Courts consistently have held that the sale of real property under the Bankruptcy Code cannot "strip off" the leasehold interests in that property. Until now, only one case held to the contrary and was generally considered an outlier. A second court's decision to allow the "stripping off" of a leasehold interest in a bankruptcy sale may have a significant impact on future distressed commercial real estate situations and may also spur an uptick in litigation.

When a lessor/debtor in a bankruptcy case rejects a real estate lease, the lessee is afforded certain statutory protections under Section 365(h) of the Bankruptcy Code. In such cases, the non-debtor lessee can treat the lease as terminated and assert a damages claim. In the alternative, it can waive any claim against the bankruptcy estate, retain possession of the leasehold property for the balance of the lease term, and continue to pay rent, offset by any actual costs incurred based on non-performance by the debtor/lessor. In a nutshell, the non-debtor lessee has the right to "pay and stay."

Section 363 of the Bankruptcy Code gives a debtor the ability to sell property of the bankruptcy estate free and clear of liens and interests. Under the usual scenario, liens held by secured creditors are stripped off and attached to the sale proceeds, essentially "cashing out" the liens through the sale.

But leases are not lien interests that can be satisfied by cash-sale proceeds. Rather, they are possessory property interests to which Congress has assigned the aforementioned statutory rights. As such, nearly all courts that have considered the issue have not allowed leasehold interests to be "stripped off" by the "free and clear" provisions of Section 363 in the sale of a leased property.

Until this month, the 2003 Qualitech case in the U.S. Court of Appeals for the Seventh Circuit (327 B.R. 537) was the only appellate case in the country that allowed lease-stripping through a Section 363 sale. Although the case created an initial stir, no other courts adopted its reasoning. But Qualitech now has company.

Qualitech's new companion arrived just days ago when the U.S. Court of Appeals for the Ninth Circuit rendered its decision in In re. Spanish Peaks Holdings II, LLC, 2017 WL 2979660 (July 13, 2017), holding that a free-and-clear sale order under Section 363 trumps the rights of lessees under Section 365(h). This decision allowed two leases to be stripped off in a sale, thereby dispossessing the lessees. The two stripped leases were held by insider entities under below-market lease terms, but that did not play a part in the court's legal reasoning.

The Ninth Circuit's decision will be subject to challenge as it is deployed in other cases. First, the court reasoned that the disposed lessees could have sought "adequate protection" under Section 363(e) of the Bankruptcy Code, but failed to do so. The court's treatment of "adequate protection" boils down to the maxim: "If you don't ask for it, you don't get it." This reasoning fails to recognize, however, that adequate protection is a basic constitutional requirement that allows the Bankruptcy Code to alter property rights in the first place. Property rights do not appear or disappear based on whether a creditor or executory contract party asks for protection. Further, this rationale rings hollow when considering the facts of the Spanish Peaks case. It was a Chapter 7 liquidation case in which the debtor could not have provided adequate protection, and the buyer made the elimination of the leases without compensation to the lessees a condition of the purchase. Thus, any request by the lessees for adequate protection would have been futile.

More importantly, the court's decision alters the rights of lessees based solely on the timing of a sale and lease-rejection motion.

Ninth Circuit case law suggests that rejection of a lease is a breach only and is not tantamount to abandonment. The leaseholds remained property of the estate after rejection, albeit without a right of possession. Therefore, the stripped leases will have to be rejected by motion or by operation of law after the sale is consummated in order to clean up the estate. However, in Spanish Peaks, because the 363 sale order was entered before a rejection order, the lessees did not have the statutory protections of Section 365(h) that they would have had if the rejection occurred before the sale order was entered.

Thus, the Ninth Circuit's decision sanctions a scenario in which the meaning of the statute and the rights of the parties can be altered merely by the sequencing of the motions filed and the orders entered in the bankruptcy case.

This will be fertile ground for the creative deployment of these Bankruptcy Code provisions. One can imagine a debtor that owns a shopping center or an office building negotiating a sale of its income property that involves the assumption of the "good leases" and the stripping of the "bad leases" before a rejection motion is filed or the mandatory time period for assumption or rejection of leases is reached, thereby negating the rights of the "bad lease" tenants to "pay and stay" under Section 363(h).

All participants in distressed commercial real estate transactions should be aware of this development, which debtors and potential purchasers of distressed real estate assets undoubtedly will use to their advantage. Just as certain is the litigation that will be created by the implementation of the strategies created by the Spanish Peaks decision, which still represents the minority position on lease-stripping under the Bankruptcy Code.

Attorneys in the firm's Bankruptcy, Reorganization and Capital Recovery Group handle all facets of financial distress, including restructurings, workouts, the refinancing of debt, creditor-debtor litigation, asset dispositions and recapitalizations, reorganizations, and liquidations, both in and outside of formal proceedings.

Attorneys in the firm's Leasing Group regularly assist clients in commercial lease transactions. Their work covers the full range of issues for landlords and tenants nationwide in a variety of industries, who rely on us to protect their interests in the industrial, commercial, office, retail, and special use spaces.

Copyright © 2017 by Ballard Spahr LLP.
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This alert is a periodic publication of Ballard Spahr LLP and is intended to notify recipients of new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own attorney concerning your situation and specific legal questions you have.