Section 365(h) of the Bankruptcy Code provides tenants special protections in the event their landlord files for bankruptcy, by giving tenants the option of retaining their possessory rights under their leases, notwithstanding the landlord’s rejection of such leases.  A question that has divided courts across the county is what happens to a tenant’s possessory interest in the leasehold when the debtor-in-possession (“DIP”) or a trustee seeks to sell the underlying real property free and clear of all “interests” pursuant to section 363(f)?  In other words, does a sale of the property “free and clear” extinguish a tenant’s possessory interests in the real property notwithstanding section 365(h)?  Nearly all courts that have considered the issue had held that section 365(h) trumps section 363(f) under the canon of statutory construction that “the specific prevails over the general,” and that a section 363(f) sale order cannot extinguish a lessee’s possessory interest in the real property being sold.

On July 13, the Ninth Circuit weighed in on the interplay between sections 363(f) and 365(h) of the Bankruptcy Code in a dispute between the undersecured lender, which purchased certain estate assets from the chapter 7 trustee (including real property leased by the debtor to non-debtor tenants Pinnacle and Opticom) and Pinnacle and Opticom.  In Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In the Matter of Spanish Peaks Holdings II), No. 15-35572 (hereinafter “Spanish Peaks”), the Ninth Circuit held that a non-ordinary course sale of estate assets pursuant to sections 363(b) and 363(f) was free and clear of the possessory rights of a non-debtor tenant codified in section 363(h) of the Bankruptcy Code.  By so holding, the Ninth Circuit deviated from the “majority approach” and instead followed the approach of the Seventh Circuit in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537 (7th Cir. 2003) (hereinafter “Qualitech”).

Specifically, the Ninth Circuit in Spanish Peaks harmonized section 363(f) with section 365(h) by holding that these statutory provisions do not actually conflict because each provision addresses a distinct set of facts.  Section 363(f) is only triggered by a DIP or trustee’s decision to sell estate assets by motion that seeks a sale free and clear of interests in the assets being sold.  Section 365(h), on the other hand, only applies when a DIP or trustee moves to reject an unexpired lease of real property.  The Ninth Circuit held that “[w]here there is a sale, but no rejection (or a rejection, but no sale), there is no conflict.”

The Ninth Circuit’s holding in Spanish Peaks is aided by a convenient procedural posture—that is, the trustee in the chapter 7 case had not moved to reject the unexpired commercial leases with Pinnacle and Opticom prior to seeking a sale of the real property, and thus section 365(h) was not triggered.  This was also true in Qualitech.  This posture, while convenient to the Court’s ruling that there is no conflict between sections 363(f) and 365(h), is limiting insofar as it is difficult to apply this holding to a fact pattern whereby a trustee or DIP had in fact moved to reject the unexpired leases of real property, and had rejected the unexpired leases, prior to moving the sell estate assets free and clear of the non-debtor tenant’s possessory rights codified in section 365(h).  Under this alternative fact pattern, sections 363(f) and 365(h) do overlap and arguably conflict in terms of each statutory provision’s intended outcome.  Section 363(f) purports to sell real property free and clear of a non-debtor tenant’s possessory right while section 365(h) allows a non-debtor tenant of a rejected lease to remain in possession of the real property notwithstanding the trustee’s sale.

It remains to be seen whether the Ninth Circuit’s decision will be limited to cases where section 365(h) has not been triggered by a rejection motion prior to the sale pursuant to section 363(f).  Regardless, the decision offers some guidance for practitioners even in cases where a free and clear sale follows on the heels of a lease rejection motion.

First, the Ninth Circuit pointed to a lessee’s right under section 365(e) to “adequate protection” in connection with a DIP or trustee’s sale of real property free and clear of a tenant’s leasehold interest as a counterweight to stripping the tenant of its possessory rights.  So long as a lessee makes a formal demand for adequate protection prior to the approval of a sale of assets free and clear of the tenant’s leasehold interests, the bankruptcy court is required to ensure that the tenant’s interests are adequately protected.  At least one court has held that adequate protection could take the form of continued possession along the lines envisioned by section 363(h).

Second, the Ninth Circuit in Spanish Peaks observed that the undersecured lender would have extinguished the tenants’ leasehold interests in the real property had the lender foreclosed its lien under applicable nonbankruptcy law.  Thus, holding that a DIP or trustee could sell free and clear of the tenant’s possessory interests comports with the secured lender’s ability to extinguish the tenant’s possessory rights under nonbankruptcy law.  Because section 365(h) did not give lessees more rights in bankruptcy than they would otherwise have under applicable nonbankruptcy law, there is no basis for making section 363(f) subject to the rights of tenants under section 365(h).

The absence of a motion to reject the unexpired leases in Spanish Peaks should not be afforded too much significance.  Whether or not a trustee or DIP has moved to reject an unexpired lease prior to moving to sell assets free and clear is, practically speaking, irrelevant.  This is so because by virtue of moving to sell real property free and clear of leasehold interests, the trustee or DIP is effectively repudiating the leases encumbering the real property that is the subject of the sale motion.  See Dishi & Sons v. Bay Condos LLC, 510 B.R. 696 (S.D.N.Y. 2014) (section 365(h) preserves lessee’s appurtenant rights in the event of rejection but does not preclude the trustee from terminating such rights under another provision (i.e., section 363(f)) of the Code).  In this regard, the Ninth Circuit’s  decision did not go as far as it could have;  it could have held that a tenant’s sole protection in connection with a section 363(f) sale is demanding adequate protection under section 363(e), irrespective of whether the trustee had actually moved to reject the unexpired lease.   Whether other courts adopt this approach in the wake of the Spanish Peaks decision remains to be seen, but at least in the Ninth and Seventh Circuits, this is where the case law appears to be heading.