. The tenants opposed the sale on the basis that Section 365(h) gave them the right to remain in possession of their leased premises notwithstanding the sale. Their objections were overruled, and the property was sold to the mortgage lender free and clear of the leases.

On appeal, the Ninth Circuit held that the tenants’ objections were properly overruled. Although the court noted that its decision was in the minority of courts that have considered the issue, it primarily relied upon an earlier decision of the Seventh Circuit in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537 (7th Cir. 2003). In Qualitech, the Seventh Circuit held that Sections 363(f) and 365(h) were not in conflict because Section 363(f) provided for a sale of property and Section 365(h) dealt with lease rejections. In addition, the Ninth Circuit noted that the result of its decision is the same as the result of a foreclosure sale by the mortgage holder because under Montana law (as well as the laws of Maryland and most jurisdictions), leases that are subordinate to a mortgage are wiped out in a foreclosure sale absent a non-disturbance agreement.

The Qualitech decision has been heavily criticized by other courts and legal commentators as a misreading of the Bankruptcy Code. Nevertheless, the only two appellate courts that have considered the issue have ruled that a lease may be eliminated through a bankruptcy sale free and clear of all interests. Although neither the Fourth Circuit nor the Maryland courts have addressed the issue, tenants are at risk if they ignore a notice of a bankruptcy sale by their landlord in a Chapter 11 case or by their landlord’s trustee in either a Chapter 7 or 11 case. Unless the tenant acts quickly to oppose the sale, its lease may be eliminated.

For questions, please contact Larry Coppel (410) 576-4238.